Profit Taxation, Innovation and the Financing of Heterogenous Firms

Innovative firms are frequently credit constrained and tend to earn an above normal return on capital. This paper considers a discrete R&D decision that splits firms into innovative and standard ones. Active intermediaries can facilitate access to credit and improve capital allocation. We find that (i) financial development boosts innovation and welfare; (ii) ACE and cash-flow taxes are neutral with respect to user cost and standard firm investment but restrict constrained investment and harm innovation and welfare; (iii) an ACE tax is less harmful than an equal yield cash-flow tax although they are equivalent in perfect capital markets; (iv) a self-financed R&D tax credit redistributes towards constrained firms and promotes innovation and welfare; (v) revenue neutral tax cut cum base broadening similarly boosts innovation and welfare.