Factor market distortion and corporate innovation: Theory and evidence from China

The paper models the effect of distortion in factor markets on corporate innovation in a developing country, where the factor markets are underdeveloped in contrast to product markets. The distortion between factor markets and product markets has deteriorated the capability of firms to obtain profits, thereby dampening the incentives of firms to invest in innovation. Using a detailed firm-level dataset with manufacturing corporate innovation activities from 2008 to 2014, we testify to the prediction from the theoretical models that distortion depresses corporate R&D investment as well as R&D per capita. We strengthen our results using an IV approach to address reverse causality. Overall, our results have shed light on an emerging literature on distortion and innovation.