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ABSTRACT:
Innovation for social progress is characterized by a double-externality challenge: knowledge spillovers due to imperfect appropriability and production or consumption externalities. We develop a micro-founded model showing that R&D tax credits addressing knowledge spillovers and taxes adjusting relative prices can be complements or substitutes in their effects on the direction of innovation. Technology-neutral innovation subsidies can either reinforce or attenuate the effects of Pigouvian taxation. We implement a difference-in-discontinuity-in-estimates research design and find that carbon taxes and R&D tax credits are substitutes in their effects on firm R&D investment and total factor productivity for firms in the UK's manufacturing sector. An increase of 1 GBP in the carbon tax increases R&D expenditures by 2% for firms in industries that are directly exposed to carbon taxes and reduces it by 9% for firms in industries that are indirectly exposed. Total factor productivity increases by 2% for both. Enhancement of productivity is driven by technology adoption and organizational innovations for directly exposed firms and just the latter for indirectly exposed firms. More generous tax credits substantially attenuate all of the effects such that they disappear entirely in some cases. Tax credits increase R&D expenditures for indirectly regulated firms, however this is inefficient relative to organizational innovation for these firms.