Behavioural additionality of China's business-tax-to-VAT reform on firms' internal and external R&D investment

This paper investigates the unintended effect of the business-tax-to-VAT (B2V) reform in China on manufacturing firms' internal and external R&D behaviour. The B2V reform was implemented in the service sectors to replace business tax with value-added tax. It creates tax incentives for downstream manufacturing firms to increase external R&D outsourcing, as purchasing R&D and technology services becomes tax-deductible after the reform. Using a large administrative firm-level dataset, we found that downstream manufacturing firms that were previously more closely linked to upstream R&D and technology services are more affected by the B2V reform, and tend to increase external R&D outsourcing and reduce internal R&D expenditures. The unintended behavioural additionality is mainly driven by small and medium-sized firms and firms with low R&D capabilities which usually bear high costs of conducting internal R&D and rely more on external R&D services. Our study implies the possibility of leveraging tax incentive measures to encourage firms to seek external knowledge and technologies.