Do firms with heterogeneous in-house R&D capacities respond differently to innovation policy? Using India’s 1998 R&D tax credit targeting firms with in-house R&D units, we find that R&D spending rose across firms, but product responses differed. Small and medium firms expanded product scope, whereas large firms improved product quality, especially among exporters and producers of differentiated goods. Our heterogeneous-firm model explains these patterns through optimization across scope, scale, and quality. A complementary welfare accounting exercise reports a 93% decline in the observed effective price index, suggesting substantial welfare gains during the policy period.