Tax Policy and Lumpy Investment Behaviour: Evidence from China's VAT Reform.

This article examines how tax policy influences firm-level investment behavior by explicitly incorporating the lumpy nature of investment, characterized by firms either making large capital expenditures ("investment spikes") or no investment at all ("inaction"). Using China’s 2009 value-added tax (VAT) reform—which allowed domestic firms to deduct input VAT on equipment and lowered the after-tax cost of investment by about 15%—the study employs comprehensive firm-level tax data and a difference-in-differences design comparing domestic and foreign firms to estimate a 36% relative increase in investment driven primarily by extensive-margin responses. A dynamic investment model embedding adjustment frictions such as fixed costs and partial irreversibility is estimated via simulated method of moments, successfully replicating the reform’s effects and showing that policies reducing the likelihood of firm inaction (e.g., VAT cuts or investment tax credits) are more effective at stimulating investment than those merely lowering the user cost of capital (e.g., corporate income tax cuts). The findings highlight the importance of accounting for investment frictions and extensive-margin responses in tax policy design, with implications extending beyond China to countries employing VATs, sales taxes, and investment tax credits.