2.1. Literature Review
In the last decade, China’s innovation capability has been markedly improved. Xi Jinping, who has served as General Secretary of the Communist Party of China, clearly stated that some major disruptive technological innovations were creating new industries or new business model, and that information technology, biotechnology, manufacturing technology, and new material technology had penetrated into almost all fields at the 2016 National Science and Technology Innovation Conference. The pace of the integration of next-generation information technologies, such as big data, cloud computing, and mobile internet with robotics and intelligent manufacturing technologies, has accelerated. Investment in education and research has strengthened the knowledge bases. However, the government’s worry is that, because of the public good aspects of knowledge and market imperfections, adequate resources are not being devoted to knowledge accumulation, resulting in an undersupply of innovation and suboptimal growth of productivity. The desire to remain at the leading edge of technological development or to move to the technological forefront in selected areas has spurred a “technical arms race” and concentrated attention on rankings of technological capability and preparedness. Drawing upon an unusually rich dataset spanning 9752 digitized archival documents, Eriksson et al. (2019) found that successful innovation policies in mature economies largely involve dealing strategically with resourceful vested interests, adjusting expectations, and removing obstacles to industrial renewal [9
]. Ho et al. (2005), using a sample of US firms for an over-40-year period from 1962 to 2001, investigated whether the future share price returns of a firm were positively related to a firm’s R&D intensity and showed that R&D investment creates value for firms over one-year and three-year horizons [10
]. Kalantonis et al. (2020) empirically investigated the effect of R&D disclosed information in firms’ financial statements on the value relevance of the reported accounting, and found that R&D reporting has a significant effect on the association of equity price with accounting data [11
]. They highlight the necessity of an improvement of the legal framework in the direction of an obligatory reporting of capitalized R&D information, which could be more attractive to the investors and shareholders.
What are important tax, legal, and fiscal considerations for a government in fostering business and technological innovation? Fiscal policy is one way how Congress and other elected officials influence the economy by using spending and taxation. The objective of fiscal policy is to create healthy economic growth. Mamuneas and Ishaq (1996) found that fiscal policy can reduce the risk of innovation investment and increase investment income, thereby stimulating enterprises to increase R&D funding [12
]. Liu et al. (2011) found that the government tax, fiscal, and other policies are increasingly important to improve and stimulate technological innovation [13
]. Herbig (1994) believed that reducing the macro tax burden is not necessary to promote regional innovation, because the reduction of taxes will lead to a decline in government fiscal expenditure, which is not conducive to the government’s regulation of regional innovation; the tax burden must be maintained at a reasonable level which can ensure good public services without creating bad incentives for innovation [14
]. Zhou (2012) believed that the macro tax burden on regional innovation did not have a significant impact, while fiscal income per capita showed a significant positive impact on regional innovation [15
]. Chen et al. (2019) believed that the scientific and technological achievements of research institutes and enterprises in the region are of practical significance only when they are transformed into new technologies and achievements that can be used by the market. Therefore, how should fiscal and tax incentive policies focus on promoting the transformation of scientific and technological achievements [16
]? Based on data from 24 manufacturing sectors in Brazil from 2001 to 2008, Gramkow and Angerkraavi (2018) explored the extent to which fiscal policies could contribute to Brazilian green innovation. They found that fiscal instruments such as low-cost (subsidy) financing for innovation and fiscal incentives for sustainable practices were effective in inducing green innovation [17
]. Fiscal policy can play an important role in stimulating innovation through its effects on R&D, entrepreneurship, and technology transfer. However, some scholars showed that excessive government financial intervention will “crowd out” the technical input and output of the enterprises (Busom, 2000; Klette and Jarle, 2012) [18
]. Zhang et al. (2017) found that enterprise income tax inhibits innovation investment enterprises in the eastern region; the tax burden of enterprises in the eastern region is higher than that of the central and western enterprises, but enterprises in the eastern region attract more innovative investment [20
]. The varying results of effectiveness of R&D tax incentives do not provide a justifiable ground for dismissing the effectiveness of R&D tax incentives. A successful R&D fiscal incentive strategy, to a large degree, depends on understanding the advantages of different policy tools.
Government fiscal subsidies and tax incentives are the two most important policy tools for the government to support business innovation (Lee, 1996; Aghion et al., 2012) [21
]. In many economies, fiscal subsidies and tax incentives have become an integral part of a broader strategy to increase investment in R&D and promote innovation. Tax incentives and direct subsidies have different roles within a policy mix for business R&D and are complementary to each other. The fiscal incentive policy includes R&D tax incentives, such as tax credits, enhanced allowances, accelerated depreciation, and special deductions for labor taxes or social security contributions. Hall (2019) presents the policy rationale for tax incentives, discusses their design and potential effectiveness, and reviews the empirical evidence on their actual effectiveness. The focus is on the two most important and most studied incentives: R&D tax credits and super deductions, and IP boxes (reduced corporate taxes in income from patents and other intellectual property). Taxes provide the income that funds the government [23
]. Chang (2018) estimates the causal effect of R&D tax incentives on R&D expenditures using new data on US states. Identifying tax variation comes from changes in federal corporate tax laws that heterogeneously and, due to the simultaneity of state and federal corporate taxes, automatically affect state-level tax laws. The results show that R&D tax incentives significantly increases firms’ innovative input and output, a 1% increase in R&D tax incentives causes a statistically significant 2.8–3.8% increase in R&D. Scholars currently have a limited understanding of the role of R&D tax incentives in developing countries [24
]. Based on the panel data of 59 listed high-tech enterprises in Western China, from 2014 to 2018, Li et al. (2020) constructed a fixed effect model to study whether enterprise innovation performance would be affected under the interaction of fiscal and tax incentives and R&D investment. It is found that both tax incentives and financial subsidies have a significant impact on the innovation performance of manufacturing enterprises through the intermediary variable of R&D input, but private enterprises enjoying tax incentives have a crowding out effect on the improvement of innovation performance by R&D input. At the same time, the interaction between tax incentives and enterprises’ expensed R&D investment is more conducive to the improvement of enterprises’ innovation performance, while the combination of financial subsidies and capitalization R&D investment also has a positive impact on the improvement of innovation performance [25
]. Cao and Chen et al. (2018) studied the impact of tax incentives on corporate innovation efficiency. The stimulation effect of R&D tax incentives may be heterogeneous across industries, enterprise scale and tax type [26
]. Wang and Kesan (2020) found a stringent corporate tax policy with narrowly tailored R&D thresholds for tax credits can positively incentivize R&D and patent applications by small and medium enterprises (SMEs) and value-added tax credits cannot induce R&D when they do not confer subsidies or a competitive advantage on SMEs [27
]. After the introduction of the personal income tax and income tax withholding, the value-added tax stands out as one of the most important tax policy innovations. In many cases, the VAT was accompanied by a reduction in customs duties and tariffs tax policy in developing countries. Alavuotunki, Haapanen, and Pirttilä (2019) examined the impact of the introduction of the value-added tax on inequality and government revenues, using newly released macro data, and found income-based inequality has increased due to the VAT adoption, whereas consumption inequality has remained unaffected [28
The second tool is government spending—which includes subsidies, welfare programs, public works projects, and government salaries. Based on the sample data of Chinese manufacturing enterprises, Yang and Liu (2019) used the method of propensity score matching and quantile regression analysis to explore the impact of fiscal and tax incentive policies on the substantive innovation of manufacturing enterprises from two perspectives. They found that fiscal R&D subsidy and tax incentive promoted the substantial innovation activities of Chinese manufacturing enterprises, but their effects were different. The incentive effect of fiscal R&D subsidy was obviously better than that of tax incentive policy. Compared with state-owned enterprises, non-state-owned enterprises’ substantive innovation behavior is more sensitive to the stimulus feedback of fiscal R&D subsidy and tax incentive. However, state-owned enterprises based on institutional arrangement are closely connected with government politics, which weakens the effect of fiscal and tax policies. State-owned enterprises prefer the strategic innovation of “seeking support”. From the perspective of fiscal and tax incentives, the effect of R&D fiscal subsidies with “exclusivity” on innovative heterogeneous enterprises shows a trend of “monotonicity increasing”, while the effect of tax incentives shows a trend of “monotonicity decreasing” [29
]. Wang et al. (2017) analyzed the impact of R&D subsidies on corporate innovation and found that different fiscal and tax policies (fiscal subsidies and tax incentives) have different incentive effects on the innovation of enterprises [30
]. Specifically, some scholars (Zhang and Du, 2019; Ning and Li, 2019) believe that, in the innovation input stage, the incentive effect of fiscal subsidies is more significant. In the output stage, the incentive effect of tax incentives is more significant [31
]. Tax incentives are usually available to all firms that invest in R&D and have a larger effect in industries characterized by high R&D thrust and for small firms (those with less than 50 employees). Meanwhile, subsidies increase innovation more in industries that are highly dependent on external finance (where R&D cannot be accommodated by current cash flow), mainly the information technology sector. Some studies suggest that R&D tax incentives stimulated the development of new products and innovation (Czarnitzki et al., 2011, Ernst and Spengel, 2011, and Westmore, 2013) [33
]. However, R&D tax incentives appear to be effective in increasing incremental innovations, but they might not result in more radical innovations, as shown by Cappelen et al. (2012) and Ernst et al. (2014) [36
Most of the previous literature analyzes the construction and determinants of a regional innovation system, or directly link the tax, fiscal expenditure, and economic growth, to analyze tax burden and fiscal science and technology expenditure on macroeconomic development. However, the empirical results are not uniform. The existing literature rarely studies the impact of different tax structures and R&D fiscal incentives on regional innovation capability.
2.2. The Influence Mechanism of Fiscal and Tax Policies on Stimulating Innovation
Tax and fiscal incentives have become the common policy tools in encouraging firms to spend more on R&D, and the recession has further raised interest in the effectiveness of these policies thereby, serving the following purposes.
(1) Increasing the overall level of R&D spending throughout the economy. Businesses have long considered tax incentives as important and sometimes necessary relief in lieu of high R&D costs. Fiscal investment or tax incentives can effectively offset the funding gap of regional innovation systems and form a significant leverage-driven effect (Xie, Tang, and Lu, 2009) [38
(2) Affecting the distribution of R&D among sectors to favor more promising sectors and to loosen the constraints, such as the supply of S&T workers. Most of the R&D outlay across countries is in IT, hardware, automotive industries, and pharmaceuticals. Fiscal and tax policy have an obvious guiding role and present the government’s macroeconomic control of the entire country or the region (Guo and Luo, 2015) [39
]. According to the national industry or the sector development strategy, the fiscal policy determines the direction of technological innovation and production. At the same time, the government has introduced tax reduction and exemption incentives for specific industries to optimize the technical structure.
(3) Reduce the innovation risk of the enterprises. R&D has the characteristics of a large-scale investment, long investment cycle, and high risk, which determine the existence of large uncertainties in independent innovation activities. The government can implement fiscal subsidies for innovative enterprises through fiscal technology expenditures, and accelerate tax depreciation, tax deductions, and other preferential tax policies to help the enterprises avoid innovation risks and thereby motivate enterprises. However, the enterprises will only be profitable if the innovation achievements are recognized. The government procurement system can increase the social demand for innovative products and reduce the market operating risks of such enterprises.
(4) Reduce R&D costs of the firms. Fiscal subsidies or tax benefits can effectively reduce the cost of innovation of economic individuals in the region, bridge the gap between the private benefits and social benefits of economic individual innovation activities, and reduce external disturbances. The introduction of “Pre-Tax Deduction of Enterprise Research and Development Expenses”, at the end of 2008, is an important way to encourage technological innovation in China in terms of taxation. This policy reduces the income tax base payable by the technological innovation enterprises by doubling the cost of technological innovation and reducing the cost of capital for technological innovation. IT outsourcing, business process outsourcing, and knowledge process outsourcing companies in designated cities, which are granted Advanced and New Technology Service Enterprise (ATSE) status, pay a reduced corporate income tax rate of 15% instead of 25%.
(5) Permission of FDI into selected industrial sectors to serve as a conduit for new technologies and possibly also as an axe for cluster development in urban technology zones and parks. China’s tax system reform in 1994 abolished the progressive income tax system for non-state-owned enterprises, reduced the nominal tax rate for state-owned enterprises to 33%, but still gave foreign companies a low tax rate (25%). Input value-added tax (VAT) on domestically manufactured equipment purchased by qualified native R&D institutes and foreign invested R&D centers is refundable. The comparative advantage of tax has set off an investment trend in which foreign capital has flooded into China. As a result, foreign mature technology is introduced and digested with the introduction of capital. Business tax exemption on revenue is derived from offshore outsourcing services and the transfer of trusted qualified technology. The option of incorporating and being taxed at a lower marginal corporate rate subsidizes risk-taking, thereby inducing the formation of new businesses (Cullen and Gordon, 2007; Russo, 2004) [40
(6) Promoting the rational allocation of the limited regional innovation resources, to avoid vicious inter-regional competition, by adopting the attitude of “competitive cooperation”. Reasonable fiscal and tax policies are conducive to the flow of innovation elements between regions and cross-regional innovation cooperation activities; if the innovation capability of different regions is greatly diverse, it will not be conducive to the improvement of innovation capability in the backward regions and the entire country. The government can realize the spatially balanced development of regional innovation capability through transfer payment policies.
Based on these arguments, we propose Hypothesis 1, as follows.
Hypothesis 1 (H1):
Fiscal and tax policies can stimulate innovation.
The fiscal policies relating to R&D can take many different forms, including tax allowances, tax deductions, super deductions, tax exemptions, and tax credits. If the government’s objective is to increase R&D intensity among firms from a relatively low level, tax incentives may be the most sensible approach. Meanwhile, direct subsidies are better suited to encourage higher-risk projects and to meet specific policy goals. If the government’s objective is to enlarge the R&D capability within certain fields or R&D milieus, in this case, subsidies would be the natural choice, since it is more difficult to target specific fields or areas of R&D activities through tax incentives. At the same time, due to the complex tax structure, there are many types of taxes, including VAT, consumption tax, income tax, and so on. Different types of taxes may have different effects on innovation. Therefore, it is necessary to test whether Hypothesis 2 holds.
Hypothesis 2 (H2):
Different tax structures have different effects on innovation.