Firm investment and exporting: Evidence from China's value-added tax reform

Highlights

• We identify the causal effect of firms' fixed investment on their exporting behavior with the Difference-in-Differences method.

• Our results show that fixed investment significantly and substantially increases the likelihood of exporting.

• We document some heterogeneity of the effect across industries with different degrees of competition and financial constraints.

Abstract

This paper contributes to the literature by identifying the causal effect of firm investment on exporting behavior. The identification hinges on regional variations in the 2004 value-added tax pilot reform in China, which generated positive investment shocks. The instrumental variable estimation results show that firm investment significantly and substantially increases the likelihood of exporting, and this effect is largely due to the positive effect of firm investment on firm productivity. Finally, the paper documents some heterogeneity of the effect across industries with different degrees of competition and financial constraints.

Introduction

“The key unanswered question is how firms obtain the characteristics that allow them to easily enter the export market.” Bernard and Jensen (2004)

A robust finding from recent firm-level analyses is that exporters are more productive than non-exporters (for a review of empirical evidence, see Bernard et al., 2012). The leading explanation is that firms with better characteristics (such as productivity) self-select into export markets (for a review of firm heterogeneity theories, see Redding, 2011). However, a question that continues to intrigue researchers is how firms obtain superior characteristics to facilitate their entrance into the export market, as exemplified in the above quotation.

Recent literature has emphasized the importance of firm investment in technology upgrading for successful exporting (see, for example, Damijan et al., 2008, Cassiman et al., 2010, Iacovone and Javorcik, 2012). However, there is an inherent empirical challenge to establish the causality from firm investment to exporting; that is, investment and exporting decisions are jointly determined. For example, Atkeson and Burstein (2010), Lileeva and Trefler (2010), Aw et al. (2011), and Bustos (2011) all model the simultaneous selection of investment in technology upgrading and exporting. Meanwhile, another complication in the identification is that there could be reverse causality from exporting to investment. For example, Criscuolo et al. (2010) find that among several thousand U.K. enterprises across all industries in 1994–2000, those engaging globally spend more resources on innovation.

This paper contributes to the literature by using a quasi-natural experiment to identify the causal effect of firm investment on firm exporting. In 2004, China started to reform its value-added tax (VAT) system in six broadly defined industries in the three northeastern provinces.¹ Under the new taxation system, the purchase of fixed assets can be deducted from the tax base, which substantially lowers the cost of fixed assets (e.g., by 13 to 17%) and hence generates substantial tax incentives for firms to invest. Previous studies (e.g., Chen et al., 2011) have shown that the VAT reform indeed increased firm investment.

Our empirical analysis uses regional variations generated by the 2004 VAT reform, that is, the reform was first piloted in only 3 of 31 provinces, as an instrument for firm investment. Meanwhile, to further improve our identification, we adopt a plausibly exogenous instruments framework developed by Conley et al. (2012), which relaxes the strict exogeneity condition of the instrumental variable. We find that firm investment has a positive and statistically significant effect on the probability of exporting. Specifically, the average exporting propensity of northeastern firms increases by 2.39% due to the increase in fixed investment after the reform, which is large relative to the average exporting propensity of 32.94% for the whole sample. These findings are robust to a battery of sensitivity checks, including using a different standard error estimation, checking a multi-industry issue, using a surviving firms sample, using an alternative measurement of investment incentives, and using different subsamples.

To shed light on the underlying mechanisms through which firm investment increases the probability of exporting, we first show that firm investment significantly improves firm productivity, which in turn significantly increases the probability of exporting. We also find that the effect of firm investment on the probability of exporting is larger in industries facing larger financial constraints, implying that firms are bounded on the supply side of credit and the VAT pilot reform largely increased firm investment by reducing credit constraints. We further find that the effect of firm investment is larger in more competitive industries, suggesting that firms in less competitive industries may partially pass the effect of the VAT pilot reform to their consumers, resulting in a smaller effect.

The remainder of the paper is organized as follows. Section 2 lays out the estimation framework, including a description of the institutional background of the VAT reform in China, a brief discussion of the conceptual framework, data and variables, and the identification strategy. Empirical findings, including main results, robustness checks and mechanisms, are presented in Section 3. The paper concludes with Section 4.