The Precision Trap: How R&D Reclassification Distorts Investment

This paper examines whether and how the precision of item classification in the income statement affects investment efficiency. I use the recent Section 174 change in R&D tax deductibility as an instrument for shifts in R&D classification and build a simple model illustrating the trade-offs firms face. The model predicts that while firms initially reclassify R&D expenditures to mitigate higher costs of investment, this misclassification introduces noise into classification precision, eventually leading to underinvestment. Using R&D-related employment as a proxy for real investments and a difference-in-differences approach, I show that firms strategically reclassify R&D as expected, and find some evidence consistent with a deterioration in investment efficiency. In line with theoretical predictions, cross-sectional tests confirm that the effect is more pronounced among firms with higher initial classification precision. Collectively, these results demonstrate the important role of classification precision in investment efficiency and highlight how tax policy changes can spill over into corporate reporting, leading to real economic consequences.