Business Group Taxation and R&D Activities

Economic theory dating to Domar and Musgrave (1944) suggests that the tax treatment of gains and losses can affect firmsf incentives to undertake high-risk investments. Exploiting a 2002 tax law change in Japan that allows business groups to adopt a consolidated taxation system (CTS) and using an IV strategy, I identify the causal impact of mitigating tax loss asymmetry on R&D activities. With unique firm-level panel data between 1997 and 2011, I show that CTS adoption increases total R&D expenses among individual business groups. More specifically, CTS adoption increases the following, especially among parent companies of business groups: the number of employees engaging in R&D; expenses for property, plant, and equipment for R&D; and expenses for R&D outsourcing. Evidence of ex-ante efficiency of CTS adoption measured by market-to-book ratio is limited, while CTS adoption improves expost efficiency measured by income from patent transactions. These findings support that mitigating tax loss asymmetry facilitates efficient developments of high-risk investments in line with Domar and Musgrave.