The impact of fiscal subsidies and tax preferences on firm innovation

Abstract

Technological innovation is the primary driver of economic development, and firms are key players in innovation activities. Financing constraints faced by firms are a significant factor limiting their motivation for technological innovation. Fiscal subsidies and tax preferences are important government policies to incentivize firm innovation, and their actual policy efficiency has been a subject of ongoing scrutiny. Existing literature predominantly focuses on analyzing and comparing the innovation incentive effects of different fiscal policies, but rarely addresses their interactive effects and policy synergy. The main objective of this paper is to investigate the heterogeneous impacts of fiscal subsidies and tax preferences on firm R&D, as well as their combined effects. Theoretically, this paper incorporates government tax reduction policies and R&D subsidy policies into a classic oligopoly model that includes firm R&D behavior. We first establish a Cournot duopoly model with homogeneous products as the baseline model, solve for the competitive equilibrium, and conduct a comparative static analysis of the fiscal policies. Subsequently, we extend the baseline model to test whether the predicted innovation incentive effects of these policies remain robust under conditions of multi-oligopoly competition, heterogeneous products, price competition, and knowledge spillovers. We find that in both the baseline and extended model equilibria, fiscal subsidies and tax preferences can enhance firms' R&D levels and private R&D expenditures. Furthermore, the positive effects of these two policies are complementary; increasing the intensity of one policy can amplify the incentive effect of the other on private R&D. We conduct further welfare analysis and find that both policies can increase consumer surplus and total surplus. The key difference lies in the fact that tax preferences increase firm profits, while fiscal subsidies reduce firm profits. Finally, we consider the government's budget constraint and find that increased fiscal subsidies raise both government revenue and expenditure, while a higher tax incentive rate will inevitably lead to a larger fiscal deficit. When the government endogenously decides between the two policies, the government increasingly prefers fiscal subsidies to tax preferences as R&D is more costly. Empirically, this paper uses data from A-share listed firms in China's Shanghai and Shenzhen stock exchanges from 2016 to 2020 to calculate the tax preference index and R&D subsidy indicators, constructing a two-way fixed effects model to estimate the impact of fiscal policies on firm R&D. First, baseline regression results indicate that both the tax preference index and R&D subsidies positively affect firms' R&D intensity. To mitigate endogeneity issues arising from government policy selection, we construct average policy intensity indicators at the province-industry level as instrumental variables and perform two-stage least squares estimation, confirming the robustness of the baseline results. Second, the promotion effects of fiscal policies on firm innovation exhibit heterogeneity. Generally, fiscal subsidies broadly promote R&D activities across various ownership structures, major industries, and regions. In contrast, the R&D incentive effect of tax preferences shows greater heterogeneity: it is concentrated among state-owned firms, private firms, and other firms in terms of ownership; primarily affects industrial and IT firms in terms of industry classification; and mainly impacts firms in the eastern regions in terms of geography. Additionally, both policies have a greater innovation incentive effect on firms with lower initial R&D levels. Finally, we analyze the combined effects of fiscal subsidies and tax preferences using fixed effects regression with interaction terms and threshold effect models. The results demonstrate that the effects of the two policies reinforce each other and are complementary. As fiscal subsidies increase, the innovation incentive effect of tax preferences gradually enhances, and vice versa. Moreover, the promotion effect of fiscal subsidies on tax preferences is relatively greater. This paper simultaneously investigates the promotion effects of fiscal subsidies and tax preferences on firm R&D and examines their positive interaction effects, concluding that fiscal and tax policies should be implemented in a coordinated manner. This provides new evidence from Chinese firms on the relationship between fiscal policies and firm innovation. On the other hand, this paper theoretically analyzes the interaction effects of these two policies on firm R&D, providing theoretical support for the empirical evidence. The findings of this paper contribute to the understanding of government intervention theories to some extent and offer suggestions for national macroeconomic regulation and policy-making. By studying the heterogeneous effects of fiscal policies, this paper helps in understanding the real effects of policies on different regions, industries, and ownership types of firms, thereby facilitating more targeted policy implementation and improving the actual operational efficiency of policies.