Trade Liberalization and Corporate Income Tax Avoidance

Transcription

1 Trade Liberalization and Corporate Income Tax Avoidance Yao Lu Xinzheng Shi * Tsinghua University December 2016 Abstract We identify the effect of trade liberalization on corporate income tax avoidance in a sample of Chinese manufacturing firms, using China s entry into the World Trade Organization (WTO). We find that firms engage in more tax avoidance in industries with larger tariff reductions. We also find that firms with better corporate governance engage in less tax avoidance than their counterparts. Further analysis shows that firms with a lack of cash or a high demand for cash before WTO entry tend to engage in more tax avoidance after WTO entry. Our study also provides evidence that manipulating costs is one way that firms avoid corporate income tax. Keywords: Trade liberalization; tax avoidance; WTO entry JEL code: D22; F61; F63; H26 * Yao Lu is an Associate Professor in the Department of Finance in the School of Economics and Management, Tsinghua University; Xinzheng Shi is an Associate Professor in the Department of Economics in the School of Economics and Management, Tsinghua University. We wish to thank Rui Wang for providing excellent research assistance, and Hongbin Li and the participants in the CCER Summer Institute 2016 for helpful comments. Corresponding author: Xinzheng Shi (shixzh@sem.tsinghua.edu.cn). 1

2 1. Introduction After the Second World War, many developing countries chose import substitution as a strategy for industrialization. However, in the past three decades, many countries have begun to favor global economic integration, particularly trade liberalization, as a development strategy. Previous research has documented that, faced with a more competitive environment after trade liberalization, 1 firms invest more in technological development, 2 which improves their productivity 3 and therefore the likelihood of their survival. 4 Collectively, this leads to rapid growth in the whole economy. 5 However, one possible behavioral response of firms to trade liberalization, i.e., corporate income tax avoidance, has seldom been studied. 6 Corporate income tax avoidance is a commonly observed behavior among firms. Schneider and Ernste (2000) point out that tax avoidance is widespread in developing countries and estimate that the tax avoidance rate is above 50% in many low-income countries. In China, the National Auditing Office uncovered RMB11.89 billion (roughly 1.6 billion dollars) in tax avoidance in 2003, based on a nationwide investigation of 788 randomly selected companies in 17 provinces and cities (Asian Wall Street Journal, A2, September 20, 2004). In this paper, we investigate the effect of trade liberalization on corporate income tax avoidance by manufacturing firms in China, taking advantage of China s 1 Levinsohn, 1993; Krishna and Mitra, 1998; Brandt et al., 2012; Lu and Yu, Rodrik, 1988; Brandt and Thun, Topalova and Khandelwal, 2011; Pavcnik, 2002; Amiti and Konings, 2007; Tybout and Westbrook, 1995; Krishna and Mitra, 1998; Brandt, et al., 2012; Ederington and McCalman, 2007; Trefler, 2004; Schor, 2004; Lileeva and Trefler, 2010; Harrison, Baggs, See Nunn and Trefler (2010) and Brandt and Thun (2010). However, some researchers find that the benefits of trade liberalization are not distributed equally among different groups. For example, Topalova (2007) finds that trade liberalization leads to an increase in the poverty rate and poverty gap in rural districts where industries more exposed to liberalization are concentrated. 6 Corporate income tax avoidance, corporate tax avoidance and tax avoidance are used interchangeably in this paper. Following the literature, we do not distinguish between tax avoidance (legal) and tax evasion (illegal) but call both of them tax avoidance. 2

3 entry into the WTO. The effect of trade liberalization on tax avoidance is not straightforward from a theoretical perspective. Previous studies (Levinsohn, 1993; Krishna and Mitra, 1998; Brandt et al., 2012; and Lu and Yu, 2015) have shown that a reduction in import tariffs due to trade liberalization increases the level of competition in the domestic market. As Shleifer (2004) notes, the cost of ethical behavior is high under heightened competitive pressure. In addition, Slemrod (2004) finds that firms whose profit performance decreases due to greater competition may resort to noncompliance so that they have more cash to invest and thus improve their prospects. Trade liberalization may therefore lead to higher incentives for corporate income tax avoidance. However, the increased competitiveness in product markets fostered by trade liberalization may increase the real value of the same amount of money. That is, one dollar gained or lost means more for firms in a more competitive environment. As Slemrod (2004) also notes, people normally value a given amount of punishment higher than the equivalent amount of tax savings. Thus, trade liberalization may increase the real cost of being caught, making firms more conservative and leading to a lower incentive for corporate tax avoidance. Therefore, the theoretical prediction of the effects of trade liberalization on corporate tax avoidance is not clear, and empirical studies are needed. 7 A common difficulty in studying tax avoidance is how to measure it. In the literature, book income is usually used as a proxy for firms true accounting profits, and therefore the gap between book and taxable income (scaled by total assets) is used as a measure of tax avoidance (Desai, 2003, 2005; Desai and Dharmapala, 2006). However, this approach works only for publicly listed firms, as book income is usually not available for non-listed firms. In this paper, we 7 Trade liberalization could affect firms tax avoidance through other channels such as reducing input tariffs, increasing excess to foreign markets, and changing domestic legal environments. However, robustness checks in our paper show that these possible channels do not drive the main results. 3

4 follow Cai and Liu (2009) in calculating an imputed profit based on the national income account. That is, we calculate the imputed profit by subtracting intermediate inputs from gross output. The gap between imputed profit and reported profit is our measurement of tax avoidance. However, the imputed profit can be legitimately different from the true accounting profit, due to differences in revenue and expense recognition rules between the national income account and the General Accepted Accounting Principles (GAAP) with which accounting profit is calculated. 8 Fortunately, the panel feature of Chinese manufacturing firms allows us to control for any time-invariant systematic difference between these two accounting systems, which may mitigate this problem. In addition, we conduct several robustness checks, described later, to justify this measurement. After China entered the WTO, import tariffs were reduced to a uniquely low level, which means that reductions were correspondingly larger for industries with higher tariff levels before WTO entry. Combining before after variation and the different levels of tariffs before WTO entry across industries, we use a difference in difference (DID) strategy to identify the effect of trade liberalization on tax avoidance, using data from Chinese manufacturing firms. We find that WTO entry induced firms in industries with a tariff one percentage point higher in 2001 to engage in RMB76,000 (roughly $12,000) more tax avoidance, accounting for 5% of the corporate income tax paid in Considering that the average tariff decreased by roughly five percentage points from pre- to post-wto entry, the induced aggregate corporate income tax avoidance would account for 25% of corporate income tax paid in We conduct several tests to investigate the validity of our identification strategy. We first check whether the pre-existing time trends of firms tax avoidance are the same for different industries. We then check whether firms 8 For example, asset depreciation rules can be different; gross output in the current year is not equal to revenue in the same year. 4

5 adjusted their tax avoidance behavior in anticipation of WTO entry. We also investigate whether the reform of state-owned enterprises (SOEs) and regulation changes for foreign direct investment (FDI) that occurred in the same period have a contaminating effect on our main results. WTO entry may change law implementation, and we check whether this change affects our results. WTO entry decreases not only output tariffs but also input tariffs, and enlarges firms exposure to international markets. We further investigate whether our main results are affected by these two factors. As processing traders are not affected by the tariff change, we estimate the same effects for processing traders as a placebo test. Finally, we check whether sample attrition affects our results. All of the results of these tests justify our identification strategy. We then conduct several tests to justify the validity of our tax avoidance measurement. We first identify a subsample of industrial firms that are publicly listed and for which information on the book-tax income gap is therefore available. For this subsample, we find a significantly positive correlation between the imputed-reported profits gap and book-tax income gap. We then estimate the effect of WTO entry on the book-tax income gap using this subsample, and find that WTO entry significantly enlarges the book-tax income gap, confirming our paper s main finding. Second, we follow Cai and Liu (2009) to investigate how WTO entry affects the response of reported profits to imputed profits. We find that WTO entry weakens the response, which confirms our finding that WTO entry induces more corporate income tax avoidance. Third, we investigate whether firms over-report output because of declining sales income after WTO entry, which may over-estimate imputed profit and therefore our measurement of corporate tax avoidance. We find no evidence that firms over-report output. These results provide support for our tax avoidance measurement. In addition, we conduct other robustness checks to examine whether our main finding is robust to different outcomes and explanatory variables. The 5

6 results show that our main finding is robust to different tests. After establishing a causal relation between trade liberalization and tax avoidance, we investigate the heterogeneous effects in terms of firms corporate governance. We find that firms with weak corporate governance (i.e., SOEs) engage in more tax avoidance than other types of firms in response to the reduction in tariffs after WTO entry. We then examine the possible mechanisms through which trade liberalization affects firms corporate tax avoidance behavior. We find that firms that have higher leverage, lower profitability, or faster growth before WTO entry engage in more tax avoidance after WTO entry. This finding suggests that being short of cash or a higher demand for cash could be the reason firms engage in more tax avoidance in a more competitive environment. Finally, we investigate how firms engage in tax avoidance by estimating the effects of WTO entry on costs per unit of sales income (including administrative costs, sales costs, financial costs, wages, and benefits). The costs for firms in industries with larger tariff reductions increase more, suggesting that manipulating costs could be a way to avoid corporate income tax. Our paper makes several contributions to the literature. First, previous research has documented that integration with the global economy is an important factor driving economic growth in developing countries. However, very few studies investigate firms tax avoidance behaviors in response to the trade liberalization. Our paper is the first to study this issue in a developing country. 9 Besides the extension of the literature on the effects of trade liberalization, focusing on developing countries is of particular importance. Tax administration in these countries is far less effective than in developed countries such as the U.S., induced tax avoidance is more likely to take illegal forms, suggesting that the social benefits of economic growth may not be as large as 9 The only other paper studying the same issue is Chen and Lin (2013), using data on publicly listed firms from the U.S. They find that more tariff reductions are related to more tax avoidance, and the effect is greater for financially constrained firms and smaller for firms with better corporate governance. 6

7 expected. Policymakers need to exert more effort to increase the efficiency of tax administration to international standards during the process of integration with the global economy. Second, we also investigate the mechanism through which trade liberalization affects tax avoidance and one possible approach used by firms to engage in tax avoidance. Although the results can only be considered suggestive, they provide useful insight into firms tax avoidance behavior. Third, we find that better corporate governance can mitigate firms tax avoidance behavior, providing additional evidence supporting predictions by Desai and Dharmapala (2006). Lastly, using China s entry into the WTO as a natural experiment, we can credibly identify a causal relation between trade liberalization and firms corporate tax avoidance. Our paper is also linked to the public finance literature that examines various determinants affecting tax avoidance activities; see, e.g., Johnson et al. (1997, 1998), Slemrod (2004), Desai and Dharmapala (2006, 2009), Crocker and Slemrod (2005), Hanlon and Slemrod (2009), Kim et al. (2011), and Beck et al. (2014). In particular, Fisman and Wei (2004) identify evidence of pervasive tariff evasion in China, and Cai and Liu (2009) investigate the relationship between competition and corporate tax avoidance among Chinese manufacturing firms. A most recent study by Chen et al. (2016) find that a substantial fraction of Chinese firms response to fiscal incentive for R&D investment is due to tax evasion. The rest of this paper is organized as follows: Section 2 introduces the institutional background; Section 3 describes the data and empirical strategies; Section 4 presents the main results; Section 5 shows robustness checks and heterogeneous effects; Section 6 investigates the mechanisms; Section 7 studies how firms engage in tax avoidance; and Section 8 offers our conclusions. 2. Background 2.1. The Corporate Income Tax System in China 7

8 The evolution of China s corporate tax system can be divided into four periods: (1) ; (2) ; (3) ; and (4) 2008-present. The central planning system dominated the first period ( ), when the majority of Chinese industrial firms were state-owned and all surpluses were sent to the government. Therefore, as described in Wu (2003), there was no corporate income tax in this period. The Chinese government introduced an income tax system in In the 1980s, large SOEs were subject to an income tax rate of 55%. These firms also divided after-tax profits between themselves and the government according to a given formula. The tax rates were 10-55% for small SOEs and 35% for private firms. In the 1980s the Chinese government introduced SOE reforms that focused on delegating decision power and giving incentives. These reforms continued through the 1990s, when a modern corporation system focusing on corporatization and governance was emphasized. During this process, many small and medium-sized SOEs were privatized and others were transformed into corporations. As a part of these reforms, the Chinese government enacted the Corporate Income Tax Code in 1994, which overhauled corporate taxation. One feature of the corporate income tax schedule in the period was that domestic and foreign firms were subject to different tax rates. With the exception of small firms with taxable incomes of less than RMB30,000, which paid 18% corporate income tax, all domestic firms paid 33% income tax. However, most foreign firms paid only 15% corporate income tax. In addition, various exemptions, tax credits, and reductions were applied to most foreign firms, meaning that they generally enjoyed much more favorable tax treatment. The different treatment of foreign firms and domestic firms lasted until A new Corporate Income Tax Code was announced at the end of Since 2008, the corporate tax rate for both domestic and foreign firms has been set at 25%. The government phased in the increase for tax rates on foreign firms 8

9 over the following five years. Tax collection agencies in China were reformed in Before 1994, all taxes were collected by provincial tax collectors, and the central government and provincial governments divided the tax revenue according to a given formula. In the 1994 reform, taxes were classified into central taxes and local taxes. Under the supervision of the State Administration of Taxation, a National Taxation Bureau and provincial taxation bureaus were established to separately collect central taxes and provincial taxes. Today, corporate income tax is classified as a central tax and is therefore collected by the National Taxation Bureau. The growth in corporate income tax, like the growth in the economy, has been impressive since 1994; total corporate income tax revenue was RMB93 billion in 1998 and increased to RMB878 billion in 2007 (China Statistical Yearbook, 2008) China s Entry into the WTO Before the economic reform in 1978, Chinese trade took place within a central-planning framework. The State Planning Commission made plans for almost all of China s export and import activities, and a few foreign trade companies controlled by the Ministry of Foreign Trade were responsible for carrying out export and import plans. In 1977, Chinese trade accounted for only 0.6% of world trade by volume (Lardy, 1994). Although China began its economic reform at the beginning of the 1980s, trade liberalization did not start at the same time. On the contrary, the government raised import tariffs on most commodities in the early years of reform. The average tariff rate was 43% in This high tariff level was maintained until 1992 (Lardy, 2002). Starting in 1986, as part of China s efforts to join the WTO, the Chinese government implemented several tariff cuts. The average import tariff rate was reduced from 43% in 1992 to 17% in There was little change in tariff after 9

10 1997 until China joined the WTO at the end of 2001(Lu and Yu, 2015). According to the agreement, the Chinese government promised to reduce the average tariff level to under 10% by Figure 1 shows the changes in the average tariff rates over time. The average value of import tariffs hides the variation in tariffs across industries. In 2001, the variation in tariffs over two-digit industries was large, equal to 0.10 (compared with the mean, 0.15). Additionally, the different levels of import tariffs in different industries before WTO entry meant there were different reductions in tariffs in different industries after WTO entry. Figure 2 shows the correlations between industry import tariffs in 2001 and the tariff reductions from 2001 to 2002, 2003, and Figure 2 also shows the correlation between industry import tariffs in 2001 and the average industry import tariffs. We can see from these graphs that industries with higher tariffs in 2001 had larger reductions in tariffs after China entered the WTO. 3. Data and Empirical Strategies 3.1. Data In this study, we mainly use two types of data: manufacturing firm data and import tariffs. The manufacturing firm data come from the National Bureau of Statistics of China (NBS). All SOEs and non-soes with sales above RMB5 million (roughly $769,000) are required to file a report on their production activities and accounting and financial information with the NBS every year. This is the most comprehensive firm-level dataset in China, and it is used to calculate matrices in the national income account and major statistics published in the China Statistical Yearbooks. The data collected by this survey have been widely used by researchers, e.g., Lu, Lu, and Tao (2010); Brandt, Van Biesebroeck, and Zhang (2012); Brandt et al. (2012); Yu (2014); Lu and Yu (2015). 10

11 The NBS issues an identification code for each firm such that we can construct a firm panel. A four-digit Chinese Industrial Classification (CIC) code is also assigned to each firm. However, the classification system for the industry code was changed in 2003, from GB/T in to GB/T after To achieve consistency in industry codes for the whole period, we convert the industry codes to GB/T Although this dataset includes rich information, some samples are still noisy, largely because of misreporting by firms. Following the literature (Cai and Liu, 2009; Yu, 2014; Lu and Yu, 2015), we delete any observations for which one of the following is true: (i) the value of fixed assets is below RMB10 million; (ii) the value of total sales is below RMB5 million; (iii) the number of employees is less than 30; (iv) total assets are smaller than liquid assets; (v) total assets are smaller than fixed assets; (vi) total assets are smaller than the net value of fixed assets; or (vii) accumulated depreciation is smaller than current depreciation. After this procedure, we have 308,179 observations, including 103,505 unique firms. All of the monetary values are deflated to 1998 values. We use data from 1999 to 2004: three years before WTO entry ( ) and three years after WTO entry ( ). An important variable in our study is tax avoidance. One widely used measure of tax avoidance is the book-tax gap (Desai, 2003, 2005; Desai and Dharmapala, 2006). However, the manufacturing firm dataset we use in this study does not include information about book income. Therefore, following Cai and Liu (2009), we use the gap between imputed profits and reported profits as a proxy for tax avoidance. The reported profits,, are the profits reported by firms when they file their annual reports with the NBS. The imputed profits are calculated according to the national income accounting system as follows: = (1) Here, is the gross output, is the intermediate inputs excluding financial charges, is the financial charges, is the total wages paid, 11

12 is the current depreciation, and is the value-added tax. All of these variables are reported by firms. Therefore, the tax avoidance engaged in by firms,, is measured as minus. We normalize the gap in this paper using total assets. One caveat to bear in mind is that the difference between imputed profits and reported profits reflects not only the tax avoidance engaged in by firms but also the systematic differences between the accounting system and the national income account system, including different expense recognition rules, asset depreciation rules, and tax credit and tax loss carry-over rules. In our analysis, we include firm fixed effects to control for time-invariant systematic differences, and we also conduct robustness checks to investigate the validity of our measurement. The import tariff data are from the World Integrated Trade Solution (WITS) provided by the World Bank. Import tariffs are set at the six-digit level of the Harmonized System (HS) product classification. To merge the data with the manufacturing firm categories, which have only CIC four-digit industry codes, we map the HS six-digit codes onto the CIC four-digit codes. As each CIC four-digit industry includes several six-digit industries, each of which has an import tariff, we construct an average tariff for each four-digit industry as follows: =. (2) Here, is the average tariff level for a four-digit industry k in year t; is the tariff level in a six-digit industry j in year t. Using the same method, tariffs in three-digit and two-digit industries can be calculated. Using a simple average, rather than a weighted average (using imports as weight), can avoid bias due to the endogenous response of imports to tariffs. However, our results are robust when imports are used as weights when calculating four-digit tariffs, as shown in the robustness section. 12

13 Table 1 shows the summary statistics for the main variables. Panel A of Table 1 shows the summary statistics for firm characteristics. On average, the reported profits by firms are RMB10 million, while the imputed profits are RMB17 million. The firms on average underreport profits by 7 million. In our data, 33% of firms are exporters and 8% of firms are processing traders. Among all firms, 24% are SOEs and 14% are foreign invested firms. We can also see that on average their sales income is RMB177 million and they have 764 employees. Panel B in Table 1 shows the average tariffs in two-, three-, and four-digit industries, which are about 16% Empirical Strategy Two variations are combined to identify the effect of trade liberalization on tax avoidance. One is the tariff reduction from before WTO entry to after WTO entry. Another results from the larger tariff reductions of industries with higher tariff levels before WTO entry. Essentially, we exploit the DID strategy. The baseline regression is estimated as follows: = + " $%& +' + +(. (3) Here, is the tax avoidance of firm i in the four-digit industry k in year t. 10 " is the tariff level in industry k in $%& is a dummy variable indicating the post-wto year, i.e., in our study. is the coefficient of interest. ' is a set of firm fixed effects. We also include year fixed effects,, in the regression to control for different levels of average tax avoidance in different years. ( is an error term with a mean equal to zero. Standard errors are calculated by clustering over industry. One issue to consider is that industry tariffs in 2001 were not randomly assigned; it is possible that industries with higher or lower tariffs in 2001 could be systematically different. These pre-existing differences could affect firms tax 10 We normalize tax avoidance using firms total assets. 13

14 avoidance behavior differently after WTO entry, thus contaminating our estimates. Fortunately, Lu and Yu (2015) show that the industry-level output share of SOEs, average wage per worker, and export intensity have robustly significant effects on industry-level tariffs in Therefore, to alleviate this concern, we follow Gentzkow (2006) and Lu and Yu (2015) to control for the interaction of the output share of SOEs, average wage per worker, and export intensity in 2001 with $%& in the regression. Several other assumptions need to hold to obtain consistent estimates of Equation (3). First, we assume that tax avoidance in industries with higher tariffs in 2001 would have followed the same trend as in industries with lower tariffs in 2001 if there had been no WTO entry. We test this assumption using data before WTO entry, i.e., data from 1999 to The details are shown in Section 4.2. Second, one possible issue is that China s entry into the WTO at the end of 2001 was expected, so firms might have adjusted their tax avoidance behavior even before the actual tariff reductions. As a robustness check, we include an additional control in the regression, " *+,$ * +&-, to investigate whether firms changed their behavior in anticipation of WTO entry. Third, if other policy changes in this period affected industries with high versus low tariffs differently, then our estimates would be biased. In the early 2000s, there were two important reforms: SOE reform and the relaxation of FDI regulations. To address this concern, we add the SOE shares, i.e., the number of SOEs divided by the number of firms in each industry, and FDI, i.e., the logarithm form of the number of foreign invested firms in each industry, to the regression to check whether the main results hold. Fourth, besides output tariffs, WTO entry reduced input tariffs as well, making it possible for Chinese firms to use more imported intermediate inputs. Furthermore, China s trading partners might have also decreased their tariffs on 14

15 Chinese products, giving Chinese firms greater access to larger foreign markets. Both could affect firms tax avoidance as well. To address this concern, we add industry-level input tariffs and export intensity to the regression to check the robustness of results. Fifth, WTO entry may improve law implementation to different degrees in different provinces. If more industries with lower tariffs were based in provinces in which law implementation was more significantly improved by WTO entry, then our estimates could be biased. To address this concern, we add an index for law implementation at the provincial level to check whether our results change. 11 To further investigate the assumptions behind the identification method used in our strategy, we also conduct a placebo test using processing traders. To address potential selection bias due to sample attrition, we also estimate Equation (3) using a balanced panel. 4. Empirical Results 4.1. Main Results Table 2 shows the main results. In column 1, we control for industry and province fixed effects. The coefficient of " $%& is and statistically significant at the 1% level. It shows that the higher the tariff level in 2001, the greater the increase in tax avoidance. In column 2, we add the interactions of $%& with three industry-level variables in 2001, i.e., average wage per worker, export intensity, and SOE shares, to the regression. The coefficient of " $%& remains very similar at and is still significant at the 1% level. In columns 3 and 4, we replace the industry and province fixed effects with firm fixed effects, and in column 4 we add the interactions of $%& with the three variables in The coefficient of " $%& decreases to in column 3 and in column This index is constructed by Fang and Wang (2006). 15

16 Both are significant at the 1% level. The similarity of these two coefficients also suggests that industry tariffs in 2001 are not likely to be endogenous. Using the specification in column 4, which we prefer, we can see that for firms in industries with tariffs 10 percentage points higher in 2001 (roughly one standard deviation), the increase in corporate tax avoidance induced by WTO entry is RMB757,000 more, accounting for roughly 47% of corporate income tax paid by an average firm in Testing the Identification Assumptions In this section, we conduct several tests to see whether the assumptions behind our identification are valid. Pre-existing Time Trend. We test whether the tax avoidance behavior of firms in different industries follows the same pre-existing time trend. We use the sample from before WTO entry, i.e., from 1999 to We first define a dummy denoting 2000 and 2001, and then replace Post in Equation (3) with this dummy and estimate the equation. We also define another dummy denoting 2001 and replace Post in Equation (3) with this dummy. We then estimate this equation again. The results of these two exercises are shown in columns 1 and 2 in Table 3. We can see that no coefficient of the interactions of the newly defined dummies and " is significant, suggesting that the pre-existing time trends are the same for firms in different industries. Behavior Change Before WTO Entry. One concern is that firms in industries with higher tariffs in 2001 were more likely to change their tax avoidance behavior if they expected tariff reductions after WTO entry, thus biasing our estimates. To address this concern, we add " *+,$ * +&- to the regression. *+,$ * +&- is a dummy variable indicating 2000, one year before WTO entry. The results are shown in column 3 in Table 3. We can see that the coefficient of " *+,$ * +&- is 16

17 not significant, suggesting that firms did not change their behavior before WTO entry. Other Policy Changes. In the early 2000s, there were two other reforms: SOE reform and the relaxation of FDI regulation. If these two reforms affected firms in different industries differently, then our estimates would be biased. To address this concern, we add the share of SOEs among all firms in the industry and the number of foreign invested firms in the industry to the regression. The results are shown in column 4 in Table 3. We can see that no coefficients of these two variables are significant, and that the coefficient of interest remains positive and significant. Input Tariffs and Larger Foreign Markets. Entry into the WTO decreased not only output tariffs but also input tariffs, making it possible for Chinese firms to use more imported intermediate inputs, which are usually considered of better quality. Furthermore, China s trading partners might have also decreased their tariffs on Chinese products, giving Chinese firms greater access to larger foreign markets. Having better inputs and gaining access to larger foreign markets could have increased firms profitability and therefore affected their tax avoidance behavior. To address this concern, we further add industry-level input tariffs and export intensity to the regression. The results are shown in column 5 in Table 3. We can see that the coefficient of interest is more or less the same. Change of Law Implementation. WTO entry might have had different effects on law implementation in different provinces. If more industries with smaller tariff reductions were located in provinces with larger improvements in law implementation after WTO entry, then our estimates would be biased. To address this concern, we add an index for law implementation at the provincial level. The index was constructed by Fan and Wang (2006). The results are shown in column 6 in Table 3. Adding this variable does not change the coefficient of the interaction of tariffs in 2001 and the post dummy. 17

18 Processing Traders. A feature of the Chinese trading regime is that a proportion of Chinese exporters are processing traders, i.e., firms that are allowed to import intermediate materials free of tariffs but are required to export all of their outputs. These firms should not be affected by China s entry into the WTO. We therefore use the sample of processing traders to estimate Equation (3), and the results are shown in column 7 in Table 3. We can see that the coefficient of " $%& is not significant. Sample Attrition. We use an unbalanced panel of firms in the main analysis. However, if firms were more likely to exit the market in industries with higher tariff levels in 2001 and if these firms tended to engage in more (or less) tax avoidance, our estimates would be biased. We test whether this concern is valid by estimating Equation (3) using a balanced panel of firms. The results are shown in column 8 in Table 3. We can see that the coefficient of " $%& is still positive and significant, suggesting that sample attrition is not a concern. 5. Robustness Checks 5.1. Justification of the Tax Avoidance Measurement We use the gap between imputed profits and reported profits to measure corporate tax avoidance. There are concerns about whether this method can accurately measure tax avoidance. In this section, we provide several justifications for using this measurement. Correlation with Book-Tax Income Gap. A commonly used measurement of corporate income tax avoidance is book-tax income gap (Desai, 2003, 2005; Desai and Dharmapala, 2006). Although we do not have information on book income for industrial firms, we match industrial firms with publicly listed firms and obtain a subsample of 325 firms between 1999 and For this small sample of firms, we have information on the book-tax 18

19 income gap. 12 The summary statistics of these firms are presented in Appendix Table A. We first regress the gap between imputed profits and reported profits on the book-tax income gap. Table 4 shows the results: we can see that all the coefficients are significantly positive and the magnitudes are large, between and 0.591, which shows that these two measures are highly correlated. We then replicate the regressions in Table 2, replacing the gap between imputed and reported profits with book-tax income gap using this subsample. Table 5 shows the results. We can see that the coefficients of Tariff2001*Post in all columns are significantly positive, consistent with the results in Table 2. These results suggest that the gap between imputed and reported profits is consistent with the book-tax income gap in terms of measuring corporate tax avoidance. One caveat we need to bear in mind is that the matched firms only account for a small part of the whole sample, therefore the supporting evidence presented here can only be considered as suggestive. Response of Reported Profits to Imputed Profits. Following the approach of Cai and Liu (2009), we estimate the effect of WTO entry on the response of reported profits to imputed profits. If WTO entry reduced the response of reported profits to imputed profits, we would have more evidence that trade liberalization induces more tax avoidance. The results are shown in Table 6. We can see that the coefficient of the triple interaction of the tariff in 2001, post-wto dummy, and imputed profits is negative and significant in all columns. The results confirm our finding that WTO entry induces more tax avoidance. Over-reporting Output. One concern is that firms in industries facing larger tariff cuts may be more likely to over-report outputs because of declining sales income due to more intense competition after WTO entry. In other words, imputed profits could be overestimated in industries with larger tariff cuts, 12 The list of publicly listed firms and information on the book-tax income gap come from RESSET ( 19

20 making it hard to differentiate this phenomenon from higher corporate tax avoidance. To see whether this issue may arise, we replicate regressions in Table 2 but replace the outcome variable with total output divided by sales income. If firms were more likely to over-report output due to the decline of sales income in industries with larger tariff cuts, we would expect to see a significantly positive coefficient of Tariff2001*Post. However, none of the coefficients shown in Table 7 are significant. This result shows that firms did not over-report outputs due to the decline of sales income Other Measurements of Explanatory or Outcome Variables In our main analysis, the four-digit industry-level tariffs are the unweighted average of the six-digit industry-level tariffs. In this section, we construct the four-digit industry-level tariffs using the weighted average of the six-digit industry-level tariffs (1998 import values are used as the weight). For further robustness checks, we also exploit the variation of two-digit industry tariffs and three-digit industry tariffs, respectively. The results are shown in columns 1-3 in Table 8. We can see that all of the coefficients of interest are positive and significant, consistent with the main results. In addition, we also use effective tax rate, which is the ratio of corporate income tax paid by firms to pre-tax profits, to measure tax avoidance, and investigate how WTO entry affects effective tax rate. The results are shown in column 4 in Table 8. Although the coefficient of " $%& is not precisely estimated, it is negative, providing some evidence that trade liberalization induces more tax avoidance Heterogeneous Effects in Terms of Corporate Governance Desai and Dharmapala (2006) emphasize the importance of corporate governance in determining tax avoidance. They argue that firms with better corporate governance tend to engage in less tax avoidance. As we do not have a 20

21 direct measurement of firms corporate governance, in this section we investigate whether the effect of trade liberalization on tax avoidance differs for firms with different types of ownership, i.e., SOEs, non-soe domestic firms, Hong Kong-Macau-Taiwan invested firms, and foreign invested firms. SOEs are usually considered to have weak corporate governance, while foreign invested firms have better corporate governance, especially in terms of financial transparency (Bushman, Piotroski and Smith, 2004). Table 9 shows the heterogeneous effects. In this table, columns 1-4 are for SOEs, non-soe domestic firms, Hong Kong-Macau-Taiwan invested firms, and foreign invested firms, respectively. We can see that the coefficient of " $%& is positive and significant in column 1 (SOEs), while the coefficient is not significant in the other columns. Our results show that firms with weak corporate governance respond to WTO entry by engaging in more tax avoidance, reinforcing the prediction of Desai and Dharmapala (2006). 6. Channels through which Trade Liberalization Affects Tax Avoidance Firms experiencing reduced profit performance due to the increased competition induced by WTO entry tend to rely on noncompliance so that they have more cash to invest and thus improve their prospects (Slemrod, 2004). Therefore, firms short of cash or with a higher demand for cash tend to engage in more tax avoidance. In this section, following Almeida, Campello, and Weisbach (2004), we use firms profitability and leverage before WTO entry to measure whether they are short of cash. Lower profitability or higher leverage means a higher degree of cash shortage. We use firms growth rate before WTO entry to measure their demand for cash. The higher the growth rate, the higher the demand for cash. Table 10 shows the results. Columns 1 and 2 are for firms with high and low profitability, respectively. We can see that the coefficient of " 21

22 $%& is significantly positive for firms with low profitability (column 2). Columns 3 and 4 are for firms with high and low leverage, respectively. We can see that the coefficient of " $%& is significant and positive for firms with high leverage (column 3). The combination of these two results suggests that firms short of cash tend to engage in more tax avoidance after WTO entry. Columns 5 and 6 are for firms with high and low growth rates before WTO entry. We use the growth rate of firms to measure their demand for cash. The higher the growth rate, the higher the demand for cash. We see that the coefficients in columns 5 and 6 are significantly positive and that the coefficient for firms with a higher growth rate is larger. This finding suggests that firms with a higher demand for cash did engage in more tax avoidance after WTO entry. 7. How Did Firms Engage in Tax Avoidance? There are several ways firms can avoid corporate income tax, among which under-recording sales revenues, over-recording costs, and transfer pricing with affiliated firms are the most common. As we do not have information on transfer pricing, our focus in this section is whether firms under-report sales revenues or over-report costs after WTO entry. In particular, we investigate the effect of WTO entry on administrative costs, sales costs, financial costs, wages, and benefits, all of which are scaled by sales income. Indeed, WTO entry significantly increases costs per unit of sales income. The results are shown in Table 11. We can see that the coefficients in all five columns are positive and significant at the 10% level or more. This result shows that firms in industries with higher tariffs in 2001 spent more for each unit of sales income, which is evidence that over-reporting costs could be a way that firms avoid corporate income tax. 22

23 8. Conclusions In this study, we investigate the effect of trade liberalization on manufacturing firms tax avoidance, using China s entry into the WTO as a natural experiment. Comparing firms in industries with different tariffs in 2001 and therefore different reductions between the pre- and post-wto entry periods, we find that WTO entry induced firms in industries with tariffs 10 percentage points higher to engage in tax avoidance totaling RMB757,000, accounting for 47% of the corporate income tax paid by an average firm that year. Furthermore, we find that firms with better corporate governance (i.e., non-soes or foreign invested firms) tended to engage in less corporate tax avoidance in response to WTO entry. We then investigate the possible channels by which WTO entry affects firms corporate tax avoidance. We find that firms short of cash or with a higher demand for cash engage in more tax avoidance when facing a more competitive environment after WTO entry. We also find evidence that firms avoid corporate income tax by over-reporting costs. Trade liberalization has been considered an important factor in China s rapid economic growth in the past three decades. Our findings suggest that the social benefits may be undermined by illegal activities induced by this trend. Government policymakers should therefore work to improve tax administrative efficiency during integration with the global economy. 23

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