Government Financial Support and Firm Innovation

Prior studies have documented a positive effect of government financial support on firms’ innovation. However, such a positive effect could be due to two alternative underlying mechanisms –‘additionality’ or ‘crowding-out’. The former, whereby government financial assistance relaxes financial constraints for recipient firms and enables their innovation, represents the desired positive effect. On the other hand, the crowding-out mechanism – whereby financially unconstrained recipient firms use government funding to simply replace their private spending – represents mistargeted government intervention. This paper attempts to disentangle these two mechanisms to understand which one of them drives empirical observations of a positive effect of government funding on firm innovation. We achieve this through formulating and testing two competing moderator hypotheses, each one being a unique derivative of the additionality and crowding-out mechanisms respectively. Our empirical analysis uses firm-level panel data from the Business Longitudinal Database (BLD) compiled by the Australian Bureau of Statistics (ABS), 2011-2016, and addresses both endogeneity and selection problems in our estimation. We find that government financial support increases the number of innovation that recipient firms produce. However, we also find that this positive effect is likely a result of the crowding-out mechanism. Financially unconstrained firms appear to benefit more from government support than financially constrained firms.