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COMPETITION AND CORPORATE TAX AVOIDANCE EVIDENCE FROM CHINESE INDUSTRIAL FIRMS Hongbin Cai and Qiao Liu This article investigates whether market competition enhances the incentives of Chinese industrial fi rms to avoid corporate income tax We estimate the effects of competition on the relationship between fi rms reported accounting profi ts and their imputed profi ts based on the national income account To cope with measurement errors and potential endogeneity we use instrumental variables exogenous policy shocks and other robustness analysis We fi nd robust and consistent evidence that fi rms in more competitive environments engage in more tax avoidance activities Moreover all else equal fi rms in relatively disadvantageous positions demonstrate stronger incentives to avoid corporate income tax Recently tax avoidance and evasion has received increasing attention both practically and in academic research 1The literature has come to view tax avoidance and evasion as an important corporate strategy and has examined various determinants affecting tax avoidance activities see e g Slemrod 2004 Desai and Dharmapala 2006 However how industrial characteristics such as competitive environment affect fi rms incentives to engage in tax avoidance activities has not been analysed Moreover almost all empirical works in this literature focus on the US experience for a notable exception see Sivadasan and Slemrod 2006 on India Using a large dataset of Chinese industrial fi rms we examine empirically how product market competition affects fi rms incentives to avoid corporate income tax We study corporate tax saving behaviour of Chinese fi rms because it is an important economic phenomenon in an increasingly important economy in the world 2For example the Chinese National Auditing Offi ce uncovered 11 89 billion Chinese yuan or RMB about 1 6 billion in 2003 based on a four month nationwide investigation of 788 companies selected at random in 17 provinces and cities The Asian Wall Street Journal A2 September 20 2004 Fisman and Wei 2004 also identify evidence of pervasive tariff evasion in China It is safe to say that these cases of uncovered We are grateful to Jo rn Steffen Pischke the editor and three anonymous referees for numerous con structive comments that greatly improved the article We have also benefi ted from the comments of Paul Devereux Amar Hamoudi Joseph Fan Huixing Huang Ginger Jin Sainan Jin Jean Laurent Rosenthal James Vere and participants at the HKUST Finance Seminar 2006 AEA annual meeting and 2006 Interna tional Conference on Corporate Governance in Asia We thank Geng Xiao for help in the early stage of this project and Yong Wei for excellent research assistance The fi rst author acknowledges support from NSFC grant Project No 70725002 and from the Chinese Education Ministry s NCET The second author s research has been supported by grants from the University Grants Committee of Hong Kong Projects No AOE H 05 99 HKU 7472 06H and HKU747107H 1 For example the US Internal Revenue Service estimated that about 17 of income tax liability is not paid Slemrod and Yitzhaki 2002 Citing the US General Accounting Offi ce Desai and Dharmapala 2006 state that By 2000 53 of large US corporations reported tax liabilities lower than 100 000 Feldman and Slemrod 2007 fi nd that On average reported positive self employment non farm small business and fame income must be multiplied by a factor of 1 54 4 54 and 3 87 respectively in order to obtain true income 2 Following the literature we do not distinguish tax avoidance e g taking advantage of loopholes in tax laws earning management and illegal evasion e g failing to report revenue or profi t Moreover tax avoidance and evasion tax avoidance tax saving and tax effi ciency are used interchangeably The Economic Journal 119 April 764 795 The Author s Journal compilation Royal Economic Society 2009 Published by Blackwell Publishing 9600 Garsington Road Oxford OX4 2DQ UK and 350 Main Street Malden MA 02148 USA 764 tax evasion represent only a tiny fraction of tax avoidance and evasion by Chinese fi rms Intuitively fi rms under greater competition pressure are more motivated to avoid tax so as to have more investment money to compete in the market place Thus fi rms in more competitive industries and fi rms in relatively disadvantageous positions within an industry should have stronger incentives to avoid tax In an earlier working paper Cai and Liu 2007 we demonstrate these results in a simple theoretical model In this article we focus on testing these conjectures empirically The dataset we use is maintained by the National Bureau of Statistics of China NBS and contains fi rm level information based on the annual accounting briefi ng reports fi led by all above scale industrial fi rms in China from 2000 to 2005 On average we have about 190 000 fi rms per year in our sample However a main challenge for our empirical analysis which is common to the literature on tax avoidance and evasion
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