Investment in Innovation and Fixed Assets: the effect of US tax reforms that reduced the relative price of equity to debt

Tax reforms in the US in the mid-1980s reduced the relative tax cost of equity and internal finance to debt by 30%, from a large reduction in the statutory rate. This paper finds evidence that for innovative firms this lead to a decrease in ordinary investment and an increase in innovative investment, while controlling for other variation in the prices of ordinary and R&D investment. This suggests that equity and internal finance are cheaper for innovation than debt finance, to the extent that exogenous decreases in their relative prices can cause innovation. The ability to substitute from ordinary investment to R&D investment was larger for firms with plentiful internal financial resources, consistent with a large external financing premium for R&D.