The Political Dynamics of Corporate Tax Avoidance: The Chinese Experience

Abstract

One institutional feature behind China’s spectacular economic growth is its political selection system, which it uses to promote officials who are capable of growing local economies. Against this backdrop, we examine how political turnovers cyclically influence firms’ tax avoidance behavior. Consistent with the prediction that newly appointed local leaders tend to collect more taxes to expand fiscal expenditures and boost local economies, we find that state-owned enterprises (SOEs) decrease their tax avoidance behavior after new leaders take office. However, this finding does not hold for non-SOEs. Our analyses also reveal that the political turnover effect on SOEs’ tax positions is stronger when the incoming leaders have more political clout to command favors from SOEs, managers’ incentives to divert resources are stronger, or politician-manager networks are more likely to work. Furthermore, SOEs that undertake less aggressive tax positions following turnovers receive more government subsidies in the future. Overall, our findings suggest that political incentives shape the tax planning activities of local SOEs in a “two-way favor exchange” manner.

Keywords: Political cycle, Tax avoidance, Agency problem

JEL Classification: H26, E32, P26, G30