Non-Penalty Regulation and Tax Avoidance: Evidence on Financial Report Inquiry Letters
DENG Yilu, CHEN Yunsen, DAI Xin
School of Economics and Management, North China Electric Power University; School of Accountancy/ China Management Accounting Research and Development Center, Central University of Finance and Economics
Summary:
The non-penalty regulation represented by inquiry letters has become an important front-line regulation, given the current emphasis on the function of stock exchange. Inquiry letter regulation focuses on the shortcomings of information disclosure and requires companies to provide supplementary explanations in a reply letter. The increasing frequency of inquiry letters has attracted the attention of the media, capital market intermediaries, and investors. Taxation stimulates market vitality and promotes economic development, so corporate tax behavior is a concern of both regulators and investors. China's stock exchanges have recently paid more attention to regulating corporate tax avoidance. However, few studies examine the relationship between China's inquiry letter regulation and corporate tax avoidance. Exploring the economic consequences of inquiry letters from the perspective of tax avoidance enriches research on both the effectiveness of non-penalty regulation and the factors influencing tax avoidance. The impact of inquiry letters on tax avoidance is as follows. On the one hand, inquiry letters improve the quantity and quality of corporate information disclosure by attracting attention and thereby increasing the costs of tax avoidance and inhibiting management's motivation and ability to implement tax avoidance behavior. On the other hand, inquiry letters may increase marginal tax avoidance income while having little impact on marginal tax avoidance costs. In addition, rising regulatory pressure may compel management to employ more tax avoidance activities to improve the firm's profit after taxes and achieve short-term goals. Based on the aforementioned arguments, whether and how inquiry letter regulation influences tax avoidance behavior is a question that requires empirical analysis. Based on an examination of Chinese A-share listed companies from 2013 to 2017, this paper finds that financial report inquiry letters restrain companies' tax avoidance behavior; the greater the total number of inquiry letters,the more inquiries for the same financial report, and the more questions in the financial report inquiry letter, the greater the reduction of tax avoidance behavior. Moreover, inquiry letters that address tax-related or research and development-related topics further decrease tax avoidance behavior. Furthermore, the regulatory effect of inquiry letters is even better for companies with lower degree of financing constraints and a higher intensity of tax administration. Overall, the non-penalty regulation of the financial report inquiry letter exhibits a certain degree of regulatory effectiveness. This paper makes two major contributions to the literature. First, it contributes to the literature on the economic consequences of non-penalty regulation. Contemporaneous studies examine the regulatory effect of inquiry letters in terms of capital markets, external audits, earnings management, and management earnings forecasts. This paper, however, examines the effectiveness of non-penalty regulation from the perspective of tax avoidance by applying empirical evidence from Chinese markets, which supplements relevant research on international non-penalty regulation.Second, this paper enriches research on the determinants of corporate tax avoidance. Previous regulatory studies examine how tax authorities and enforcement influence companies' tax avoidance behavior; however, few investigate the impact of securities regulation, especially front-line stock exchange regulation, on corporate tax avoidance. This study also has practical significance by extending the relevant research on the real effects of front-line stock exchange regulation. The effectiveness of inquiry letter regulation is affected by a company's financing constraints and the external regulatory environment. To improve the regulatory impact of inquiry letters, implementing continuous and accurate regulation, completing with follow-up regulatory measures, are necessary.
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