Innovation is a crucial driver of economic growth, particularly in emerging economies like China. While direct R&D subsidies are a common policy tool to stimulate innovation, tax cuts offer a more comprehensive approach by alleviating financial constraints for firms. This study specifically examines the effects of tax cuts on enterprise innovation in China, acknowledging the unique challenges presented by emerging economies' financial market distortions and intellectual property system weaknesses. The research aims to provide a deeper understanding of how tax cuts influence technological innovation through three main economic mechanisms. Firstly, it analyzes how tax cuts help companies overcome financial constraints and improve their access to capital. Secondly, the study explores how tax cuts promote a specialized division of labor within firms and lead to increased efficiency. Thirdly, it investigates how tax cuts lead to value creation by enabling firms to enhance their pricing power and reinvest profits into further innovation. By focusing on these key mechanisms, the research seeks to shed light on the intricacies of tax policy and its impact on innovation in the Chinese context, filling a gap in the literature by linking macro and micro effects of tax cuts and using a comprehensive dataset of Chinese listed manufacturing firms.

Existing literature demonstrates varying efficacy of tax cuts in stimulating innovation, especially in emerging economies. While studies on China show a positive response of enterprises to tax cuts, this effect is not universal across all countries and contexts. The research also explores the underlying mechanisms, including the mitigation of positive externalities associated with R&D, reduced tax burdens leading to efficient resource allocation, and decreased resources allocated to tax evasion. However, limitations of tax cuts have also been identified, such as potential crowding-out effects, information asymmetry issues, and negative impacts on productivity if tax cuts are financed by reducing public services. Existing studies often rely on narrative identification methods or difference-in-difference approaches, lacking a systematic analysis linking macro and micro outcomes. The current study intends to build upon this literature by addressing these gaps and focusing on the interplay between tax cuts, financing constraints, and innovation in a Chinese context.

This study employs a sample of Shanghai and Shenzhen A-share listed manufacturing enterprises from 2008 to 2019, using data from Wind and CSMAR databases. After data cleaning and filtering for continuous data over five years, two variables are used to measure enterprise innovation: R&D expenditure intensity (Rdintensity) and the ratio of net increment of intangible assets to total assets (ITAssetRatio). The explanatory variable is the forward-looking average effective tax rate (EATR), which captures both the impact of tax reduction and the influence of different financing methods, avoiding the issue of tax evasion confounding the results. A dummy variable, 'Incentive,' is created to identify firms that experienced tax cuts, defined as a decrease in the effective average tax rate accompanied by an increase in profits. Control variables include corporate asset-liability ratio, current debt ratio, proportion of intangible assets, cash holdings, investment expenditure rate, Tobin’s Q value, return on net assets, enterprise age, growth, and liquidity ratio. A two-stage least squares (2SLS) regression is employed to address endogeneity issues using the intensity of local government tax administration as an instrumental variable. The first stage regresses the Incentive variable on the instrument, and the second stage uses the predicted value of Incentive to estimate the effects on R&Dintensity and ITAssetRatio. The robustness of the findings is checked through various tests and analyses.

The benchmark regression results (Table 2) reveal a significant positive relationship between tax cuts (Incentive) and both Rdintensity and ITAssetRatio. This suggests that tax cuts stimulate innovation in Chinese manufacturing firms. The 2SLS regression (Table 3) confirms this positive effect even after addressing endogeneity. The results highlight that the incentive effect works through multiple channels. The 'financing effect' shows heterogeneity, with internal and equity financing significantly boosted by tax cuts, while the effect on debt financing is less pronounced. The 'specialized division of labor' and 'added value' effects are also identified as contributing factors. Further analysis reveals that the effect of tax cuts is particularly pronounced for high-tech firms and that the "additional tax deduction on R&D expenses" policy shows a stronger effect than the "15% preferential tax rate" policy. The study also highlights the mismatch between innovation input and output, suggesting that further policy adjustments are needed. Detailed coefficients, significance levels, and R-squared values are provided in Tables 2 and 3. The F-statistics and other tests confirm the validity of the instrumental variables and address concerns about weak instruments.

The findings support the hypothesis that tax cuts stimulate enterprise innovation in China. The results confirm the effectiveness of tax cuts as a policy tool for fostering innovation, particularly in the manufacturing sector. The significant positive effect persists even after accounting for potential endogeneity, highlighting the robustness of the findings. The identification of multiple mechanisms—financing constraints, specialized division of labor, and added value creation—provides a comprehensive understanding of how tax cuts exert their influence. The heterogeneity in the financing channels implies that policies should target specific financing needs of different types of firms. The superior performance of targeted R&D tax deductions compared to broader corporate tax cuts suggests that more precise and efficient policy designs are important. These insights have implications for policy design and implementation in China and other emerging economies, suggesting the importance of a nuanced approach to tax-based innovation policies.

This study provides strong evidence that tax cuts effectively stimulate innovation among Chinese listed manufacturing firms, operating through various mechanisms. Policymakers should leverage these findings to refine tax reduction policies, tailoring them to the specific needs of different firm types and focusing on targeted incentives. Further research should explore the impact on smaller firms, incorporating additional control variables, and evaluating alternative econometric approaches for more comprehensive policy optimization.

The study's limitations include a focus on listed firms, potentially overlooking the impact on smaller and medium-sized enterprises (SMEs). While firm-level control variables are included, unobserved factors might influence innovation. Future research should address these limitations by employing surveys, case studies, and exploring other econometric techniques. The use of a fixed effects model restricts the analysis of dynamic effects over time.