Competition and Corporate Tax Avoidance:
Evidence from Chinese industrial firms
——蔡洪滨 刘俏
陈亮
魏科
倪利丹
孙理娜
【Contents】
I. Introduction
II. Text
1.Institutional Background
2.Theoretical Conjectures , Empirical Methodology and
Testable Hypotheses
3.Data and Variable Definitions
4.Empirical Results
5.Robustness Checks and Further Discussions
6.Conclusion
Copyright © 2012 Andy Guo. All rights reserved。
2
【Introduction】
1. This article investigates whether market competition
enhances the incentives of Chinese industrial firms to
avoid corporate income tax.
2.We estimate the effects of competition on the relationship
between firm’s reported accounting profits and their
imputed profits based on the national income account.
Copyright © 2012 Andy Guo. All rights reserved。
3
【Introduction】
3. To cope with measurement errors and potential
endogeneity, we use instrumental variables,exogenous
policy shocks and other robustness analysis.
4. ①We find robust and consistent evidence that
firms in more competitive environments engage in more tax
avoidance activities.
②Moreover, all else equal, firms in relatively
disadvantageous positions demonstrate stronger
incentives to avoid corporate income tax.
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4
【Introduction】
Research Background:
1. Phenomenon and fact:
Recently tax avoidance and evasion has received
increasing attention both practically and in academic
research.
2. Previous literature has examined various determinants
affecting tax avoidance and evasion, but characteristics
such as competitive environment affect firm’s incentives in
tax avoidance has not been analysed.
3. Almost all empirical works in this literature focus on the
US experience.
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5
【Introduction】
Research Background:
Note:
Following the literature, we do not distinguish tax voidance
( e.g. taking advantage of loopholes in tax laws, earning
management) and illegal evasion(e.g. failing to report
revenue or profit).
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6
【Introduction】
Consciousness 1
Consciousness 2
Firms in more
Firms in relatively
competitive
disadvantageous
industries have
positions within an
stronger incentives
industry should have
to avoid tax.
stronger incentives to
avoid tax.
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7
【Introduction】
Data resource and treatment :
The dataset we use is maintained by the National Bureau
of Statistics of China(NBS).
Time:2002-2005
Quantity:190000 firms per year
8
【Introduction】
Challenge in empirical analysis:
Firm’s true accounting profits are not observable.
How to overcome the challenge?
1.Previous scholars often use book incomes(账面收入）
as proxy （代理变量）for true profits(真实利润）.
2. But this approach works only for public companies since
book incomes for non-listed companies are usually
unavailable
3、Therefore, we calculate an imputed corporate profit
based on the national income account. However, the
imputed profit is not a good proxy for true accounting
profit( not as good as book income账面收入）
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9
【Introduction】
Challenge in empirical analysis:
For our purpose, we only need to assume that the imputed
profit and the true accounting profit are positively correlated.
It is obvious to hole!假设推算利润和真实利润是正相关的，这
是显然成立的！
Therefore, our empirical strategy is to test hypotheses
regarding how competition (and other variables of interest)
affects the sensitivity of the reported profits to the imputed
profits.
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10
【Introduction】
Results:
1. Our theoretical predictions are all confirmed by our
empirical results.
2.Specifically, we find strong evidence indicating that
competition in the product market enhances firm’s incentives
to engage in tax avoidance activities.
3. Our main empirical results are robust to alternative
specifications.
4. The competition effect is also economically significant.
5. Our analysis also yields useful results regarding other
factors that may affect firm’ s incentives to engage in tax
avoidance activities.
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11
【Introduction】
Contributions:
1. The evidence is from
China.
2. We proved the
competition increased the
tax avoidance behavior.
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12
【Introduction】
1.Institutional Background
2.Theoretical Conjectures, Empirical Methodology
and Testable Hypotheses
3.Data and Variable Definitions
4.Empirical Results
5.Robustness Checks and Further Discussions
6.Conclusion
Copyright © 2012 Andy Guo. All rights reserved。
13
【1.Institutional Background】
1.In the central planning system before economic
reforms started in 1978, Chinese industrial firms were
mostly state-owned (except small collective firms).
2. In 1994 China enacted the Corporate Income Tax
Code that overhauled corporate taxation.
3. The tax collection agencies were also reformed in
1994.
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14
【1.Institutional Background】
4. Along with impressive economic growth in the last three
decades, the economic landscape in China has changed
dramatically over the reform years.
5. The high economic growth and increasing tax collection
efforts together produce impressive growth of corporate income
tax revenue for the Chinese government since the reforms in
1994.
6. However, enforcement and collection of corporate income tax
are still considered
rather weak.
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15
【1.Institutional Background】
4. Three problems:
(1) insufficient manpower in the collection agency to deal with the increasing
number of firms;
(2) lack of training and skills in the collection agency to collect corporate
income
tax (which is much more complicated than other taxes such as VAT); and
(3) ineffective management system in the collection agency.
5. Among the many avoidance and evasion methods, the following
seem to be among the most common:
(a) mis-recording sales revenue (e.g., under accounts receivable);
(b) abusing tax credits (e.g., claiming recycling materials);
(c) transfer prices with affiliated firms;
(d) earning management (e.g., to smooth profit and loss); and
(e) fake receipts.
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16
【2.1Empirical Methodology】
(1) πit r=ditπit
+ eit+ζit
πit r is the profit firm i reports in year t,
πit is firm i’s true accounting profit in year t,
dit< 1 and eit <= 0 are two parameters,
ζit is a mean zero error term.
This means that firms under-report their profits.
Clearly, the amount of profit under-reported is πit- πit r,
decreasing in dit and eit. In other words ,when dit and eit
are greater, firm i reports more truthfully.
17
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【2.1Empirical Methodology】
dit and eitdepend on market competition and other
firm characteristics. Intuitively, firms under greater
competitive pressure are more motivated to avoid tax
so as to have more investment money to compete in
the market place. Thus, firms in more competitive
industries and firms in relatively disadvantageous
positions within an industry should have stronger
incentives to avoid tax.
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18
【2.2Theoretical Conjectures】
Conjecture 1. All else equal, profit under-reporting
becomes more severe in more competitive
environments.
Conjecture 2. All else equal, profit under-reporting
becomes more severe when tax rates or
marginal returns of capital are larger, or when
the cost of tax avoidance is smaller.
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19
【2.2Empirical Methodology】
(2) PROit=Yit-MEDit-FCit-WAGEit-CURRDit-VATit
Yit is the firm’s gross output;
MEDit measures its intermediate inputs excluding
financial charges;
FCitis its financial charges (mainly interest
payments);
WAGEit is the firm’s total wage bill;
CURRDi is the amount of current depreciation;
VATitis the value added tax.
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20
【2.2Empirical Methodology】
(3) πit=ηit+ PROit +θit
ηit is an unknown parameter.
θit is a mean zero error term.
The unobservable ηit reflects the (firm-specific)
differences in profit calculation between ccounting
system and the national income account system. A
priori, we do not know the sign of ηit : it can be
positive or negative.
By
substituting (3) into (1), we derive
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21
【2.2Empirical Methodology】
(4) RPROit = ditPROit +Eit+εit
we use RPROit to replace πit r .
Eit= ditηit +eit .
εit = ditθit + ζit
(5) dit=β0+β1Competj,t+β2Taxi,t+β3Financei,t +β4Firm
Sizei,t+β5Xi,t +εit
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【2.2Empirical Methodology】
(5) dit=β0+β1Competj,t+β2Taxi,t+β3Financei,t +β4Firm
Sizei,t+β5Xi,t +εit
j denotes the industry of firm i;
Competj,t measures the level of competition in industry j;
Taxi,t is firm is tax rate in year t;
Financei,t is a measure of how easily firm i can access
capital market;
Xi,t is a set of control variables that includes other firm
characteristics, time fixed effect and location fixed effect.
23
【2.3Hypothesis】
(5) dit=β0+β1Competj,t+β2Taxi,t+β3Financei,t +β4Firm
Sizei,t+β5Xi,t +εit
Hypothesis 1. β1< 0, i.e., a firm’s incentives to engage in tax
avoidance are positively correlated with the degree of
product market competition.
Hypothesis 2. β2 < 0, i.e., a firm’s incentives to engage in tax
avoidance are positively correlated with its tax rate.
Hypothesis 3. β3> 0, i.e., a firm’s incentives to engage in tax
avoidance are negatively correlated with its accessibility to
capital market.
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【2.3Hypothesis】
(5) dit=β0+β1Competj,t+β2Taxi,t+β3Financei,t +β4Firm
Sizei,t+β5Xi,t +εit
Hypothesis 4. β4> 0, i.e., larger firms have weaker incentives
to engage in tax avoidance.
We have a specification for Ei,t, which is similar to that for di,t
as in (5). That is to say,
Ei,t=α0+ α 1Competj,t+ α 2Taxi,t+ α 3Financei,t + α 4Firm
Sizei,t+ α 5Xi,t +εit
α = β* η
Since we cannot determine the sign of ηit and since
Eit= ditηit +eitour model has no prediction about how
25
Copyright
©
2012
Andy
Guo.
All
rights
reserved
。
Ei,twill be affected by competition or other variables.
【3.1Dataset】
1.The sources of data
A large dataset developed and maintained by the
National Bureau of Statistics of China (NBS),which
contains annual survey data of all above scale
industrial firms in China.
The information reported to the NBS should be quite
reliable.
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26
【3.1Dataset】
2. Sort out the data
observations whose information on critical is
missing;
misclassified observations whose operation scales
are clearly smaller than the classification standard of
above scale firms;
observations that have a negative value for some
variables;
observations with extreme variable values (the
values of key variables are either larger than the
99.5 percentile or smaller than the 0.5 percentile).
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27
【3.1Dataset】
3. The result of data processing
We obtain a sample of 514,394 observations
representing 194,635 unique firms for the period
from 2000 to 2005.
All monetary terms are in terms of 2000 constant
Renminbi(RMB).
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28
【3.2Variables : Profit measures】
Using these data, authors compute the imputed
profit (PRO) defined under the national income
account system as in (2).
We normalise both imputed profits and reported
profits by firms total assets (TA).
We define a variable GAP to denote the difference
between the two profit measures.
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29
【3.3Variables: Competition variables】
1
2
3
The
number of
abovescale firms
operating in
a four-digit
industry.
The
Herfindahl
index of
total sales
in a fourdigit
industry.
The
concentra
-tion ratio.
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4
The
industry
average
profit
margin.
30
【3.3Variables: Competition variables】
1
The number of
N
N
above-scale
firms
i 2
operating in a fourdigit industry.
i 1
i 1
X
HHI   ( )   ( S )
X
We use its natural
logarithm in our
analysis.
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2
The Herfindahl index
of total sales in a
2
four-digit industry.
It’s the sum of
squares of the market
shares (by sales) by
all firms in industry j.
31
【3.3Variables: Competition variables】
3
4
The concentration
ratio.
The industry average
4
profit margin.
by the four largest
firms in industry j (by
sales).
sales in a four-digit
industry.
total pre - tax profit
It’s the total market
total
sales
share accounted for
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Xi
CR  
It’s the ratio ofXtotal
i 1
pre-tax profit
to total
32
【3.3Variables: Competition variables】
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33
【3.4Variables: Other Variables】
1
Tax
Actual corporate incom tax
——————————————————
Total financial
charges
Reported
pre-tax
profit
2
Access to
credit
Total financial charges
——————————————————
Total assets
3
Tax=0 for lossmaking firms
Ownership DSOE, Dprivate, Dforeign, DHK/TW,
status
Dmixed and Dcollective
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34
【3.4Variables: Other Variables】
4
Firm size
Log(the number of
employees)
5
Sales/Outp
ut
Sales
——————
Total output
6
Location
dummies
merge Tibet, Qianghai
and Ningxia，merge
Chongqing and
Sichuan
Time
7
dummies
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35
4. Empirical Results
1
OLS Regressions
2
IV Estimates
3
Natural Experiment
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36
4. Empirical Results
To get a feeling of how competition may affect a firm’s profit hiding incentive,
we plot the difference between the imputed profit and reported profit against
the logarithm of the number of firms in an given two-digit industry.
Although this quick
look at the data
should be taken with
caution, it does
suggest that the
difference between
the imputed and
reported profits may
be related to the
degree of market
competition.
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37
4. Empirical Results
Hypothesis
β 2<0
β 3>0
β 4>0
Log of no. of firms
Herfindahl index
β 1<0
Profit Margin
Market Share by
Top 4 Firms
Smaller
RPRO
higher competition
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β 1>0
38
【4.1. OLS Regressions】
We first use the OLS regression to estimate (6), in which we use four
alternative measures of competition at the four-digit industry level.
If
(i) the imputed profit
is a good proxy for the
true accounting profit,
(ii) there are no
measurement errors
in the imputed profit,
(iii) firms do not
under-report profit,
then the coefficient of
the imputed profit
should be one and
that of the intercept
should be zero.
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39
【4.1. OLS Regressions】
In column (2), we add all variables specified in (6) except the
competition variables and their interactions with the imputed profit.
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40
【4.1. OLS Regressions】
In columns (3) and (4), we only consider the impact of competition
(measured by the Herfindahl index and the profit margin, respectively) on
the relationship between the reported profit and the imputed profit.
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41
【4.1. OLS Regressions】
In columns (5)–(8), we estimate (6) with OLS regressions using different
competition measures.
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42
【4.1. OLS Regressions】
The results on other variables of interest are also largely
consistent with our conjecture.
β2<0
Β3>0
Β4>0
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43
【4.1. OLS Regressions】
Table 3 also reports the estimated coefficients of ownership dummies.
From the sensitivity of the reported profit to the imputed profit, private
firms and Hong Kong and Taiwan firms report lower profits than SOEs,
collective firms and foreign firms report higher profits than SOEs, while
mixed ownership firms are not significantly different from SOEs.
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44
【4.2. The Impact of Competition
on Profit Hiding: IV Estimates】
While the OLS regression results support our hypotheses, they should
be interpreted with caution.
1.omitted
variables
2.Measured
errors
cause an endogeneity problem if these omitted
variables are related to observed right-hand-side
variables such as competition variables and the
imputed profit.
the imputed profit and the competition variables
in our empirical analysis are likely to be
measured with errors. OLS will yield biased and
inconsistent estimates.
3.the difficulty rely on industry-level variations in competition
of comparing to capture the effect of competition on firms tax
competition avoidance behavior.
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45
【two approaches to solve
the cautions】
A primary approach
use the method of
instrumental variables both
the imputed profit and the
measure of competition.
identify appropriate
instrument variables and
use the 2SLS regression to
estimate the βis in (6).
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A second approach
use variations introduced
by a natural experiment in
China in 2002, i.e., China’s
WTO entry, which exposed
several Chinese
manufacturing industries
to heightened product.
46
【First method: IV Estimates
-------two instruments】
imputed profit
Av.PRO
the four-digit industry
average imputed profit
(excluding the firm itself) as
the instrument for a firm’s
imputed profit.
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competition
STEP---------the competition
variables is the number of
application procedures a firm
has to go through in order to
enter a four-digit industry .
It is unlikely to be related to
factors affecting firm’s profit
reporting once they have
entered.
47
【4.2. The Impact of Competition
on Profit Hiding: IV Estimates】
To save space, we only report the results of using the profit margin as the
measure of competition. We report the second stage regression results in
Table 4.
β2<0
Β3>0
Β4>0
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48
【4.2. The Impact of Competition
on Profit Hiding: IV Estimates】
It should be emphasised that in case of multiple endogenous variables, the
equation by equation F-statistics might be misleading. The instruments can
be weak although they are very significant in each first stage regression.
the instruments
used in our
2SLS
estimations are
not subject to
the weak
identification
problem.
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49
【4.2. The Impact of Competition
on Profit Hiding: IV Estimates】
Table 5 presents the results of the first-stage regressions for models
(2)–(4) of Table 4.
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50
【4.3. A Natural Experiment】
Another way of dealing with endogeneity and identifying causality is to
use exogenous shocks to competition intensity (natural experiment).
In 1995 the State Development and
Planning Commission
of China
(SDPC)
• The SDPC
revised
the catalogue in
issued its first investment
catalogue,”
the
2002 to loosen
up restrictions
on a
• As a in
result,
Catalogue Guiding
Foreign
Investment”
in
number
of industries
order the
to benumber of firms jumped
Industry, definingcompliant
what investment
projects
with the
WTO regulations.
substantially
from 2002 to 2003 in
were encouraged,
permitted,
restricted
orindustries
• Among
the 37
four-digit
that (from 86 to 129)
large-sized
refrigerator
prohibited for foreign
wereinvestors.
reclassified
intointhe
permitted
and
power
plant equipment (from 156
category in 2002tofrom
restricted
to the Herfindahl index
240).
Similarly,
foreign investment in 1995, large-sized
in the large-sized refrigerator (power
refrigerator (4063) and power plant
plant
equipment)
decreased
equipment (4011)
were in manufacturing.
substantially from 0.299 (0.042) in 2002
to 0.101 (0.03) in 2003.
51
【4.3. A Natural Experiment】
Time dummy variable
We define a time dummy
variable POST which takes the
value of 1 after 2002 and 0
otherwise. For each of the two
industries, we also identify a
comparable industry which is in
the same three-digit industry but
has been opened since 1995.
They are Electrical Fans (4064)
and Electric Generator (4012)
respectively.
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Another dummy
variables
TREAT is a dummy variables
specifying whether a firm was
permitted in 2002. The
coefficient of TREAT*POST*
Imputed Profit thus captures the
difference between the
treatment and control groups in
the changes in the sensitivity of
the reported profit to the
imputed profit before and after
2002.
52
【4.3. A Natural Experiment】
Columns (1) and (4) report the OLS results, including treatment firms
and control firms for the two newly opened industries respectively.
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53
【4.3. A Natural Experiment】
While we use PMARGIN as the competition measure, we also include
POST, TREAT, and their interactions with imputed profit as controls.
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54
【4.3. A Natural Experiment】
IV estimates
Column (6) presents the
second stage regression
results for power plan
equipment/electrical
generator industries. While
the IV estimate on the
variable of interest – the
interactive term of the profit
margin with the imputed
profit – is positive and
marginally significant, the
Cragg-Donald statistic is as
high as 34.63 and passes
the 5% critical value.
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55
【4.3. A Natural Experiment】
We report both the OLS results and IV results. The bottom of the Table
reports the first stage regression results for the IV regressions. Robust
standard errors adjusting for sample clusters appear in parentheses.
We instrument for the
profit margin with
TREAT*POST and for the
interactive term of profit
margin with imputed profit
with TREAT*POST
*Imputed Profit under the
assumption that opening
up those industries
changes the competitive
landscape.
【 5 . Robustness Checks 】
1
Profit Smoothing
2
Market Definition
3
An Alternative Possibility
4
Other Variables
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57
【 5.1Profit Smoothing 】
Reported profit depends on its contemporaneous
imputed profit
however，
firms may try to smooth profit over time
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58
【5.1Profit Smoothing】
1
include the
one-year
lagged
imputed
profit as an
additional
independent
variable in the
baseline model
2
reported
profits
respond to
both last
year’s and
this year’s
imputed
profits
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3
average of
imputed and
reported profits
for each firm
over the six
years
59
【 5.1Profit Smoothing 】
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60
【5.1Profit Smoothing】
1
include the oneyear lagged
imputed profit
as an additional
independent
variable in the
baseline model
2
reported
profits
respond to
both last
year’s and
this year’s
imputed
profits
Copyright © 2012 Andy Guo. All rights reserved。
3
average of
imputed and
reported profits
for each firm
over the six
years
61
【 5.1Profit Smoothing 】
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62
【 5.1Profit Smoothing 】
—
+
+
+
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63
【5.1Profit Smoothing】
1
include the
one-year
lagged
imputed
profit as an
additional
independent
variable in the
baseline model
2
reported
profits
respond to
both last
year’s and
this year’s
imputed
profits
Copyright © 2012 Andy Guo. All rights reserved。
3
average of
imputed and
reported profits
for each firm
over the six
years
64
【 5.1Profit Smoothing 】
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65
【 5.1Profit Smoothing 】
The effect of competition on
corporate tax avoidance is robust to
the possibility that firms smooth
profit over time.
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66
【 5.2 Market Definition 】
We define an industry according to the four-digit
industry codes specified by the NBS in the national
market
however，
not all firms compete in the national market
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67
【 5.2 Market Definition 】
1
Our sample period is
from 2000 to 2005,
during which China
continued to broaden
and deepen its marketoriented reforms，
especially pronounced in
the industrial sectors
(Holz, 2006).
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2
Focus on above scale
industrial firms, who are
more likely to operate
and compete in the
national market
68
【 5.2 Market Definition 】
Here we make an assumption that the geographical
boundaries of a product market are regional.
Compute competition measures and estimate the
baseline models accordingly.
Empirical results qualitatively similar to those based
on the national market assumption.
Results are robust to different geographic
definitions of product markets.
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69
【 5.3 An Alternative Possibility 】
We argue that firms in more competitive industries
report less profits for each unit of imputed profit in
order to save tax.
However,
One alternative possibility is that firms in more
competitive industries have more difficulties
converting imputed profits into
accounting profits.
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70
【 5.2 Market Definition 】
We obtain from the our dataset the available components of
working capital accruals and variables
The change in inventories scaled by total assets (DINVi,t);
The change of current liabilities scaled by total assets (DCLi,t);
The ratio of depreciation in the current year to total assets
(DCURRDi,t);
The ratio of sale charges to total sales (SCi,t);
The ratio of administrative charges over total sales (ADCi,t).
Add the above five variables and their interactions with imputed
profit to the baseline regression model
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【 5.3 An Alternative Possibility 】
Copyright © 2012 Andy Guo. All rights reserved。
72
【 5.3 An Alternative Possibility 】
The results are robust to the
possibility that firms in more
competitive industries face more
technical difficulties in converting
imputed profits into accounting
profits.
Copyright © 2012 Andy Guo. All rights reserved。
73
【 5.4 Other Variables 】
managerial incentives and corporate governance
the differences of tax avoidance behaviour
between different types of firms.
SOEs and mixed firms,Collective, private and
Hong Kong and Taiwan firms, and foreign firms
further analysis is clearly needed to establish the
link, which exceeds the scope of this article
Copyright © 2012 Andy Guo. All rights reserved。
74
【 5.4 Other Variables 】
enforcement actions by tax authorities
tax authorities in China take it easy on firms in
competitive industries and hence these firms engage in
more tax avoidance activities
tax collecting agencies in China are not very
sophisticated yet
Targeting profitable industries and taking it easy on
less profitable ones
Copyright © 2012 Andy Guo. All rights reserved。
75
【 5.4 Other Variables 】
effective industry tax rate is positively correlated with
competition. 0.0483, 0.0257,0.0664, and 0.0668
tax enforcement is not necessarily more lax in
competitive industries
overseas tax havens and deductions of employee
stock options
Outbound investments by Chinese firms are not very
active for
most of our sample period.
76
Copyright © 2012 Andy Guo. All rights reserved。
【 5.4 Other Variables 】
The firms with sizable overseas/offshore incomes are
mainly foreign firms and Hong Kong and Taiwan firms.
Moreover, we estimate the reported profit equations on
a domestic-firm-only sub-sample and obtain
qualitatively similar results.
During our sample period and until today, employee
stock options are rarely used in Chinese industrial
firms, and are not commonly used even for those
publicly listed firms in China.
Copyright © 2012 Andy Guo. All rights reserved。
77
【 6. Conclusion 】
competition pressure drives Chinese industrial
firms to engage in more tax avoidance activities.
improved tax enforcement, strengthened financial
market regulation and policies that ensure all
market participants have a level competitive
field.
help tax authorities to improve auditing
strategies
Copyright © 2012 Andy Guo. All rights reserved。
78
Thank
YOU!