Innovation in the face of CSR compliance

This study explores the impact of social policies, specifically India's Corporate Social Responsibility (CSR) Regulation of 2013 (Section 135), on corporate innovation. While innovation is traditionally incentivized by fiscal policies like tax cuts and R&D credits, this paper, ‘Do social policies foster innovation? Evidence from India's CSR regulation’ investigates the less explored area of regulations promoting sustainable and socially responsible business practices.

The CSR regulation mandates that qualifying Indian firms allocate 2% of pre-tax profits to CSR projects. The paper hypothesises that firms near the threshold would manipulate profits to avoid regulation and predicts an increase in Research and Development (R&D) expenses as a strategy. Using Prowess data, the study first establishes an increase in CSR expenses post-regulation but finds no difference between innovative and non-innovative firms. It focuses on all firms listed on the two main stock exchanges (the Bombay Stock Exchange and the National Stock Exchange).

The study addresses concerns about resource allocation efficiency by analysing firms' innovation history. Firms with prior innovation investments are more likely to increase R&D expenses, while non-innovative firms opt for CSR compliance due to the high setup costs of R&D infrastructure. Importantly, the paper finds that the increased R&D expenses lead to tangible innovation outcomes, such as more patent applications and new product announcements.

This research contributes to the literature by revealing the impact of social policies on corporate innovation, offering insights into the debate on fiscal incentives for innovation, and emphasising the unintended consequences of policy thresholds. It further contributes to understanding how CSR regulations affect Indian companies, highlighting potential long-term benefits for those evading the regulation through increased innovation activities.

Institutional background and conceptual framework

The study focuses on India's CSR regulation (Section 135) and its unintended consequences for firms' R&D expenses and innovation outcomes. Section 135, implemented in 2014, mandates firms meeting specific criteria to spend 2% of their average pre-tax profits on CSR activities in specified impact areas. The criteria include net worth, turnover, and net profit thresholds.

The conceptual framework considers the rationale behind making CSR mandatory and the compliance basis. It explores the notion that CSR regulation may be a public finance decision to generate additional revenue for social development projects. The "comply or explain" policy is speculated to provide an adjustment period for firms to establish spending infrastructure, with penalties introduced for non-compliance over time.

Hypotheses are formulated to test how firms manipulate pre-tax profits to avoid CSR compliance (Hypothesis 1) and whether firms near the profit threshold increase R&D expenses as an alternative (Hypothesis 2). The study posits that firms with a history of innovation are more likely to increase R&D expenses to bypass CSR compliance (Hypothesis 2a).

The study investigates the strategic responses of firms to CSR regulation, focusing on profit manipulation, increased R&D expenses, and the subsequent impact on innovation outcomes.

Data and interpretation

The study utilises Prowess data on listed Indian firms from 2010 to 2019, focusing on the impact of Section 135 of the Companies Act on CSR expenses, R&D expenditures, and innovation outcomes. The sample comprises 76,380 firm-year observations, narrowed down to 41,412 for empirical models requiring consistent data. Key thresholds for qualifying under CSR regulation include net worth, turnover, and net profit.

Data on patent applications (26,631 patents) and new product announcements (35,793) are collected using fuzzy matching techniques. The study employs a fuzzy matching algorithm to associate firm names in patent applications with the Prowess sample, ensuring data quality.

The empirical strategy involves regression models assessing the average effect of CSR law on CSR expenses, focusing on firms near the profit threshold. Bunching analysis detects discontinuities in pre-tax profits, indicating potential manipulation. Multivariate regression models explore the relationship between CSR law and R&D expenses, considering various control variables.

The study tests the impact of CSR regulation on innovative firms, employing triple interactions and examining firms' attempts to avoid CSR qualification through discontinuity analyses. It concludes with regression models assessing the economic effects of the policy on innovation outcomes, specifically patent applications and new product announcements. The robustness of results is ensured through alternate specifications and time-series plots.

Results

The key results of the study, focus on the impact of the CSR law on Indian firms' CSR expenses, the strategic behaviour around pre-tax profit thresholds, and the relationship between CSR law and R&D expenses.

• CSR law and CSR expenses:

  Using regression models, the authors examine the average effect of the CSR law on Indian firms' CSR expenses. The results reveal a notable growth in average CSR expenses of sample firms following the CSR law. However, when specifically analysing firms in the narrow pre-tax profit bandwidth (₹40 million to ₹49.99 million), there is no significant change in their CSR expenditure post-regulation. This suggests that firms near the profit threshold do not alter their CSR spending relative to those further below it, indicating a lack of trade-off between CSR and R&D expenses.

• Bunching of pre-tax profits:

  The analysis of bunching around pre-tax profit thresholds provides compelling evidence of firms manipulating profits to avoid CSR law compliance. Bunching is observed on the left of the profit threshold, showcasing a higher fraction of firms just below it. This behaviour is not observed at net worth and sales turnover thresholds, highlighting the relative ease of manipulating profits compared to other financial metrics.

• CSR law and R&D expenses:

  The paper presents estimates of R&D expenses for firms in the narrow profit bandwidth, revealing a statistically significant increase post-regulation. This increase is not observed in other corporate expenses such as compensation, overhead, and professional service costs. The results remain robust across various specifications, confirming that firms strategically increase R&D expenses to avoid qualifying for the CSR law.

• Heterogeneous treatment effects:

  Examining heterogeneous treatment effects, we find that innovative firms and those in innovative industries in the bandwidth increased R&D expenses post-regulation compared to non-innovative counterparts. Firms with no previous innovation history did not show a significant increase in R&D spending, indicating that the CSR regulation primarily incentivizes already innovative firms to scale up their R&D activities.

• Effects on innovation outcomes:

  Focusing on tangible innovation outcomes, we observe that Bandwidth firms increasing R&D expenses post-regulation filed additional patent applications and announced new products. The results suggest positive innovation outcomes for firms strategically increasing R&D spending to avoid CSR law compliance.

• Extensions and robustness:

  Various robustness tests confirm the reliability of our findings. The results hold across different bandwidths, with varying thresholds, and are not confounded by factors such as changes in export market conditions or equity ownership patterns.

Conclusion

This study demonstrates that Indian CSR policies drive innovation. Firms near the CSR regulation's profit threshold engage in earnings management, reducing reported profits and increasing R&D expenses to avoid compliance. This strategic behaviour leads to tangible innovation outcomes, with proximate firms applying for one extra patent and announcing two new products in the subsequent three years. The findings suggest that indirect incentives from social policies can foster genuine innovation, avoiding concerns about misleading information associated with direct fiscal incentives for R&D.

The full paper can be viewed here