To stimulate investment and promote production efficiency, the Chinese government has undertaken a series of value-added tax (VAT) reforms. One of those reforms, in 2009, reduced not only the purchasing price of equipment, but also investment frictions, i.e., the price gap imposed by the pre-reform VAT system between new and used equipment. We find that this reform increased equipment investment by 36% and, more importantly, the increase was driven by investment spikes (i.e., investment greater than 20% of capital stock). Using a dynamic investment model, we find that tax policies that directly reduce investment frictions, such as investment tax credits, are more effective in stimulating investment than policies such as corporate income tax cuts or bonus depreciation.

China has undertaken a series of value-added tax (VAT) reforms since 2004. The reforms began in the manufacturing sector and gradually expanded to the whole economy. These reforms aimed to improve economic efficiency and stimulate investment. In fact, the past decade has witnessed strong investment growth in China. As Figure 1 shows, total investment grew to more than double that in the US or the EU by 2016. VAT reforms, particularly in manufacturing, significantly increased investment in equipment (e.g., Cai and Harrison 2018; Liu and Mao 2019).

We then study how firms respond to tax incentives using a dynamic investment model that captures the Chinese tax setting. This model shows that policies that directly reduce investment frictions are more effective at stimulating investment than policies that only reduce the cost of investment. This lesson from China’s 2009 VAT reform is applicable to the administration of the VAT system in other countries, and to countries with other related fiscal policies, such as input taxes and investment tax credits.

China’s 2009 VAT reform reduced the price gap between new and used capital

China relied on a production-based VAT system prior to 2004. While firms were allowed to deduct input taxes on materials, they could not receive credits for equipment or other fixed assets. Given the 17% primary VAT rate, a firm purchasing 1000 RMB of equipment would pay 1170 RMB in total. On the other hand, when a firm sold used equipment, which was purchased at the VAT-included price, the firm was unable to recover the additional VAT. This practice created a gap between the price of new and used equipment, which is known as “partial irreversibility” (e.g., Cooper and Haltiwanger 2006). Partial irreversibility affects investment decisions. In particular, unless firms receive sufficiently high or sufficiently low productivity shocks, they may prefer not to adjust their capital level. Consistent with this friction, our data shows that almost half of firms do not invest in a given year.

The Chinese government launched a series of pilot programs to allow firms to deduct input VAT on equipment. While these programs started in 2004 in Northeast China (e.g., Cai and Harrison 2018), the reform was unexpectedly extended to the whole country in response to the 2008 financial crisis. This policy shock created distinct consequences for two groups of firms: domestic (Chinese) firms and foreign (non-Chinese) firms because foreign firms had been allowed to deduct input VAT on equipment even before the reform. Therefore, while the 2009 VAT reform did not affect investment in foreign firms, it substantially reduced investment costs for domestic firms. We exploit this natural experiment by using foreign firms as the control group and domestic firms as the treatment group in our empirical analysis.

Investment increased by 36%, driven by investment spikes

In comparing the investment of domestic and foreign firms before and after the reform, we find that the VAT reform significantly increased the investment by domestic firms at both the extensive and intensive margins. We first consider the extensive margin—whether a firm invests or not. Panel A of Figure 2 plots the fraction of domestic firms (red line) and foreign firms (blue line) investing in any given year. The two lines track each other well before the reform. After 2009, however, the fraction of domestic firms with positive investment increases by around 5 percentage points, or 10% relative to the 50% average rate. We then consider the intensive margin, the average investment-to-capital ratio. Panel B shows that, compared to foreign firms, the investment rate of domestic firms increased by about 3.6 percentage points, a 36% increase relative to an average investment rate of 10%.

Figure 2 Effects of 2009 China’s VAT Reform

The increase in investment was driven by investment spikes, i.e., by investment rates greater than 20%. We show this by decomposing the investment response into two categories: (1) investment rate smaller than 20% (non-spike investment rate), and (2) investment rate greater than 20% (spike investment rate). Panel A of Figure 3 plots the average non-spike investment rate of domestic and foreign firms. The reform had a limited effect on the non-spike investment rate. In contrast, the reform increased the spike investment rate by 3.5 percentage points for domestic firms, which is more than 10 times the effect on the non-spike investment rate. Comparing the spike investment rate to the total effect, we find that 90% of the total effect is accounted for by an increase in investment spikes. This result shows that beyond lowering the price of capital, the reform stimulated investment spikes by narrowing the price gap between new and used capital.

Figure 3 Decomposing the Effects to Spike and Non-Spike Investment

Simulating alternative policies

Motivated by the lumpy investment response at the extensive margin, we estimate a dynamic investment model with various adjustment frictions and tax instruments. This model quantifies how tax policies interact with investment frictions and is able to replicate the reduced-form effects of the reform.

Based on the empirical evidence from China’s VAT reform and the model simulation, we conclude that it is crucial to take into account investment frictions when evaluating the effectiveness of tax policies. We find that policies that reduce the importance of investment frictions are more effective at stimulating investment than policies that only lower the cost of capital.

(Zhao Chen, Fudan University; Xian Jiang is a Ph.D. candidate of Economics at Duke University; Zhikuo Liu, Shanghai University of Finance and Economics; Juan Carlos Suárez Serrato, Duke University; Daniel Yi Xu, Duke University.)

Cai, Jing, and Ann Harrison. 2019. “Industrial Policy in China: Some Intended or Unintended Consequences?” Industrial and Labor Relations Review. https://doi.org/10.1177/0019793919889609