Tax Policy and Lumpy Investment Behavior: Evidence from China’s VAT Reform

We incorporate the lumpy nature of firm-level investment into the study of how tax policy affects investment behaviour. We show that tax policies can directly impact the lumpiness of investment. Extensive-margin responses to tax policy are key to understanding the effects of different tax reforms and to designing effective stimulus policies. We illustrate these results by studying China’s 2009 VAT reform, which lowered the tax cost of investment and reduced partial irreversibility — the price gap between new and used capital. Using comprehensive tax survey data and a difference-in-differences design, we estimate a 36%% relative investment increase that is driven by investment spikes. Using a dynamic investment model that fits the reduced-form effects of the reform, we show that policies that directly reduce the likelihood of firm inaction are more effective at stimulating investment.