School of Accountancy, Central University of Finance and Economics; School of Business, Renmin University of China; Wuxi Taihu University; School of Business, Beijing Technology and Business University
Summary:
Innovation plays a critical role in establishing competitive advantage and promoting economic growth, and the factors that affect innovation have received significant research attention. According to the literature, a sophisticated incentive system can reliably promote corporate innovation. However, the system should provide effective incentives for both managers and employees because studies have shown that stock options for employees, labor protection measures, and labor unions have important effects on corporate innovation. In recent years, the income structure of employees has diversified with the development of the economy in China. However, salaries are still the dominant form of income. Moreover, there may be significant differences between employees' nominal pre-tax salaries and their actual after-tax salaries due to the high personal income tax rates. In this case, payroll tax avoidance activities may affect the effectiveness of compensation incentives, and thus affect corporate innovation. Two competing hypotheses are theoretically related to the consequences of payroll tax avoidance activities. First, unlike standard routine work, innovation projects require employees to commit substantial effort in continually learning to adapt to the new environment created by innovation. Thus, it is costly for employees to carry out innovative projects. If the level of compensation does not cover the high private cost of being involved in corporate innovation, the employees will lack the motivation to participate. In particular, the high personal income tax rates in China significantly reduce employees' actual after-tax salaries, and therefore weaken the effectiveness of compensation in promoting corporate innovation. Therefore, because payroll tax avoidance effectively lowers the tax rate of employees, it is likely to improve the effectiveness of compensation in promoting corporate innovation. Second, the risk preferences of deciders are stable at any particular time. Because the variance in after-tax salaries increases the perceived risk of employees to balance their risk exposure, the employees have an incentive to reduce their involvement in high risk innovation. Moreover, employees' payroll tax avoidance activities may increase the volatility of their after-tax salaries over time. For instance, employees' nominal pre-tax salaries will be much higher when company earnings are higher. However, the progressive tax rates for wage and salary earners reduce the difference between the peaks and troughs of the compensation. In other words, payroll tax avoidance can also hinder corporate innovation. In this study, we investigate whether and how payroll tax avoidance affects corporate innovation using a sample of Chinese A-share listed firms from 2007 to 2015. Following the literature, we measure corporate innovation using the invention patent applications in a given year. Our findings are as follows. (1) The extent of payroll tax avoidance is significantly and positively correlated with corporate innovation. (2) The positive correlation is more pronounced when there is high taxable pressure on employees, and the reform of the individual income tax system in 2011 inhibited the positive correlation. These results suggest that payroll tax avoidance promotes innovation by reducing the adverse effects of payroll tax and strengthening the compensation incentive effect. (3) For state-owned companies and companies located in high tax enforcement regions, payroll tax avoidance plays a greater role in promoting innovation. (4) This positive correlation is significantly attenuated for firms' with higher per capita salary fluctuations. (5) The positive correlation is more significant in companies that provide significant benefits for innovators. We contribute to the literature in three ways. First, different with the literature focusing on the stock options of employees, labor protection measures, and labor unions, we provide new evidence on the relationship between the motivation and innovation of employees by studying their payroll tax avoidance activities. Second, the effect of corporate tax avoidance on innovation has been discussed in the literature. Thus, we add to the literature on tax avoidance and corporate innovation by examining the impact of payroll tax avoidance on corporate innovation. Third, this study extends the literature on the economic consequences of payroll tax avoidance. Although studies have investigated the influence of payroll tax avoidance on firms' accounting performance, to the best of our knowledge, we provide the first evidence tying payroll tax avoidance to a vital dimension of corporate performance, namely, corporate innovation.
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