•Allocation and effectiveness of R&D subsidies analyzed for Chinese firms.•Allocation determined by prior grants, high quality inventions, firm ownership.•R&D subsidies crowd-out business R&D investments but are neutral in later periods.•No crowding-out for repeated recipients, hightech firms, minority state-owned firms. In this study we investigate the allocation of China’s R&D subsidies and their effectiveness in stimulating business R&D investments for the population of Chinese listed firms between 2001 and 2006. With respect to subsidy allocation, we find that firm selection is mainly determined by prior grants, high quality inventions, and minority state-ownership. Market-oriented provincial governments distribute grants less frequently, and firms located in developed provinces receive grants more often. Considering effectiveness, R&D subsidies instantaneously crowd-out business R&D investment but are neutral in later periods. In 2006, one public RMB reduces business R&D investments by half an RMB. However, crowding-out is not prevalent for repeated recipients of R&D subsidies, high-tech firms, and minority state-owned firms.