How innovation protects manufacturers against cheap imports

The rise of China, triggered by its transition to a market-oriented economy and rapid integration into world trade, has been identified as a major source of disruption for the manufacturing sector in high-income economies. Autor et al. (2013) estimate that the surge in China’s exports over the last two decades is responsible for as much as 25% of the aggregate decline of US manufacturing employment (Figure 1).

Figure 1. China’s import penetration and manufacturing employment

Source: Autor et al. (2013).

In this context, innovation is often viewed as a panacea against import competition from low-wage countries. Because wage differences will take time to adjust, so the argument goes, competing on costs is bound to fail. The best hope for firms in high-income countries is to innovate and escape competition by climbing the quality ladder. This view has largely influenced corporate and public policies. Import competition has induced firms to invest in technological change (Bloom et al. 2015) and in product-quality upgrading (Amiti and Khandelwal 2013), while governments allocate large amounts of taxpayers’ money to subsidising R&D. There is, however, little evidence that R&D does help firms to escape import competition from low-wage countries.

Generating exogenous variations in firm R&D investments from state tax credit

In a recent working paper (Hombert and Matray 2015), we provide evidence that firms’ R&D capital stock has a causal effect on their resilience to trade shocks. The identification challenge comes from the fact that innovation is endogenous. Even if we see a positive association between firm-level innovation and better resilience to trade shocks, we cannot conclude whether innovation improves resilience to trade shocks or whether firms which are more resilient to trade shocks choose to invest more in R&D.

We address the identification problem using tax-induced changes to the user cost of R&D investment. After the introduction of the US federal R&D tax credit in 1981, US states started to introduce R&D tax credits as well. In 2006, 32 states were offering tax credits, in some cases considerably more generous than the federal credit (Wilson 2009). The staggered implementation of these tax credit policies generates variation in the price of R&D across states and over time, which in turn generates exogenous variation in R&D across firms (Bloom et al. 2013).

Figure 2. State R&D tax credits

Source: Wilson (2009).

We also exploit the fact that some sectors have been strongly exposed to import penetration from China (e.g. textiles, electronics, furniture, industrial equipment) while other sectors have not (e.g. tobacco, printing, food, petroleum). Our empirical design relies on this cross-industry heterogeneity to implement a difference-in-difference strategy that compares the performance of firms that benefit from R&D subsidies relative to firms that do not, in sectors with high import penetration relative to sectors with low import penetration.

R&D investments make manufacturing firms more resilient to trade shocks

We first confirm prior evidence that China’s import penetration has sizeable adverse effects on the unconditional (i.e. independently from their R&D level) performance of US manufacturing firms. When US imports of Chinese goods increase by one standard deviation (which represents $20,000 per US worker), the average US firm experiences a decrease in annual sales growth of 2 percentage points and its return on assets decreases by 1 percentage point.

However, these negative consequences of trade shocks are mitigated for US firms that have invested more in R&D. We estimate that moving from the bottom quartile to the top quartile of the distribution of R&D capital reduces the adverse impact of Chinese competition by about a half. Innovative firms are more resilient to trade shocks both in terms of sales and profitability than their less innovative peers. We also find that while the average firm in import-competing industries downsizes in response to lower sales and profitability, more innovative US firms are able to avoid this outcome. They are less likely to reduce capital expenditures or to cut employment when import competition from China increases.

Conclusion

Our results indicate that innovative firms are better armed to face competition from emerging countries. They also point to the role of public policies towards innovation and suggest that policies like R&D subsidies can help mitigate adverse consequences of global competition.

References

Amiti, M and A K Khandelwal (2013), “Import Competition and Quality Upgrading’”, Review of Economics and Statistics 95, pp. 476-490.

Autor D H, D Dorn and G H Hanson (2013), “The China Syndrome: Local Labor Market Effects of Import Competition in the United States”, The American Economic Review 103, pp. 2121-68.

Bloom N, M Draca and J Van Reenen (2015), “Trade Induced Technical Change: The Impact of Chinese Imports on Innovation, Diffusion and Productivity”, forthcoming in Review of Economic Studies.

Bloom N, M Schankerman and J Van Reenen (2013), “Identifying Technology Spillovers and Product Market Rivalry”, Econometrica 81, pp. 1347-1393.

Hombert, J and A Matray (2015), “Can Innovation Help U.S. Manufacturing Firms Escape Import Competition from China?”, HEC Paris Research Paper No. FIN-2015-1075.

Wilson, D (2009), “Beggar thy Neighbor? The In-State, Out-of-State and Aggregate Effects of R\&D Tax Credits”, Review of Economics and Statistics 91, pp. 431-436.

This article is published in collaboration with Vox EU. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Adrien Matray is an Assistant Professor of Economics, Princeton University.

Image: A ship is loaded with containers at Sydney’s Port Botany container terminal. REUTERS/David Gray