DP7626 Profit Taxation, Innovation and the Financing of Heterogeneous Firms

Author(s): Christian Keuschnigg, Evelyn Ribi
Publication Date: January 2010
Keyword(s): credit constraints, innovation, investment, profit taxes, R&D subsidies
JEL(s): G38, H25, L26
Programme Areas: Public Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=7626

Credit constraints are more frequent among growth companies with large investment opportunities. For the same reason, profit taxes may harm innovative firms more than standard ones. This paper develops a model of heterogeneous firms where an endogenous share opts for innovation and faces credit constraints in the subsequent expansion phase. We emphasize four results: (i) R&D subsidies not only encourage innovation but also relax finance constraints and help innovative firms to exploit investment opportunities to a larger extent. (ii) Taxes which are neutral in a neoclassical world, still restrict expansion investment of constrained firms by reducing free cash-flow and thereby discourage innovation. (iii) A revenue neutral increase in profit taxes to finance larger R&D subsidies redistributes towards innovative firms and boosts aggregate productivity and welfare. (iv) A revenue neutral tax cut cum base broadening policy similarly boosts innovation and welfare.