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| Government Fiscal Incentives, Tax Enforcement, and Enterprise Earnings Management: A Study Based on the Natural Experiment of Fiscal PMC Reform |
| LI Guangzhong, JIA Fansheng
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| Business School, Sun Yat-sen University |
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Abstract The Chinese government, due to its tax claim on cash flows, is de facto the largest minority shareholder in almost all corporations. Therefore, it has the incentive to impose stringent tax enforcement, which has a spillover effect on corporate governance. However, serious identification issues arise in research as a result of the inability to overcome endogeneity problems, such as reverse causality and missing variables. A key issue in the study of such problems is how to clearly identify the motives for government tax enforcement. The fiscal PMC reform is a natural experiment that provides the opportunity to examine how tax enforcement affects corporate earnings management, as it enables provinces to directly contact the counties regarding business matters such as revenue and expenditure division, transfer payments, capital transactions, financial budgets, and year-end settlements.This reform changes government tax enforcement incentives at the county level. In view of this, we use the data on industrial enterprises in China from 1998 to 2006, treat the PMC reform as an exogenous shock, and investigate whether tax enforcement affects corporate governance from the perspective of enterprise earnings management. Earnings management is an important aspect of corporate governance that affects not only corporate information transparency and investment efficiency, but also the market information environment and resource allocation. Therefore, earnings management is significant for enterprises, markets, and economic development.Theoretically, when a county-level government strengthens tax enforcement due to tax incentives, less earnings management is observed, while loosening tax enforcement produces the opposite effect. We find that the PMC reform effectively reduces the earnings management behavior of enterprises. Compared with the unreformed counties, the reformed counties' earnings quality is 10.7% higher than average. This conclusion passes a series of endogeneity and robustness tests, including the dynamic effect test, propensity score matching sample regression, alternative dependent (independent) variables, and subsample analysis. We also find that the impact of PMC reform is only significant in enterprises under the jurisdiction of county-level governments, and when the county-level government has a large fiscal deficit or a large tax base, the PMC reform influence is stronger, further indicating that PMC reform can improve county-level government tax enforcement incentives, and thus the quality of corporate earnings. Finally, we find that the PMC reform reduces tax avoidance behavior by enterprises and significantly increases the fiscal revenue of governments. Overall, our findings show that the PMC reform increases county-level government financial incentives, stimulates county-level governments to enforce tax laws strictly, reduces the earnings management and tax avoidance of enterprises within their jurisdictions, and increases county-level government fiscal revenue.The main contributions of this paper are as follows. First, it provides evidence on how government tax enforcement affects corporate earnings management based on a natural experiment, thus enriching the literature on government tax enforcement and corporate governance. Second, it provides micro evidence for how the PMC reform alleviates financial difficulties for county-level governments, and confirms that the PMC reform encourages county-level government to enforce tax laws more strictly, thereby reducing tax avoidance behavior and increasing the fiscal revenue of the government. Third, the paper expands the research on fiscal decentralization and government governance structures, and provides a reference for how to optimize county-level government functions. It finds that the PMC reform encourages county-level government to further fulfill its agency responsibilities and impose stringent tax enforcement, optimizing county-level government functions. The conclusion of this paper is that improving county-level government financial autonomy and the tax-sharing ratio by optimizing government structures can alleviate the inter-governmental agency problem and stimulate county-level governments at the frontline of economic construction to enforce tax laws more strictly. This not only improves county government fiscal revenue, but also alleviates financial difficulties for county-level governments and optimizes the regional accounting information environment, which plays an important role in optimizing resource allocation, improving investment efficiency, and promoting economic development.
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Received: 12 February 2018
Published: 01 April 2019
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