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Contents lists available at ScienceDirect

Research Policy
journal homepage: www.elsevier.com/locate/respol

Firm R&D, innovation and easing financial constraints in China: Does

corporate tax reform matter?
Anthony J. Howell
School of Economics, Peking University, China

a r t i c l e i n f o a b s t r a c t

Article history: This paper studies the relationship between firms’ innovation activities, financial constraints and corpo-
Received 19 January 2016 rate tax reform in China. A firm-level proxy for financial constraints is derived using cash-flow analysis and
Received in revised form 29 June 2016 subsequently linked to various innovation activities of the firm. As an identification strategy, difference-
Accepted 11 July 2016
in-differences with exact matching is employed to study whether a reduction in the corporate tax burden
Available online xxx
via China’s 2004 value-added tax (VAT) reform influences firms’ innovation activities given they face
increasing financial constraints. The results reveal that low access to liquidity in the private sector has
JEL classification:
a persistent negative effect on firms’ innovation activities and reduces the innovation success for more
D22
O16
R&D intensive firms. Given increasing financial constraints, a reduction in private-sector firms’ corporate
O31 tax burden spurs new product and process sales despite failing to affect either their decision to pursue
R&D or the amount to invest. The findings suggest that easing financial constraints alone cannot correct
Keywords: the market failure caused by underinvestment in China’s private sector.
Financial constraints © 2016 Elsevier B.V. All rights reserved.
Firm R&D
Innovation
Tax reform
China

1. Introduction In the empirical literature, existing studies generally confirm

Development of the financial sector plays an important role
in society that promotes technological innovation and economic
development (Schumpeter, 1911). In advanced market economies,
financial intermediaries help to finance tangible and intangible
investments, thereby enabling firms to pursue innovation (King
and Levine, 1993). In the absence of well-functioning financial sys-
tems, however, as is often the case in transitioning economies, a
lack in the availability of credit can constrain resource allocation
and reduce firm-level investment (Paravisini, 2008).
Investments in intangible assets like R&D are particularly sensi-
tive to financial constraints due to the significant amount of initial
capital infusion required in order to purchase high-tech equipment
and pay high-skilled workers (Hall and Lerner, 2010). As a result,
low access to liquidity may prevent potentially profitable R&D
investment opportunities from happening when firms are unable to
rely on internal funds, leading to a market failure in innovation that
adds to that created by the public good nature of R&D knowledge.
In turn, by diminishing R&D spending, financial constraints may
reduce firms’ innovation as well as their economic performance
(Carpenter and Petersen, 2002).
E-mail address: tonyjhowell@pku.edu.cn
that a lack of access to liquidity constrains firms’ innovation
activities (Aghion et al., 2012; Brown et al., 2012; Howell, 2015b),
although the effects may be heterogenous across different firms
and industries (David and Hall, 2000). Several recent contributions
using natural experiments show that a reduction in the firms’
financial constraints promote technological innovations (Amore
et al., 2013). Amore et al. (2013), for instance, find that an expansion
in credit supply brought about by interstate banking deregulation
in the U.S. increased firms’ patenting activities, particularly for
firms highly dependent on external capital and located closer
to entering banks. These findings highlight the importance of
specific policies to alleviate financial constraints and motivate
technological innovation.
Relatedly, discussions about corporate taxation reforms and
innovative competitiveness have emerged at the forefront of policy
discourse. A tax hike is generally thought to reduce firm innovation
because it may lower firms’ internal cash flows, which are a major
source of innovation financing (Hall and Jorgenson, 1967). In line
with this view, several empirical studies show that firms innova-
tion activities are sensitive to both specific tax changes related to
R&D (e.g. R&D tax credits) (Bloom et al., 2002), as well as changes
in the general corporate tax rates (Mukherjee et al., 2016). Despite
these findings, there is a longstanding skepticism over whether tax
reforms can effectively address the market failure embodied in the

http://dx.doi.org/10.1016/j.respol.2016.07.002
0048-7333/© 2016 Elsevier B.V. All rights reserved.

Please cite this article in press as: Howell, A.J., Firm R&D, innovation and easing financial constraints in China: Does corporate tax reform
matter? Res. Policy (2016), http://dx.doi.org/10.1016/j.respol.2016.07.002
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2 A.J. Howell / Research Policy xxx (2016) xxx–xxx
relationship between financing constraints and firms’ innovation
activities (Mansfield, 1986; Grossman and Helpman, 1991).
Drawing from the above discussion, the current paper attempts
to study the linkages between firm innovation, financial constraints
and corporate tax reform in China. First, cash-flow analyses are
carried out to derive a firm-level proxy for financial constraints.
Next, the financial constraints proxy is separately linked to the fol-
lowing firm-level innovation indicators: (i) the decision to invest
in innovation estimated using a random effects probit model; (ii)
the investment intensity, correcting for selection bias,1 estimated
using the consistent estimator introduced in Wooldridge (1995);
and (iii) the new product and process sales intensity estimated
using a random effects model.
It is acknowledged upfront that the relationship between
financial constraints and firms’ innovation activities is likely
to be endogenous. As an identification strategy, China’s 2004
value-added tax (VAT) reform is used to study the impacts of a
liquidity shock via a reduction in the corporate tax burden on the
innovation activities of firms with varying degrees of liquidity
constraints. A key concern about China’s 2004 VAT reform is that
the affected areas and sectors may be non-random, leading to
concerns of selection bias in the policy treatment. Ultimately, to
control for this source of selection bias, exact matching combined
with the difference-in-differences estimator is used to better
identify the causal effect of VAT reform on financially constrained
firms’ innovation activities.
This paper makes the following main contributions to the liter-
ature. First, the effects of financial constraints is linked to several
dimensions of the innovation process. Typically, existing studies
tend to focus on studying the effects of financial constraints on only
one stage of innovation, i.e. R&D investments or patenting activities.
There is strong evidence, however, that low access to liquidity may
influence various dimensions of the innovation process, including
the decision to invest and the amount of that investment (Bond
et al., 2005), as well as firms’ innovative performance in the later
stages (e.g. patents, and new products, processes and services)
(Fagerberg et al., 2005).
The second main contribution of this paper pertains to study-
ing the effects of loosening financial constraints on innovation in a
transitioning economy context. Previous studies have shown that
a reduction in firms’ financial constraints spurred innovation in
advanced market economies such as the U.S. (Amore et al., 2013;
Nanda and Nicholas, 2014). However, the same outcome is not nec-
essarily expected to occur in transitioning economies like China,
in part, because the co-existence of other innovation barriers may
reduce the firm’s ability to recoup innovation-related sunk costs.2
Chinese firms may therefore opt to not pursue innovation even after
their financial constraints are loosened.
The outline of the paper is as follows. The subsequent section
links innovation, financial constraints and corporate tax reform
in the Chinese context. Section 3 introduces the data. Section 4
outlines the procedure to measure firms’ financial constraints. Sec-
tions 5 and 6 present the main results and Section 7 concludes.
2. Firm innovation, financial constraints and tax reform in
China
In an effort to promote future sustainable growth, China
has emphasized in earnest the promotion of its ‘indigenous’
1
Following the literature, firm size is used to satisfy the exclusion restriction,
which is shown empirically to satisfy the identification assumptions in the current
Chinese context.
2
In addition to binding financial constraints, additional innovation barriers in
China include poor intellectual property rights, lack of consumer demand, and low
talent pool, among others (Howell, 2015a).
Please cite this article in press as: Howell, A.J., Firm R&D, innovation and easing financial constraints in China: Does corporate tax reform
matter? Res. Policy (2016), http://dx.doi.org/10.1016/j.respol.2016.07.002
innovation capabilities (zizhu chuangxin). As a result of its indige-
nous innovation push, China has shifted from a successful low-tech
manufacturing economy to a high-tech economy, and has done so
almost completely under the purview of the general public. Since
the turn of the century, R&D spending as a percentage of its GDP
nearly tripled from 0.75% in 2001 to 2.046% in 2014, second only to
the United States.
Despite its relative innovation success, several barriers pose
serious risks to pursuing innovation in China, including intellec-
tual property theft, a low talent pool, poor institutional protection,
insufficient market demand, and financial constraints, among oth-
ers (Howell, 2015a). Chief among these barriers is the lack of access
to finance, which is considered to be a major constraint on Chinese
innovation particularly for privately-owned enterprises due to dis-
criminate lending practices that favor state-owned enterprises. Hu
et al. (2005), for instance, find that non-R&D performing firms in
the private sector cited the lack of funding as the main constraint
to carrying out R&D.
Access to liquidity is difficult for private firms given that 60%
of lending in China comes from China’s big 4 state-owned banks,
the majority of which go to SOEs (Nee and Opper, 2012). As a result,
hard budget constraints in the private sector, along with fierce com-
petition and the public good nature of new knowledge, force many
private firms to pursue short-term profit maximization strategies
at the expense of investing in R&D projects. Consequently, the pri-
vate sector’s commitment to reaching stated innovation goals is
low, bringing into question the potential that private firms can
contribute to indigenous innovation.
Due, in part, to their recognition of the challenges present in
the investment climate, the Chinese central government began
to experiment with reforms to its value-added tax (VAT) start-
ing in 2004. Initially introduced in 1994, the VAT quickly emerged
as one of the major sources of state-revenue. Unlike in many
other countries, China’s VAT was production-based meaning that
purchases of fixed investment could not be deducted from sales
when calculating VAT liabilities. This led to investment goods being
subject to the VAT twice, first as final products and second as inter-
mediate inputs for their users.
Due to firm investments being subject to double taxation on
investment goods, the main concern was that firms would be
less likely to invest, and continue to operate with old equipment
and out-of-date technology. As a pilot study, China implemented
VAT reforms in 2004 in three northeast provinces (e.g. Liao-
ning, Jilin, and Heilongjiang provinces) in six selected industries
(e.g. agricultural product processing, equipment manufacturing,
petrochemicals, metallurgy, ship building and automobile man-
ufacturing). The VAT reform converted value-added tax from
the original production-based VAT to a consumption-based VAT,
thereby removing the double taxation on investment goods.
Following the 2004 reforms, the VAT’s share of total state tax
revenue declined from approximately 48% in 2002 to 31% by 2009.
To justify the loss in state revenue, the main intended objective of
the VAT reform was to reduce the tax burden on firms in order to
boost their investments in fixed goods, and by extension, intangible
assets. In a recent paper, Lu and Liu (2015) find that the VAT reform
indeed led to a positive effect on firms’ fixed investments, although
the authors’ do not consider the effects of the VAT reform on firms’
innovation behavior.
3. Data
This study utilizes the Annual Report of Industrial Enterprise
(ASIF) Statistics compiled by the State Statistical Bureau (NBS) of
China for the years 2001–2007. The dataset includes all of the
“above scale” SOEs and non-SOEs with annual sales over 5 million
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250
SOE
Semi−POE
POE
200
Number (1000s)
150
100
50
0
2001 2002 2003 2004 2005
Year
Fig. 1. The composition of China’s domestic enterprises, 2001–2007.
Yuan (≈$600,000), which accounts for between 90–95% of indus-
trial output in China during the time period of analysis (Brandt
et al., 2012). The data contain in-depth information about the firm’s
characteristics and many of the financial variables from the firm’s
balance sheet, income statement, and cash flow statement. Fol-
lowing Brandt et al. (2012), the panel is constructed over time
by using the firm’s name, industry, address, etc. to assign unique
numerical IDs. Overall, 95.9% of all year-to-year matches are con-
structed using firm IDs, and 4.1% using other information on the
firm.
An important advantage of the ASIF dataset is that it provides
information about the firm’s ownership structure, although in real-
ity, it is inherently difficult to know the ultimate owner of the firm.
For instance, 15% of the firms that legally register as state-owned
enterprises are not actually state-owned based on the share of paid-
in capital. For this reason, information about the share of paid-in
capital rather than the firm’s legal designation is used to identify
firm ownership types.
To take into account differences in access to liquidity, firms are
accordingly split into three classifications based on the share of
state-owned capital. Privately-owned enterprises (POEs) are firms
where the majority shareholder is a private, non-state entity and
the state holds no stake in the company. Semi-privately-owned
enterprises (semi-POEs) or hybrids are also firms where the major-
ity shareholder is a private, non-state entity, but the state remains
as a minority shareholder. Lastly, SOEs are firms where the state is
the majority shareholder.
Fig. 1 shows the change in the number of enterprises and the
ratio of POEs, semi-POEs, and SOEs. The number of China’s domes-
tic enterprises increased from over 125,000 in 2001 to over 250,000
in 2007. The increase in the total number of firms is driven by the
entrance of POEs, most of which were previously smaller firms that
grew their sales revenue above the 5 million RMB threshold as
opposed to being new startups. The ratio of POEs increased sig-
nificantly during the time period from approximately 0.55 in 2001
to more than 0.90 in 2007.
Please cite this article in press as: Howell, A.J., Firm R&D, innovation and easing financial constraints in China: Does corporate tax reform
matter? Res. Policy (2016), http://dx.doi.org/10.1016/j.respol.2016.07.002
3
0.9
POE
0.8 Semi−POE
SOE
0.7
0.6
Ratio
0.5
0.4
0.3
0.2
0.1
0.0
2006 2007 2001 2002 2003 2004 2005 2006 2007
Year
Another advantage of the ASIF dataset is that it contains infor-
mation on the amount of firms’ investments in R&D and the amount
of new product and process sales. In regards to the firms’ new prod-
uct and process sales, most Chinese firms during the 2001–2007
time period were not actually bringing forth products and processes
that were new to the world, rather they were engaged in incremen-
tal types of innovation based on imitation practices. As pointed out
by Lu and Tao (2009), a large percentage of the new product or pro-
cess sales include revenue streams that stem from the adoption of
external technology developed by other firms in different regions.
Table 1 provides the descriptive statistics related to firms’ inno-
vation activities. The percent of POEs engaged in R&D decreased
slightly from 11.5% in 2001 to 10.1% by 2007, due in part, to the
large number of POEs that entered into the sample during the time
period. R&D spending increased substantially across all firm owner-
ship types, although SOEs increased their investments by 216.4%
compared to 70.2% for POEs. New product and process sales inten-
sity also increased rapidly over the time period, around 33% across
each firm ownership type.
Despite being among the largest and most comprehensive Chi-
nese firm database, the ASIF data also suffers from a number of
shortcomings, such as accounting errors, sample selection issues
and missing information. Several steps are taken to minimize these
issues. First, observations that have negative or zero values for key
variables such as capital, inputs, output and total workforce are
removed from the sample. Second, observations are dropped if total
assets are less than liquid assets or total fixed assets.
Lastly, issues about sample selection exist. First, the minimum
sales threshold of 5 million RMB is strictly enforced on non-SOEs
but this is not the case for SOEs. To ensure that the sample of firms
is comparable, all state enterprises with less than 5 million RMB
in revenue sales are removed from the sample. Second, while the
ASIF data includes information on over 400,000 firms, nearly 30%
of these firms report information for only one consecutive year. A
main reason why firms exit the sample in the same year that they
enter is because their sales dropped below the minimum threshold.
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Table 1
Summary information on firms’ innovation activities by ownership type.
Pursue R&D (0 = No, 1 = Yes)
2001 2007 % Change
POEs 0.115 0.101 −12.2
Semi-POEs 0.175 0.238 36.0
SOEs 0.121 0.147 21.5
In order to reduce attrition in the sample, only firms that report at
least two consecutive years of information are kept in the sample.
4. Measuring financial constraints
Since the seminal contribution by Fazzari et al. (1988), the iden-
tification strategy for financing constraints has become centered
around the firms’ cash flows (Cleary, 1999). The two most com-
mon approaches include estimating a reduced from of accelerator
models of investment or using the more recent structural approach
of Euler equations. Empirically, both of these approaches used to
estimate financial constraints on investments in innovation are the
same as for physical investments.
The Euler equation is a structural model derived from a
dynamic optimization problem under the assumption of symmet-
ric, quadratic costs of adjustment, relating current investment
to last period’s investment and the marginal product of capital.
While Kaplan and Zingales (1997) criticize methods that rely on
investment-cash flow sensitivities to derive a proxy for financial
constraints, their critique has yet to be proven theoretically in a
dynamic multi-period setting with investment adjustment costs.
Besides the Euler model offers several advantages over the other
alternatives based on Q theory. First, the assumptions required
to estimate the Euler equation are less strong (Moreno-Badia and
Slootmaekers, 2009). Second, the Euler approach can control for
all expectational influences on the investment decision. Lastly, the
Euler approach does not require any information on the firms’ mar-
ket value or dividends, which are typically used to derive proxies
for financial constraints based on Q theory. Such information is not
available in the ASIF dataset since the majority of sampled firms
are not publicly listed.
4.1. Euler equation approach
The Euler approach is a dynamic investment model and is esti-
mated using a generalized method of moments (GMM) estimator.
Standard errors will be inconsistent due to the fixed effects being
correlated with the lagged dependent variable. First differencing
the equation removes the fixed effects, removing concerns related
to omitted-variable bias. However, the dependent variable contin-
ues to bias the coefficient estimates, and many of the variables are
jointly endogenous. To control for these biases, the so-called sys-
tem GMM method is used to instrument for variables that are not
strictly exogenous using lagged first differences in levels, in addi-
tion to the usual lagged levels as instruments for equations in first
differences (Arellano and Bover, 1995; Blundell and Bond, 1998).
The empirical specification of the Euler equation is as follows:
 I   Iit−1
  Sales   Cash 
it it−1 it−1
= 0 + 1 + 2 + 3
Kit−1 Kit−2 Kit−1 Kit−1
+ ˛i + ıt + it
where Iit is the investment expenditure of firm i at time t. Note
that because no direct measurement of firm’s fixed investment is
included in the ASIF data, the procedure outlined in Brandt et al.
(2012) is used to construct the firm’s capital stock and estimate
Please cite this article in press as: Howell, A.J., Firm R&D, innovation and easing financial constraints in China: Does corporate tax reform
matter? Res. Policy (2016), http://dx.doi.org/10.1016/j.respol.2016.07.002
R&D intensity (%) New product/process sales intensity (%)
2001 2007 % Change 2001 2007 % Change
0.121 0.206 70.2 2.423 3.648 33.6
0.129 0.363 181.4 2.718 4.113 33.9
0.183 0.579 216.4 2.515 3.736 32.7
firm investment.3 Salesit−1 is the net revenue received from the
sales of products, goods, and services in the previous year. Cashit−1
represents a firm’s internal financial position, measured by its stock
of liquid assets at the start of period t. ˛i represents a firm-fixed
effect and ıt denotes a time dummy.
A firm is considered to be financially constrained if the cash
coefficient,  3 , is estimated to be positive. The basic idea behind
this equation is that the larger the sensitivity of investment to cash
stock (or cash flow), the more constrained the firm is because it has
to rely on its internal funds to finance its investment projects.
4.2. Empirical model
In general, the existing literature tends to compare the cash sen-
sitivity of investment for firms after splitting them up into groups
based on a characteristic that is expected to, a priori, affect financial
constraints. However, dividing firms on the basis of one indicator
may not always be sufficient, since firms of the same subgroup may
face financial constraints heterogeneously because of other factors
that are not controlled for. In addition, firms are not allowed to
transition between the financially constrained and unconstrained
groups.
To correct for these issues, some studies employ an endogenous
switching regression method with unknown sample separation,
which does not require prior information about whether a firm is
financially constrained (Almeida and Campello, 2007). The main
drawback with this method, however, is that it makes very restric-
tive assumptions about the underlying investment model. As
an alternative approach, Moreno-Badia and Slootmaekers (2009)
construct a firm-level score of cash sensitivity based on several
characteristics (e.g. firm size, age, and leverage) that may influ-
ence the firm’s ability to access liquidity, while controlling for the
information contained in the other factors.
Following this alternative approach, this paper considers the fol-
lowing set of firm characteristics to proxy for the degree of financial
constraints: size, age, leverage, export intensity and subsidy inten-
sity. In general, smaller firms tend to have a higher sensitivity of
investment to internal funds. This is because smaller firms often
lack sufficient collateral, show a more volatile pattern of growth
and earnings, and greater difficulties in raising debt since they are
more prone to bankruptcy. Similar with size, firm age is another fac-
tor that influences the firm’s financial constraints. Younger firms
face larger agency and information problems and lack sufficient
collateral to obtain external financing.
The relationship between leverage and investment is ambigu-
ous in the literature (Lang et al., 1996). While a higher leverage
indicates that firms have had previous access to external finance,
being heavily indebted reduces firms’ current funds available for
investment and may create larger hurdles in accessing additional
sources of external capital. Firms that export are thought to be less
credit constrained because they are usually more profitable and
have more access to collateral. Similarly, firms that receive more
(1)
subsidies from the state will signal to investors and banks that the
3
Note that all pecuniary variables are depreciated with 2-digit price deflators
constructed by Brandt et al. (2012).
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Table 2 variables are treated as potentially endogenous. Each regression

Euler equation specifications.
includes time dummies to control for idiosyncratic disturbances
Iit /Kit−1 (system GMM) over time as well as interactions of the variable Cashit /Kit−1 with
two-digit industry dummies to allow for differences in finan-
POE Semi-POE SOE
(1) (2) (3) cial constraints across sectors. The results from the Sargan and
Hansen tests for over-identifying restrictions are unable to reject
Iit−1 /Kit−1 0.653*** 0.845*** 0.834***
(0.005) (0.026) (0.026) the validity of the instruments, and the tests of second-order serial
Salest /Kt−1 0.057*** 0.015** 0.229*** correlation find no evidence of second-order autocorrelation in the
(0.001) (0.005) (0.033) differenced residuals.
Casht /Kt−1 × Size −0.526*** −0.474*** −0.320*** The results indicate that the coefficients on lagged investment
(0.008) (0.079) (0.051)
Casht /Kt−1 × Age −0.007* −0.176*** −0.128***
and sales have the correct sign and are positive irrespective of firm
(0.003) (0.023) (0.020) ownership status. The coefficients on the interactions of the cash
Casht /Kt−1 × Leverage −0.017 −0.191** −0.274*** variable tend to conform to expectations. Larger and older firms
(0.015) (0.075) (0.062) face significantly less financial constraints. Highly indebted firms
Casht /Kt−1 × Export 0.379*** 0.079* 0.003
tend to experience significant liquidity constraints. Lastly, more
(0.009) (0.039) (0.048)
Casht /Kt−1 × Subsidies 0.114*** 0.036*** 0.018* export- and subsidy- intensive firms, respectively, encounter sig-
(0.004) (0.009) (0.008) nificantly fewer hurdles to accessing external funds.
Industry dummies Yes*** Yes*** Yes***
Time dummies Yes*** Yes*** Yes*** 4.3. Deriving a firm-level score for financial constraints
Number of firms 105,025 13,408 8320
Sargan test 0.00 0.00 0.00 The estimated coefficients for the  s and the ı s obtained in Eq.
Sargan/Hansen 0.325 0.278 0.218
(2) can be used to calculate a firm-specific score of financial con-
AR(2) 0.348 0.318 0.271
straints based on the firm’s characteristics. Note that although the
Notes: Heteroskedasticity consistent standard errors are reported in parentheses. coefficients are constant over the entire sample period, the charac-
The Sargan/Hansen and autocorrelation specification tests are reported as p-values.
All regressions include time dummies as well as Casht /Kt−1 interactions with two-
teristics of each firm change over time; hence, the degree of firms’
digit industry dummies; although not reported, the p-values for the Wald test of financial constraints also varies over time. The firm level score is
joint significance are shown for both groups of included variables. K is the firm’s derived as follows:
tangible and intangible fixed assets, net of accumulated depreciation, and is con-
structed as defined in Brandt et al. (2012). Sales is the firm’s net revenue received
from the sale of products, goods and services. Cash is the ratio of cash flow over total ˆ 1 Sizeit + 
F̂it =  ˆ 2 Ageit + 
ˆ 3 Levg it + 
ˆ 4 Export it
tangible fixed assets, where cash flow is defined as the sum of the firm’s net income
and depreciation. Leverage is the ratio of the firm’s short-term liabilities to total ˆ 5 Subsidiesit + ı̂n Industryn
+ (3)
assets (net of accumulated depreciation). Export is the ratio of firm’s exports to total
productivity. Subsidies is the ratio of the amount of production-related subsidies the where the firm faces financial constraints if F̂it > 0, and an increas-
firm receives from the state or local governments to total productivity. ing F̂it indicates a higher degree of liquidity constraint that the firm
*
p < 0.05.
** faces.
p < 0.01.
***
p < 0.001. Table 3 shows the overall magnitude and distribution of the
degree of financing constraint across firm ownership types. For ease
of interpretation, if a firm is not financially constrained (i.e. F̂it ≤ 0),
firm has the support of the state and is less likely to fail, and are thus
the FC Score is censored to zero.4 Not surprisingly, the proportion
likely to be less financially constrained (Hyytinen and Toivanen,
of firms that face financial constraints is substantially higher for
2005).
POEs (80.8%) compared to semi-POEs (52.5%) and SOEs (35.1%). In
To assess the statistical significance of a given factor in proxy-
addition, POEs face more extreme financial constraints as indicated
ing financial constraints, each of the above-discussed variables is
by the higher mean value.
interacted with (Cashit−1 /Kit−1 ) in Eq. (2):
Table 4 shows how the proxy for financial constraints and
 I  
I
  Sales  firms’ innovation activities vary by industry. Overall, the degree
of financial constraints are quite heterogenous across industries.
it
= 0 + 1 it−1 + it−1
2
Kit−1 Kit−2 Kit−1 The degree of overall financial constraints is highest in the Agro-
  food processing industry (0.95), which is more than twice as large
Cashit−1 as in the Communication equipment industry (0.44). This does not
+ 3 × + ˛i + ıt + it (2)
Kit−1 imply, however, that firms in less constrained industries are not
financially constrained. Looking at the standard deviations, indus-
with
tries with a larger overall degree of financial constraints tend to
have larger variation across firms.
 = 1 ln (Size)it + 2 ln (Age)it + 3 Levg it + 4 Export it
5. Linking financial constraints to firms’ innovation
+ 5 Subsidiesit + ı1 Industry1 + · · · + ıN IndustryN .
activities
Sizeit is measured as the total number of firm employees, Ageit is
the age of the firm, Levgit is the ratio of long-term liabilities to total In order to study how access to liquidity may influence indige-
assets, Exportit is ratio of exports to firm’s total productivity, and nous innovation in China, the financial constraints proxy, F̂it , is
Subsidiesit is the ratio of production-related subsidies to the firm’s separately linked to the firm’s: (i) decision to pursue R&D, (ii) R&D
productivity. Lastly, sensitivity of investment to cash across indus- intensity, and (iii) innovation intensity. For (i) and (ii), the R&D
tries is also taken into account by allowing for a different intercept intensity of the firm is observed if, and only if, firms decided to
for each 2-digit CIC industry (Industry1 , . . ., IndustryN ).
Table 2 presents the results from the Euler equation model.
A system GMM estimator is applied combining equations in first 4
Note that only a minority of firms have a score less than zero and that the results
differences with equations in levels. All of the right-hand side are not sensitive to censoring.

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Table 3
Summary information for the financial constraints proxy.

# of firms Firms with financial constraints Financial constraints (F̂it )

(F̂it > 0)

# % Mean Standard deviation

POE 105,025 84,284 80.8 0.712 0.579

Semi-POE 13,408 7034 52.5 0.468 0.368
SOE 8320 2920 35.1 0.284 0.127

Notes: Financial constraints are calculated based on Eq. (3).

invest in R&D. Therefore, equation (i) is a selection equation indi-
cating whether or not the firm pursues R&D and equation (ii) is the
outcome equation. Taking advantage of the panel structure of the
data, equation (i) is estimated using a random effects probit model,
expressed as follows:
 RDI it =
RD∗it
(1) (1)
1 if = ı(1) F̂itn + ˇ(1) xit + ˛i + it
RDit =
if RD∗it = ı(1) F̂itn + ˇ(1) xit + ˛i
(1) (1)
0 + it ≤ c̄
where RDit is an (observable) indicator function that equals 1 if
firm i decides to pursue R&D in year t, and 0 otherwise. RD∗it is
a latent indicator function whereby the firm incurs R&D expend-
itures if these are above a given threshold c̄. F̂itn proxies for the
(1)
firm’s financial constraints, and xit is a vector of explanatory vari-
ables that includes the firm’s age, size, and capital intensity, and a
set of 2-digit industry dummies. The firm’s age and size are both
important factors that influence firm’s innovation activities. Cap-
ital intensity is included in order to avoid capturing the effects of
(1)
financial constraints on firms’ capital accumulation. ˛i captures
the unobserved firm heterogeneity.
(1)
Finally, it is an error term. The random effects structure
assumes that the errors are not correlated with the regressors,
an unrealistic assumption in this case. To address this issue, the
Mundlak specification is used by including a vector of means of
the time-varying regressors as control variables to allow for some
correlation between the random effects and the regressors.
Given the firm’s decision to invest in innovation, the firm’s R&D
intensity is estimated as follows:

RDI ∗it = ı(2) F̂itn + ˇ(2) xit + ˛i
(2) (2) (2)
+ it if RDit = 1
(5)
(1)
> c̄ RDI it = 0 if RDit = 0
(4)
(1)
where RDI ∗it is the unobserved latent variable representing the
firm’s R&D intensity (the ratio of R&D expenditures to the firm’s
(2)
total sales revenue). F̂itn , xit , and their corresponding parameters,
(2) (2)
along with ˛i and it have the same interpretation as in Eq. (1).
Correcting for selection effects, Eq. (2) is estimated using the con-
sistent estimator introduced in Wooldridge (1995). That is, a pooled
OLS model is estimated including T inverse mills ratios (interacted
with time dummies), which are obtained from estimate T probit
models (one for each year).
Because the inverse mills ratio is used, it is required to find an
exogenous variable to satisfy the exclusion restriction for more
robust estimation. In this case, it is decided to use firm size to
satisfy the identification assumption. That is, the size of the firm
is expected to influence the decision to invest in innovation, but
it does not affect the intensity of that investment once the deci-
sion to invest has been taken. The appropriateness of this exclusion
restriction is briefly discussed as follows.

Table 4
Financial constraints and innovation activities by industry.

# of firms Financial constraints (F̂it ) Innovation activities

Mean Standard deviation R&D intensity New product and process sales intensity

Agro-food processing 7272 0.95 0.70 0.05 1.13

Timber 2747 0.80 0.59 0.02 1.94
Smelting of non-ferrous metals 2522 0.76 0.64 0.08 2.87
Smelting of ferrous metals 3211 0.75 0.65 0.03 1.76
Furniture 1483 0.74 0.59 0.05 2.27
Non-metallic mineral products 10, 073 0.73 0.58 0.09 2.08
Beverage manufacturing 1636 0.71 0.60 0.09 2.38
Raw Chemicals 9141 0.69 0.57 0.18 3.23
Leather 2899 0.69 0.56 0.04 2.37
Manufacture of Artwork 2804 0.68 0.55 2.38 2.47
Rubber 1527 0.67 0.54 0.12 3.05
Pharmaceuticals 2652 0.67 0.47 0.87 7.66
Food manufacturing 2751 0.67 0.54 0.11 2.21
General machinery 11, 336 0.64 0.53 0.18 3.96
Plastics 6073 0.64 0.52 0.07 2.42
Apparel 5660 0.64 0.53 0.03 2.07
Paper 3810 0.63 0.50 0.03 1.30
Chemical fibers 805 0.62 0.52 0.10 3.84
Printing 2274 0.62 0.44 0.06 1.36
Special machinery 5501 0.60 0.49 0.52 6.19
Measuring instruments 1726 0.59 0.45 1.17 9.21
Textiles 12, 878 0.59 0.52 0.05 2.18
Metallic mineral products 7772 0.57 0.48 0.07 2.18
Articles for cultures and sports 1464 0.57 0.47 0.07 2.78
Electrical machinery 7985 0.54 0.46 0.28 5.29
Transportation equipment 5547 0.53 0.45 0.27 5.21
Communication equipment 3204 0.44 0.36 1.18 10.09

Notes: Financial constraints are calculated based on Eq. (3).

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Table 5
Estimating the effects of financial constraints on firms’ innovation effort.

R&D decision (RE probit) R&D intensity (consistent estimator)

POE Semi-POE SOE POE Semi-POE SOE

(1) (2) (3) (4) (5) (6)

FC Score −0.048*** −0.011 −0.009 −0.012** −0.024 −0.115

(0.010) (0.194) (0.080) (0.004) (0.034) (0.158)
Size 0.044*** 0.075*** 0.121** ... ... ...
(0.003) (0.012) (0.054) ... ... ...
Age 0.011*** 0.029** −0.010 0.032*** 0.043*** 0.015
(0.001) (0.012) (0.024) (0.008) (0.012) (0.021)
Capital intensity 0.040*** 0.092*** 0.081* 0.036*** 0.073*** 0.148*
(0.018) (0.022) (0.039) (0.011) (0.010) (0.064)

Time dummies Yes*** Yes*** Yes*** ... ... ...

Industry dummies Yes*** Yes*** Yes*** Yes*** Yes*** Yes***
Number of firms 105,025 13,408 8320 105,025 13,408 8320
Means Yes*** Yes*** Yes*** Yes*** Yes*** Yes***
Rho 0.811 0.745 0.781 ... ... ...
Corrected predictions 74.2% 77.2% 78.3% ... ... ...
IMR * time dummies ... ... ... Yes*** Yes*** Yes***

Notes: Columns (1)–(3) report marginal effects (at the means) for the probability of engaging in R&D and Columns (4)–(9) are reported as coefficients. Bootstrapped standard
errors in parentheses. Means of the time-varying regressors are included as control variables to allow for some correlation between the random effect and the regressors.
Rho is the percentage of total variance contributed by the panel-level variance component (Rho > 0 indicates that the panel estimator is different from the pooled estimator).
The interaction between IMR (inverse Mills ratio) and time dummies is significant at 0.1% confirming the inclusion of a selection equation in Columns (7)–(9).
*
p < 0.05.
**
p < 0.01.
***
p < 0.001.

It is well known that larger firms tend to benefit from various
advantages related to innovation.5 Empirically, however, Cohen
and Klepper (1996) show that there is a positive and proportional
relationship between R&D investment and size of the firm. That is
large firms invest more in R&D in level but not proportionally more
once the decision to invest has been taken. Moreover, in transition-
ing economy contexts, a positive association is usually reported
between size and propensity to invest, yet the results regarding
R&D intensity indicate that those larger firms are not necessarily
the ones that invest the most (Crespi and Zuniga, 2012).
Nevertheless, the relationship between firm size and R&D
expenditures is likely to be highly context specific. As an empir-
ical check, the relationship between firm size and R&D intensity is
compared for smaller and larger firms by industry (see Table A1
in the appendix). In 20 out of 27 two-digit industries, there is no
statistically significant difference in the amount of R&D spending
by larger and smaller firms. Of the 7 industries where statistical
significance is observed, there is no clear trend that suggests larger
firms spend more on R&D. These results help confirm that using
firm’s size as the exclusion restriction is valid.
Table 5 reveals the results linking firms’ financial constraints to
their decision to invest in R&D and the amount of expenditures. The
coefficients on the FC proxy are negative across each specification
irrespective of firm ownership, but are only statistically significant
for POEs. The lack of statistical significance on semi-POEs and SOEs
helps to confirm that the share of state ownership matters in terms
of the firm’s ability to access external liquidity. State-backed firms
benefit from favorable lending practices, whereas firms in the pri-
vate sector without state support have lower access to liquidity,
and are therefore, unable to collateralize research activities.
In terms of the other control variables, the estimated coefficients
are in line with expectations. Older firms are more likely to invest
in R&D, and invest more intensively, across each specification
(although the coefficients on SOEs are not statistically significant).
Capital intensive firms are more likely to invest in R&D and invest
more intensively across each specification.
5
For instance, larger firms benefit from R&D fixed costs spread over greater out-
put, economies of scope relating to R&D production, and R&D diversification.
In order to examine the effects of financial constraints on new
product and process sales, a knowledge production function is used
to estimate equation (iii) above. It is expressed as:
Innovit = ı(3) F̂itn + RDI ∗it−1 + ˇ(3) xit + ˛i
(3) (3) (3)
+ it (6)
where Innovit is a continuous variable corresponding to the firm’s
innovation intensity (the ratio of new product and process sales to
firms’ total sales revenue). RDI ∗it−1 is the latent R&D intensity pre-
dicted in Eq. (2) lagged one time period to take into account the
‘time to build,’ opportunity cost and uncertainty inherent in the
innovation process. The other parameters have the same interpre-
(3) (1)
tation as before, and xit includes the same variables as xit above.
In line with Eqs. (1) and (2), a random effects model is used to esti-
mate Eq. (3). Note that RDI ∗it is estimated for all firms, not just firms
that report positive investments in innovation. This assumption is
based on the fact that all firms exert some kind of innovative effort,
but may not necessarily report those efforts.
Table 6 reports the results, which shows that financial con-
straints have a negative and statistically significant effect on firms’
new product and process sales, but only for POEs. In line with
the literature (Fagerberg et al., 2005), these findings suggest that
private-sector firms’ innovation financing behavior is not strictly
limited to R&D; rather financial constraints may also affect other
aspects of innovation as well. In particular, firms pursue activi-
ties besides R&D, such as the acquisition of complementary assets,
which involve different costs and different degrees of risk bearing
for innovative firms, and are therefore relevant to the demand and
supply of their external capital.
An interaction term between financial constraints and R&D
intensity is included in Columns (4)–(6) to examine whether or not
financial constraints reduce firms’ R&D efficiency. The results show
that the interaction term is negative and statistically significant, but
only for POEs, an indication that more R&D intensive firms in the
private sector are less successful innovators due to their insufficient
access to liquidity. As state above, one reason for this outcome is
because the cost of funds influences POEs’ ability to acquire com-
plementary assets in addition to R&D. That is, R&D intensive firms
that face (unexpected) financial constraints may be unable to pur-
chase additional external technologies, particularly new processes,

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Table 6
Estimating the effects of financial constraints on firms’ new product and process sales.

New product and process sales intensity (RE)

POE Semi-POE SOE POE Semi-POE SOE

(1) (2) (3) (4) (5) (6)

FC Score −0.017** 0.151 1.830 −0.018** 0.162 1.109

(0.006) (0.167) (1.287) (0.007) (0.133) (1.480)
R&D intensity *
0.696*** 0.526*** 0.177 0.764*** 0.550*** −0.360
(0.007) (0.066) (0.453) (0.011) (0.104) (1.409)
Size 0.087*** 0.229*** 0.456 0.087*** 0.229*** 0.461
(0.004) (0.050) (0.377) (0.004) (0.050) (0.384)
Age 0.062*** 0.258*** −1.175** 0.063*** 0.257*** −1.185**
(0.005) (0.053) (0.402) (0.005) (0.053) (0.409)
Capital intensity 0.086*** 0.248*** 0.782* 0.087*** 0.248*** 0.778*
(0.004) (0.064) (0.345) (0.004) (0.064) (0.355)
FC Score × R&D intensity* ... ... ... −0.128*** −0.057 −0.226
... ... ... (0.014) (0.171) (1.822)

Time dummies Yes*** Yes*** Yes*** Yes*** Yes*** Yes***

Industry dummies Yes*** Yes*** Yes*** Yes*** Yes*** Yes***
Number of firms 105,025 13,408 8320 105,025 13,408 8320
R2 within 0.109 0.145 0.198 0.111 0.148 0.195
R2 between 0.124 0.213 0.232 0.122 0.214 0.232
R2 overall 0.119 0.225 0.219 0.117 0.226 0.221

Notes: Bootstrapped standard errors in parentheses.

*
p < 0.05.
**
p < 0.01.
***
p < 0.001.

which in turn, limit their ability to convert innovation inputs into
new innovation sales.
5.1. Alternate specifications and robustness checks
Several alternative specifications and robustness checks are
estimated in Table 7. Note that only the coefficient estimates
for the financial constraints variable are reported. Taking into
account both firm- and industry-level heterogeneity, the sample
of firms is broken up for each firm ownership type according to
the firm’s size and age, as well as the firm’s average industrial R&D
intensity and average industrial share of SOE employees. Lastly,
as a robustness check, a standard accelerator model of invest-
ment (Fazzari et al., 1988), which links the demand for capital

Table 7
Alternate specifications and robustness checks.

R&D decision (RE probit) R&D intensity (consistent estimator) New product and process sales
intensity (RE)

POE Semi-POE SOE POE Semi-POE SOE POE Semi-POE SOE

(1) (2) (3) (4) (5) (6) (7) (8) (9)

Firm size
≤100 employees −0.032* −0.193 −0.000 −0.111*** −0.142 −0.189 −0.069* −0.141* −0.025
(0.013) (0.145) (0.179) (0.030) (0.086) (0.167) (0.031) (0.060) (0.142)
>100 employees −0.037 0.048 0.011 −0.101*** 0.151 −0.728 −0.432*** −0.326 0.394
(0.021) (0.086) (0.282) (0.030) (0.197) (0.192) (0.079) (0.396) (0.243)
Firm age
≤5 years −0.054*** 0.028 −0.002 −0.084** 0.027 0.156 −0.150* −0.405 −0.352
(0.016) (0.136) (0.091) (0.029) (0.148) (0.515) (0.070) (0.597) (0.448)
>5 years −0.047* −0.037 0.005 −0.024 0.060 0.108 −0.095*** −0.076 0.144
(0.021) (0.194) (0.003) (0.037) (0.315) (0.593) (0.030) (0.077) (0.196)
Industry R&D intensity
Lower −0.003 0.078 0.000 0.006 0.097 −0.156 −0.024 0.139 0.085
(0.011) (0.074) (0.000) (0.012) (0.090) (0.284) (0.057) (0.474) (0.057)
Higher −0.088*** 0.218 −0.000 −0.228*** 0.436 −0.472 −0.346*** −0.221 −0.259
(0.023) (0.208) (0.000) (0.046) (0.396) (0.373) (0.102) (0.218) (0.141)
Industry share of SOE
Lower −0.042** −0.148 −0.000 −0.033 −0.075 −0.602 −0.524*** 0.192 0.568
(0.015) (0.122) (0.000) (0.023) (0.175) (0.902) (0.073) (0.263) (0.353)
Higher −0.006 −0.205 −0.000 −0.001 −0.564 −0.705 −0.012 0.048 −0.431
(0.020) (0.153) (0.052) (0.038) (0.339) (0.672) (0.085) (0.029) (0.381)
Alternative proxy
Accelerator −0.021*** 0.106 −0.006 −0.019 0.031 0.024 −0.036*** −0.014 −0.218
(0.005) (0.073) (0.005) (0.015) (0.022) (0.143) (0.010) (0.022) (0.129)

Notes: Columns (1)–(3) report marginal effects (at the means) for the probability of engaging in R&D and Columns (4)–(9) are reported as coefficients. Bootstrapped standard
errors in parentheses. As in Table 4, in each specification, the variable means are included in the R&D equations (Columns 1–6) and the IMR * Time Dummies are included in
the R&D intensity equations (Columns 4–6). For all of the regressions (except the last row), the financial constraints are calculated using the Euler equation methodology. In
the last row, the financial constraints are estimated using a standard accelerator model of investment.
*
p < 0.05.
**
p < 0.01.
***
p < 0.001.

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Table 8
Effects of the VAT reforms on financially constrained firms’ innovation activities (CER-DID).

R&D decision (RE probit) R&D intensity (consistent estimator) New product and process sales
intensity (RE)

POE Semi-POE SOE POE Semi-POE SOE POE Semi-POE SOE

(1) (2) (3) (4) (5) (6) (7) (8) (9)

VAT reform −0.016*** −0.019 0.052*** −0.042*** −0.011 0.098** 0.097*** 0.139* 0.156**
(0.003) (0.013) (0.010) (0.008) (0.030) (0.037) (0.020) (0.067) (0.056)
FC Score −0.028*** −0.021 0.023 −0.012*** −0.051 0.043 −0.045*** 0.005 −0.074
(0.001) (0.017) (0.019) (0.002) (0.029) (0.035) (0.005) (0.033) (0.047)
VAT reform × FC Score 0.011 0.026 0.101 0.017 0.089 0.121 0.066** 0.053* 0.024
(0.006) (0.042) (0.056) (0.013) (0.073) (0.079) (0.024) (0.025) (0.021)

Time dummies Yes*** Yes*** Yes*** ... ... ... Yes*** Yes*** Yes***
Industry dummies Yes*** Yes*** Yes*** Yes*** Yes*** Yes*** Yes*** Yes*** Yes***
Number of firms 14,141 1998 1137 14,141 1998 1137 14,141 1998 1137
Means Yes*** Yes*** Yes*** Yes*** Yes*** Yes*** ... ... ...
Rho 0.698 0.781 0.743 ... ... ... ... ... ...
Corrected predictions 83.2% 84.5% 76.3% ... ... ... ... ... ...
IMR * time dummies ... ... ... Yes*** Yes*** Yes*** ... ... ...
R2 within ... ... ... ... ... ... 0.119 0.128 0.081
R2 between ... ... ... ... ... ... 0.172 0.214 0.132
R2 overall ... ... ... ... ... ... 0.142 0.195 0.119

Notes: Columns (1)–(3) report marginal effects (at the means) for the probability of engaging in R&D and Columns (4)–(9) are reported as coefficients. Bootstrapped standard
errors in parentheses. Means of the time-varying regressors are included as control variables to allow for some correlation between the random effect and the regressors.
Rho is the percentage of total variance contributed by the panel-level variance component (Rho > 0 indicates that the panel estimator is different from the pooled estimator).
The interaction between IMR (inverse Mills ratio) and time dummies is significant at 0.1% confirming the inclusion of a selection equation.
*
p < 0.05.
**
p < 0.01.
***
p < 0.001.

goods to the change in firm sales, is used to estimate financial
constraints.
The results show that the negative effect of financial constraints
on POEs’ innovation activities is driven by smaller and younger
firms, respectively. The innovation activities of POEs in more R&D
intensive industries are particularly sensitive to financial con-
straints since they need a large amount of capital infusions to keep
up with the latest technologies and invest in new frontier research.
The innovation activities of POEs in more reformed industries (e.g.
a lower share of SOE employees) face more acute competition
due to liberalization, thereby increasing their risk of foreclosure
and decreasing their attractiveness in terms of accessing external
liquidity. Lastly, the coefficients obtained from using the Acceler-
ator model show that the results on the different firm ownership
types are remarkably robust. That is, financial constraints hinder
the innovation activities of POEs, but not for semi-POEs or SOEs.
In addition, results from the Accelerator model further confirm
that the negative effects of financial constraints on POEs innova-
tion activities persist both in the decision to pursue R&D and in the
amount of new product and process sales. Although the evidence
is less robust in terms of POEs’ R&D intensity (given the decision
to invest has already been made), as seen by the loss of statistical
significance. One reason why POEs may be less affected by financial
constraints in the R&D spending equation is because a firm is more
likely to set up an R&D program if it has (or expects to have) strong
cash flow, in which case, financial constraints will be less binding.
6. VAT reform, financial constraints and innovation
The results obtained in the last section raise the question about
how policies can help to mitigate the negative effects of financial
constraints in the private sector and boost innovation activities.
To address this question, regional variations in China’s 2004 VAT
reform can be used to study how a reduction in firms’ tax bur-
den influences their innovation activities, particularly as they face
increasing financial constraints. A key concern about the 2004 pilot
VAT reform, however, is that the specific areas and sectors may
be non-random, leading to concerns of selection bias in the policy
treatment. To control for this source of selection bias, a method
of difference-in-differences with exact matching is employed to
estimate the impact of VAT reforms on the innovation activities of
financially constrained firms.
A two-stage approach is developed. First, coarsened exact
matching (CEM) is carried out to ensure the comparability between
the treatment and comparison groups (see the Appendix for
a description of the matching technique). Second, difference-
in-differences (DID) estimation is used to help remove the
time-invariant unobserved heterogeneity across firms, such as
industry specific effects and managerial skill. The dependent
innovation variables are first differenced by calculating the differ-
ence between the post-treatment (2004–2007) and pre-treatment
(2001–2003) means on the balanced sample of firms that are
observed both before and after the VAT reforms were implemented
in 2004.
The results are reported in Table 8. The direct impact of the 2004
VAT reform led to a reduction (increase) in POEs’ (SOEs) innovation
effort, and to a positive increase in new product and processes for
all ownership types. In terms of economic magnitude, the size of the
coefficients are largest for SOEs. Not surprisingly, SOEs tend to be
more responsive to changes in state policies intended to encourage
investments. Interestingly, the VAT reform led to an additionality
effect on POEs’ new product and process sales despite having a sub-
stitution effect on their innovation effort. One potential explanation
is that the 2004 VAT reforms decreased the cost of tangible capital
relative to intangible capital, thereby making additional purchases
of fixed investments, including external technologies, more attrac-
tive than investing in R&D. In support of this view, Lu and Liu (2015)
rely on the same ASIF database and find that the 2004 VAT reform
indeed led to substantial increases in firms’ fixed investments. By
contrast, SOEs operating under the mandate of the state are less
sensitive to the relative changes in the cost of R&D capital and are
more concerned with fulfilling the innovation goals set out by the
state.
The coefficients on the interaction term reveal that the VAT
reform led to an increase in new product and process sales for finan-
cially constrained POEs and semi-POEs, respectively, in spite of not

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having any statistically significant effect on their innovation effort.
The results provide some indication that the 2004 VAT reforms
encourages financially constrained firms to innovate more effi-
ciently, in part, by acquiring new external technologies. However,
the easing of financial constraints fails to encourage investment in
indigenous innovation in the private sector, thereby bringing into
question the ability of general tax reforms to promote indigenous
innovation efforts.
Besides shifting the relative cost of intangible capital, another
reason why private sector firms may fail to invest in R&D even after
financial constraints have been relaxed is due to the co-existence of
other barriers to innovation (e.g. weak intellectual property laws,
insufficient market demand, and low talent pool, among others).
Howell (2015a), for instance, shows that some Chinese firms fail to
appropriate adequate gains from their innovation activities due to
various dimensions of innovation risk. Investing in innovation may
remain too risky for many firms even after financial constraints are
relaxed. Private sector firms may therefore prefer to accumulate
physical capital and existing technologies that are already success-
ful in the marketplace in order to reduce unnecessary innovation
risk.
financial constraints matter for investment in transitioning
economies where firms face a variety of other innovation barriers.
Acknowledgements
The author would like to thank the School of Economics at
Peking University for funding support during the preparation of this
manuscript. The author benefited from comments and other forms
of assistance from the editor, Maryann Feldman, two anonymous
referees, Canfei He, Yang Rudai, and participants at the Interna-
tional Conference on Innovation Studies at Tsinghua University. All
errors and omissions are the responsibility of the author.
Appendix A. Empirical check
Table A1
R&D intensity by firm size.
Industry Firm sizea
Smaller Larger Difference

Agro-food processing 0.036 0.091 0.055***

Food manufacturing 0.094 0.084 −0.01
Beverage manufacturing 0.058 0.024 −0.033***
7. Concluding remarks
Textiles 0.027 0.022 −0.006
Apparel 0.021 0.022 0.002
Access to liquidity is a major obstacle for innovation in tran- Leather 0.016 0.013 −0.003
sitioning economies, although it remains unclear to what extent Timber 0.015 0.009 −0.006
financial constraints affect different dimensions of firm innova- Furniture 0.022 0.036 0.014
Paper 0.015 0.016 0.001
tion. In addition, the ability of policies to mitigate the negative Printing 0.034 0.039 0.005
effects of financial constraints and motivate innovation have not Articles for cultures and sports 0.060 0.052 −0.008
been well-documented, especially in transitioning economies. This Raw Chemicals 0.125 0.173 0.047**
paper studied the relationship between firms’ innovation activities, Pharmaceuticals 0.707 0.853 0.145
Chemical fibers 0.074 0.047 −0.027
financial constraints and corporate tax reform within a transition-
Rubber 0.059 0.117 0.057*
ing Chinese economy context. Plastics 0.056 0.064 0.008
The main empirical results are as follows. First, low access to Non-metallic mineral products 0.050 0.043 −0.008
liquidity is associated with lower innovation effort (both the like- Smelting of ferrous metals 0.019 0.018 −0.002
lihood of pursuing R&D and the intensity of that R&D) and lower Smelting of non-ferrous metals 0.038 0.141 0.103***
Smelting of non-ferrous metals 0.050 0.066 0.017
new product and process sales among private-sector firms. Sec- General machinery 0.122 0.140 0.018
ond, financial constraints hinder R&D intensive firms in the private Special machinery 0.439 0.450 0.011
sector from commercializing their research activities, resulting in Transportation equipment 0.127 0.176 0.048**
lower innovative success, most likely because these firms face Electrical machinery 0.186 0.227 0.041
Communication equipment 0.890 0.641 −0.249***
(unanticipated) costs that prevent them from appropriating nec-
Measuring instruments 1.014 1.166 0.152
essary complimentary assets. Manufacture of Artwork 5.071 0.060 −5.011
Third, a loosening of financial constraints via the 2004 VAT a
A firm is designated as a smaller firm if the firm’s total sales revenue is less than
reform spurs new product and process sales despite failing to the median amount for all firms, otherwise it is a larger firm.
promote indigenous innovation in the private sector. General cor- *
p < 0.05.
porate tax reforms may therefore help to encourage new product **
p < 0.01.
***
and process sales, driven in part by the appropriation of external p < 0.001.
technologies, but do not necessarily promote indigenous techno-
logical capabilities in the private sector. A rather straightforward
explanation for this outcome is that the 2004 VAT reform led to Appendix B. Matching techniques
a reduction in the relative cost of tangible investments, making
the acquisition of external technology more attractive compared to Matching techniques are used to construct a control group of
investing in R&D. This explanation is further supported by Lu and firms that match most closely to treated firms based on observable
Liu (2015) who show that the 2004 VAT reform led to increases in characteristics. A list of covariates is linked to China’s 2004 VAT
firms’ fixed investments. reforms in order to identify the most appropriate control group.
While the existing literature indicates that financial constraints The covariates include both firm-level and region-industry level
are a major barrier to innovation in China (Nee and Opper, 2012), variables to take into account various indicators of firm’s internal
reducing them does not necessarily correct the market failure capabilities and productivity while also controlling for the con-
caused by underinvestment. As in other transitioning economies, ditions of the local operating environment. Firms in the control
the prevalence of other innovation barriers (e.g. weak intellectual group are matched to the treatment group on the basis of the pre-
property laws, insufficient market demand, and low talent pool, treatment (1998–2001) mean of these variables.
among others) may further reduce the attractiveness of pursuing A probit model is employed to see if the chosen covariates are
R&D even after financial constraints are relaxed. A major challenge actually important determinants of the VAT reform, expressed as:
for future research is to evaluate policies that specifically target
the cost of R&D in order to better determine whether reducing Treatment it = ˛0 + ˛1 Zij + ˛2 Industryit + it (B.1)

Please cite this article in press as: Howell, A.J., Firm R&D, innovation and easing financial constraints in China: Does corporate tax reform
matter? Res. Policy (2016), http://dx.doi.org/10.1016/j.respol.2016.07.002
G Model
RESPOL-3316; No. of Pages 12 ARTICLE IN PRESS
A.J. Howell / Research Policy xxx (2016) xxx–xxx 11

Table A2
Determinants of 2004 VAT reform.

Dependent variable: 2004 VAT reform

POE Semi-POE SOE

(1) (2) (3)

Firm size −0.004*** −0.002** −0.001

(0.0002) (0.001) (0.001)
Firm age 0.0009*** 0.003** 0.004***
(0.0003) (0.001) (0.001)
Firm capital intensity −0.003*** −0.005* −0.002
(0.0003) (0.002) (0.002)
Firm labor productivity −0.002*** −0.005* −0.004*
(0.0004) (0.002) (0.002)
Firm sales growth −0.003*** −0.004** −0.001
(0.0003) (0.001) (0.003)
Average region-industry exports −0.113*** −0.102*** −0.091***
(0.002) (0.011) (0.015)
Average regional-industry R&D −0.050*** −0.105*** −0.058***
(0.003) (0.014) (0.019)
Average region-industry subsidies 0.027*** 0.047*** 0.033***
(0.0004) (0.002) (0.003)
Average region-industry SOE share −0.007*** −0.011*** −0.011***
(0.001) (0.002) (0.002)
Average region-industry entry rate −0.282*** −0.224*** −0.305***
(1.310) (4.368) (6.863)

Notes: This table tests whether the variables used for propensity score matching are important determinants of the policy treatment. The binary dependent variable equals
1 if the firm is affected by the 2004 VAT reform, and 0 otherwise.
*
p < 0.1.
**
p < 0.05.
***
p < 0.01.

Table A3
Balancing tests for matching: PSM and CER.

Propensity score matching Coarsening exact matching

Mean t-Test Mean t-Test

Treated Matched t-Statistic p-Value Treated Matched t-Statistic p-Value

Firm size 4.602 4.622 −1.459 0.145 4.680 4.702 −0.049 0.963
Firm age 2.093 2.094 −0.098 0.922 2.102 2.091 0.029 0.978
Capital intensity 5.142 5.160 −1.396 0.163 4.749 4.760 −0.094 0.928
Labor productivity 5.441 5.424 1.295 0.195 5.286 5.308 −0.262 0.802
Firm sales growth 1.312 1.304 0.891 0.373 1.036 1.043 −0.059 0.955
Regional exports 0.084 0.085 −1.156 0.248 0.096 0.093 0.187 0.858
Regional RD 0.115 0.114 0.335 0.738 0.104 0.103 0.101 0.923
Regional subs 1.271 1.265 0.848 0.397 1.309 1.310 −0.034 0.974
Regional entry rate 0.047 0.047 −1.036 0.300 0.050 0.048 −0.464 0.665

Notes: Matching method is applied to test whether there is a significant difference between the treated and matched groups on potential determinants of China’s 2004 VAT
policy.

where Treatmentir equals 1 if firm i in year t was exposed to the
VAT reform in 2004, and 0 otherwise. Zij includes a vector of firm
and local industry characteristics, and Industryit includes a set of
industry dummies.
Table A2 shows the results from the estimation of the probit
model. The objective here is to first check whether the selected
covariates are important determinants of the policy treatment. All
covariates are measured by the mean before the policy treatment.
The results show that the covariates are indeed statistically signifi-
cant. In each specification, firms that receive policy treatment tend
to be smaller in size, older in age, less capital intensive, less pro-
ductive, have lower sales growth, and are in local industries that
are less export and R&D intensive, more heavily subsidized, more
reformed and have lower entry rates.
Based on the above determinants of policy treatment, a matched
control group is constructed to compare with treated firms. Propen-
sity score matching (PSM) is the most common matching method
used in observational studies. Although in relation to other match-
ing techniques such as coarsened exact matching (CEM), matching
based on propensity scores has been shown to yield more biased
estimates of the causal effect across different sample sizes (King
et al., 2011). For this reason, both PSM and CEM techniques are
compared below.
To assess the credibility of the matching procedures, a formal
pairwise t-test comparison between the treated and matched con-
trol firms to see whether there are any significant differences using
both PSM and CEM. Table A3 presents the balancing tests, compar-
ing the pre-treatment mean of the VAT determinants between the
treated and matched groups. For both PSM and CEM, the large p-
values indicate that there is no significant difference in the selected
covariates between the treated and matched samples. However,
CEM tends to offer better matches and also retains more firms in
the analysis (n = 17, 276) compared to PSM (n = 13, 351). Therefore,
CEM appears to provide the most appropriate foundation for the
subsequent DID estimation.
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