Cascades of Tax Policy through Production Networks: Evidence from Japan

The effectiveness of tax policies targeting firms has been evaluated conventionally based on the effects on the firms that are directly affected by the tax policies. However, the indirect effects through the supply chains of the directly affected firms can also be of first-order importance. This paper estimates the indirect effects on firm performance of tax incentives for investment through production networks, exploiting the quasi-experimental event of an investment stimulus policy targeting small and medium enterprises and unique proprietary data of supply chains in Japan. After confirming the direct effects, I find evidence suggesting that the indirect effects on direct suppliers are even larger than the direct effects, while no discernible effects are found on downstream firms. The absence of downstream effects appears to stem from the fact that treated firms crowd out the market share of untreated large firms, leading to an insufficient change in market prices. In total, while the tax policy successfully stimulates the targeted small firms, its spillover effects are primarily confined to the upstream customers which tend to be large.