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| Strategic Reactions to Corporate Tax Avoidance in China: Evidence from Listed Corporations |
| LI Qingyuan, LIU Yechang
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| School of Economics and Management,Wuhan University |
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Abstract In recent years, most research on the causes of corporate tax avoidance has focused on internal factors, such as a company’s managerial characteristics, or external factors, such as the macroeconomic cycle. Few studies have investigated corporate tax avoidance in relation to the interaction between the tax avoidance of companies in the same industry. The social economics research on non-market interaction effects has shown that it is challenging to identify the strategic responses of a company. Manski (1993) stated that the similarities between group members’ responses can be considered the result of exogenous effects, correlated effects, and endogenous effects (i.e., strategic reactions). To overcome the omitted variables and “reflection” problems, Manski (2000) later proposed an instrumental variable that only affects the behavior of certain individual group members without affecting the behavior of all of the members. Leary and Roberts (2014) validated the effectiveness of the instrumental variable of idiosyncratic returns in the tax avoidance literature.
We use data on China’s A-share listed companies from 2007 to 2016 and use the idiosyncratic stock returns of enterprises in the same industry as the instrumental variable to test the relationship between the tax avoidance behaviors of competitors in the same industry (Leary and Roberts, 2014). In particular, we model a firm’s tax avoidance as a function of (i) its own firm-level characteristics, (ii) its common industry-level characteristics, and (iii) the tax avoidance decisions of its industry competitors (Rajan and Zingales, 1995; Leary and Roberts, 2014). We find that the tax avoidance of private enterprises in the same industry exhibits strategic complementarities whereby a change in a firm’s tax avoidance leads to a direct change in the tax avoidance of its industry competitors, and vice versa. We then explore the possible mechanism of the strategic complementarities and find that it may be explained by the leader-follower mechanism. Large firms arguably have more resources and stronger incentives to gather private information about the optimal level of tax avoidance. In turn, smaller firms might monitor the tax avoidance activities of their larger industry competitors to infer private information from their tax avoidance decisions. We also find that the attenuation of geographical distance is conducive to lowering the cost of collecting information in the same industry, and thus leads to a more significant strategic complementarity within the same industry. That is, the imitation of corporate tax avoidance policies has a “local preference” in the same industry. Finally, because of the inherent difficulty of credibly identifying direct strategic reactions (e.g., Angrist, 2014), we conduct a “falsification test” to assess the robustness of our inferences to alternative explanations (Cohen-Cole and Fletcher, 2008). We repeat our first set of tests using firms’ pre-tax financial performance, which should not exhibit strategic reactions if the firms do not alter their pre-tax performance in response to that of their industry competitors, rather than their tax avoidance. If our results are a product of the endogenous relation between the idiosyncratic stock returns and tax avoidance of industry competitors, then we should find evidence of spurious strategic reactions to firms’ pre-tax performance. However, we find no evidence of strategic reactions to pre-tax net income, which strengthens our results.
Our findings contribute to the research on the determinants of tax avoidance, which has almost exclusively focused on firm- and manager-level characteristics, and has not formally considered whether the strategic interactions among firms influence their tax avoidance. We also draw on the literature on geographic distance and regional industrial concentration (Krugman and Obstfeld, 2000; Bai et al., 2004; Fu, 2009; Ayers et al., 2011), and examine the strategic reactions to corporate tax avoidance in relation to geographical distance. The observed effects of the strategic complementarities expand the potential application of this theoretical mechanism to domestic and foreign markets. Finally, we contribute to the literature by providing evidence that competitors’ (or peers’) decisions can affect firms’ decisions not only through social interaction (e.g., Beck et al., 2014; Leary and Robert, 2014; Bird et al., 2018), but also by influencing the monetary costs and benefits of the firms’ strategic interactions. This finding has potential policy implications because it suggests that policies that seek to limit or curtail the tax avoidance of a subset of firms could inadvertently affect the tax avoidance of their otherwise unaffected competitors through the strategic reactions that we document.
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Received: 15 June 2018
Published: 24 October 2019
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