Do Tax Policies Drive Innovation by SMEs in China?

There is little empirical evidence showing how innovation by small and medium enterprises (SMEs) is impacted by tax policies, especially SMEs from developing countries. We explore how targeted policies of corporate tax (firm-specific) and value-added tax (product-specific) in China impact their domestic SMEs' R&D investment and R&D output. We find that a stringent corporate tax policy with specified R&D thresholds for qualifying for tax credits is narrowly tailored to positively incentivize R&D and patent applications by firms, including SMEs. We also find that a value-added tax (VAT) policy without any R&D thresholds is over-inclusive in terms of its impact on the subsidized SMEs' innovation because SMEs can produce software products to qualify for the subsidies, regardless of whether their software products are innovative or not, though it does create a spillover effect on R&D by SMEs in other technology sectors who may choose to qualify for these VAT credits by incorporating software or ICs into their products