Media Briefings

THE ‘DARK SIDE’ OF COMPETITION: CHINESE FIRMS DRIVEN TO CORPORATE TAX AVOIDANCE

  • Published Date: April 2009

Greater competition may drive firms to avoid paying corporate taxes. That is the central conclusion of research by Hongbin Cai and Qiao Liu. Their study, published in the Economic Journal, analyses data on nearly 200,000 industrial firms in China to gauge the extent of ‘profit hiding’ as a strategy for corporate tax avoidance.

While it is generally believed that competition promotes efficiency, it can also have a
‘dark side’. In the absence of a level playing field and in an environment of weak institutions, competition may force firms, especially those at disadvantageous positions, to engage in illegal or unethical behaviour to gain competitive advantage.

This study finds that Chinese firms in a more competitive environment do indeed engage in more profit hiding. It also finds that firms in relative disadvantageous positions have stronger incentives to hide profit and avoid corporate income tax.

The researchers draw several policy implications from their work:

  • In a market environment with poor institutional infrastructure, competition may well encourage socially wasteful activities as firms use all possible ways to get ahead.
  • Policies intended to promote competition in developing and transition economies must be accompanied by reforms that improve institutions such as improving tax enforcement, strengthening financial market regulation and ensuring all market participants have a level competitive field.
  • Tax authorities can improve their auditing strategies by identifying which types of firms are more likely to be guilty of tax avoidance, namely firms in competitive industries.

The intuition that competition leads to tax avoidance is very difficult to test given the illicit nature of such behaviour. Cai and Liu develop an innovative approach to gauge the extent of profit hiding, using the firm-level profit based on national income accounts as a proxy for a firm’s true accounting profit.

The National Bureau of Statistics of China compiles the national income account information on a regular basis. According to the Law of Statistics in China, such information cannot be used for other purposes (such as tax) and hence is less subject to firm manipulation.

In the absence of any attempts at profit hiding or tax avoidance, a firm’s reported accounting profit should be highly correlated with the imputed profit based on the national income accounts. The deviation of reported profits from imputed profits thus reveals the degree of profit hiding/tax avoidance.

The two authors apply this empirical approach to a sample of close to 200,000 Chinese industrial firms over the period 2000-2005. Controlling for other factors that may cause the deviation of accounting profits from imputed profits, they find that firms in more competitive environments engage in more profit hiding. They also find that firms in relative disadvantageous positions have stronger incentives to hide profits and avoid corporate income tax.

In a natural experiment, the authors examine firms’ profit hiding in two particular industries – large-sized refrigerators and power plant equipment – that had been opened to foreign investment in 2002 by China’s State Development and Planning Commission.

The change in regulation substantially increased the number of firms in the two industries. As a result of heightened competition, firms in the two industries demonstrate an increased level of tax avoidance.

The study is one of the first tests of the relationship between competition and firms’ tax avoidance behaviour. Its innovative empirical approach can be applied in a wide range of contexts. For example, the authors are currently applying the approach to the question of whether good corporate governance practice makes firms most honest.

ENDS

Notes for editors: ‘Competition and Corporate Tax Avoidance: Evidence from Chinese Industrial Firms’ by Hongbin Cai and Qiao Liu is published in the April 2009 issue of the Economic Journal.

Hongbin Cai is at Peking University. Qiao Liu is at the University of Hong Kong.

For further information: contact Romesh Vaitilingam on 07768 661095 (email: romesh@vaitilingam.com); Hongbin Cai via email: hbcai@gsm.pku.edu.cn; or Qiao Liu via email: qliu@hkucc.hku.hk