Does government debt impede firm innovation? Evidence from the rise of LGFVs in China

Does government debt impede firm innovation? We address this question by examining the effects of the debt accumulated by local government financing vehicles (LGFVs) across Chinese prefectures between 2006 and 2012 on industrial firms’ R&D spending and patents. We find that government debt reduces firms’ R&D expenditures and lowers firms’ number of new patents. One plausible explanation is that government debt raises firms’ capital costs, which limits innovation activities. Consistently, we find that the innovations of firms that are more likely to be financially constrained – small firms and firms with low cash flow – are more affected by the expansion of government debt. Our results imply that although government deficit spending may stimulate the economy in the short run, it could have negative repercussions for economic productivity in the longer run.