Interest rates, R&D investment and the distortionary effects of R&D incentives

Abstract

This paper conducts the first analysis of how interest rates are related to firms’ allocation of investment between R&D and non-R&D activities and how R&D incentives alter this relationship. It theoretically predicts that if firms receive incentives mostly in the form of grants and subsidies that reduce their dependence on external finance, their share of R&D spending increases (decreases) during a credit tightening (easing). Conversely, if tax credits are the primary incentive, firms decrease (increase) their share of R&D spending during a credit tightening (easing). The paper demonstrates empirical support for these predictions by using firm-level financial and sector-level R&D incentives data and a unique methodology that focuses on the within firm allocation of investment.