Article For the Final Project Flashcards
Globalization and U.S. Corporate Tax Policies: Evidence from Import Competition
Journal: Management Science
Authors: Tao Chen, Chen Lin, Xiang Shao
Date: 2021
Citation Information
From the abstract
Purpose: To show how globalization affects the corporate tax policies of U.S. manufacturing firms
Methods / systems: Using U.S.-granting China Permanent Normal Trade Relations as a
quasi-natural experiment, we find a significant increase in tax reduction activities for firms
facing higher exposure to Chinese imports
Findings: The effect is more pronounced for firms with
higher managerial slack. We also find that the effect is stronger for firms in less diversified
products market and faster changing industries. We also show that U.S. firms facing higher
Chinese import competition are more likely to engage in other tax-motivated activities:
acquisition of subsidiaries in low-tax regions and suspected transfer pricing. Furthermore,
we explore the 2017 tax cut and the recent U.S.-China trade dispute and find that firms
engage less in tax reduction activities after the 2017 tax cut and after the tariff increase for
Chinese imports.
PNTR
Permanent Normal Trade Relations
Why care for PNTR
PNTR pushed the U.S. market to be more open to
Chinese products by eliminating the threat of large
tariff increases on Chinese imports
Therefore, the passage of PNTR reduced a great amount of the uncertainty in importing goods from China, which then caused substantial import competition pressure in the United States
We find that firms in industries with greater exposure to the passage of PNTR reduce taxes more aggressively. The effect is not only statistically significant, but also economically significant
Therefore, the effect
of PNTR on tax reduction is expected to be stronger
for firms with weaker corporate governance
What was before PNTR
Before PNTR, since 1980, Chinese imports have already enjoyed the Normal Trade Relations (NTR) tariff rate, but the tariff rate had to be renewed every year by Congress
If Congress did not approve the renewal in any particular year, a much higher tariff rate (non-NTR rate)
would be applied to imports from China
For example, in 1999, the average NTR rate was only 4%, but the average non-NTR rate was 37%
DID
Difference-in-differences analysis
To measure each industry’s exposure to PNTR
we use the NTR gap—the difference between the NTR
and non-NTR tariff rates
How did they measure tax reduction activities
We first follow the literature and use the effective
tax rate and book-tax difference to measure tax reduction activities in the main analysis
CETR
Cash effective tax rate
This is used for the for the effective tax rate
We use CETR because cash saving is the major benefit of tax reduction for shareholders
We winsorize CETR to the range [0, 1]. A lower CETR
indicates higher tax reduction
DDBTD
Desai and Dharmapala’s (2006) residual book-tax difference
This was used for the for the book-tax difference which adjusts for earnings management
In addition to measuring tax reduction activities using data from firms’ financial statements, we study
other nonfinancial dimensions of tax reduction activities:
(1) firms’ merger and acquisition (M&A) deals,
targeting firms in tax havens or places with lower tax
rates than the United States as a proxy for potential
tax reduction and sheltering activities;
(2) input offshoring from the Hoberg and Moon (2017) offshoring database, as a proxy for suspected transfer pricing activities;9 and
(3) relocation of firms’ headquarters to
states with lower state corporate tax rates
Using these
three alternative measures of tax reduction activities:
From the 3 alternative in the slide above
we find strong evidence that firms that face higher
Chinese import competition are more likely to acquire
subsidiaries in low-tax regions, to engage in suspected
transfer pricing activities, and to relocate to states
with lower state corporate income tax rates.
How does this paper contributes to the following strands of literature
First, it adds to the corporate tax planning
literature by investigating new potential driving factors of firms’ tax reduction activities
-For instance, despite the massive amount of tax reduction activities and its policy importance, little is known on what fundamentally drives firms to avoid taxes
-Moreover, the literature focusing on the institutional environment points out that tax reduction might be induced by bureaucracy, corruption, weak legal institutions, and inefficient public services
Second, this paper is among the first to document
that competitive pressure caused by globalization materially and causally affects firms’ incentives to engage in tax reduction activities
Moreover, the research adds to the literature on the
impacts of globalization, for example, on markups, capital intensity, and skill content
-
- Identification, Sample, and Data
- Identification, Sample, and Data
2.1. Identification
Specifically, we use a DID specification in estimating the impact of PNTR on tax reduction and examine whether firms in industries exposed to larger import competition due to PNTR save taxes more aggressively
NTR Gap
A good attribute of the NTR gap is its exogeneity
2.2. Sample Construction
To construct the sample, we extract financial and accounting data from Compustat’s North America Fundamentals Annual database from 1990 to 2007 (before the recession).
We classify the firm industry at the six-digit NAICS level
In the end, the sample consists of 3,921 U.S. traded firms and 27,309 firm-year observations.
2.3. Measure of Tax Reduction Activities
Following the literature, we focus on two financial
measures of tax reduction: the cash effective tax rate
1) CETR?
2) DDBTD?
- Empirical Results
3. 1. Baseline Results
Columns 1 and 2, in Panel A, report the results without control variables, and columns 3 and 4 report the results with control variables
For both sets of results, negative (positive) coefficients of NTRGap · post for estimation with CETR (DDBTD) provide consistent evidence that firms in the industries that are more exposed to Chinese imports reduce taxes more aggressively after PNTR.
- Robustness Checks
3. 2.1. Alternative Measures of Tax Reduction
In this section, we test the robustness of the baseline results with five alternative measures of tax-saving activities
1) The first is the generally accepted accounting principles effective tax rate (GETR)
2) The second alternative measure is the cash flow effective tax rate (CFETR)
3) The third measure is the book-tax
difference based on Manzon and Plesk (MPBTD)
4) The fourth measure is the book-tax difference (BTD)
5) The fifth alternative measure is the
effective tax rate difference (ETRDIFF)
3.2.2. Controlling for Potential Confounding Effects
A potential problem with the DID specification is that
the effect of PNTR may be confounded with dynamic
effects of location (e.g., state tax regulation changes in
response to import competition)
The grant of PNTR might also be confounded with
other industry-wise shocks, such as the reduction of
China’s barrier to foreign investment and other notable events such as the burst of the tech bubble
3.2.3. Dynamic Effects
If the increase in tax reduction
activities is indeed caused by PNTR as we expect, the
NTR gap should be correlated with tax reduction
measures after 2000 but not before
3.2.4. Segment-Based Exposure to PNTR
Firms may operate in more than one business segment. Therefore, our measure of firms’ exposure to PNTR may be noisy, as different segments within firms may be exposed to different shocks because of PNTR
3.2.5. Import Penetration
One concern is that imports from China may be driven by not only increased productivity
of Chinese industries, but also the decreasing productivity of some U.S. industries
U.S. imports from China are driven by supply-side
shocks (e.g., Chinese productivity) from China and
demand-side shocks from the United States, which
could cause endogeneity and bias our results because
we only want to test the effect of the supply-side
shock, that is, China’s increased competitiveness
Therefore, to isolate the supply-side shock from China, we use Chinese imports in eight other developed
countries (Australia, Denmark, Finland, Germany,
Japan, New Zealand, Spain, and Switzerland)
3.2.6. Intermediate Goods
The increase in U.S. imports from China makes cheaper intermediate goods more accessible for U.S. firms, which could possibly mitigate the direct effect of Chinese import competition.
The evidence suggests that our main results are
not undermined by the more accessible cheaper Chinese intermediate goods.
- Further Explorations of PNTR Effects
In our main result, we find that PNTR increases firms’
tax reduction activities
This section studies the moderating factors that influence the relationship between PNTR and tax reduction
In addition, we explore whether firms would engage in other tax reduction activities (cross-border M&A, transfer pricing, and relocation) and cost reduction activities (outsourcing) due to PNTR.
4.1. Managerial Slack
Competition increases tax-saving incentives by reducing managerial slack and thus pushing managers to devote more effort to tax planning
To test this channel directly, we examine how managerial slack affects the effect of Chinese import competition on tax reduction activities
**Note: we cannot directly observe managerial slack
Previous research has found that weak corporate governance increases managerial slack therefore, we use corporate governance as a proxy for managerial slack
4.2. Product Market Characteristics
Product market factors may influence corporate capital structure and thus tax planning
Moreover, firms that are less diversified and in a faster-changing industry may face higher market threats and could respond more strongly when they are exposed to globalization shocks
Therefore, we use a subsample analysis with three measures:
1) First, we measure product diversification using the product similarity score of Hoberg and Phillips (2016), which is the total score of word similarity in the firm’s product description compared with peer firms in the annual reports required by the U.S. Securities and Exchange Commission
2) Second, also based on product descriptions in the 10-K reports, we use the product market fluidity index constructed by Hoberg et al. (2014) to measure the intensity of product evolution for firms’ rivals.
3) Third, we use the traditional HHI index.
Consistent with our expectation, Table 7 shows that
firms with less diversification and higher market fluidity are involved in more tax reduction activities
when they are exposed to Chinese imports.
4.3. Other Tax Reduction Activities
Firms may also use tax shelters, transfer pricing, or relocation as alternative ways to lower their tax payments
In this section, we use firms’ cross-border
M&As in tax havens, offshoring activities, and relocation of state tax jurisdiction in addition to financial measures of tax reduction
4.3.1. Cross-Border Mergers and Acquisitions
We define a region as a low-tax region if it has a lower corporate tax rate than that in the United States
As expected, Table 8 shows that firms that face
higher competition caused by PNTR are indeed engaged in more M&A deals targeting low-tax regions
-The evidence includes the higher probability
of acquiring companies in low-tax regions (column
1), greater total number of deals targeting low-tax regions (column 2), and greater number of low-tax regions where companies acquire new firms (column
3).
-It is possible that the passage of PNTR may drive
U.S. firms to acquire more Chinese firms for offshoring, and this could increase M&A deals targeting Chinese firms
-
4.3.2. Transfer Pricing
We then use firms’ offshoring
activities to identify suspected transfer pricing activities
Taking advantage of tax benefits in certain countries, some companies use transfer pricing as a way to
reduce tax payment, such as Apple’s transfer pricing
arrangement with Ireland
Firms may purchase from overseas subsidiaries with over-priced inputs and leave the profits in countries where they have tax benefits. Therefore, we use firms’ offshoring activities to detect suspected transfer pricing
The input offshoring activities in the data set are categorized into two types:
(1) internal offshoring, where the firm purchases inputs
from the given nation when the firm also owns assets in the given nation; and
(2) external offshoring, where the firm purchases inputs from the given nation when the firm does not own assets in the given nation
This provides further evidence that PNTR
causes firms to engage in more tax reduction activities through suspected transfer pricing
4.3.3. Relocation
We then test whether firms will
move to states with lower corporate income tax rates because of fiercer competition triggered by PNTR
4.3.4. Outsourcing
PNTR increases competition; thus, it pushes firms to reduce costs
PNTR also provides firms opportunities to purchase cheaper inputs from China.
Both factors may drive firms to engage in outsourcing
Both results indicate a positive relationship between import competition and outsourcing activities, suggesting that Chinese import competition indeed drives firms to engage more in outsourcing activities to reduce cost
- Alternative Natural Experiments
In this section, we provide additional analysis on the
effect of import competition on tax reduction activities
using three alternative experiments: state tax cuts, the
2017 U.S. Tax Cuts and Jobs Act, and the U.S.-China
trade dispute
5.1. Competition Shocks from Tax Policy Change
Firm may face stronger competition when the states of competitors in the same industry impose tax cuts.
5.2. 2017 U.S. Tax Cuts and Jobs Act
The estimation shows that firms
engage less in tax reduction activities when their industries are target industries for tariff increases on
Chinese imports
- Concluding Remarks
This paper studies the import competition effects of
globalization on tax reduction activities
Building on a natural experiment—the United States granting China PNTR—we explore how greater exposure to Chinese imports affects the tax reduction activities of U.S. firms
Using a DID approach, we find that U.S. firms
engage significantly more in tax reduction activities
following PNTR
The effect is stronger for firms with weaker corporate governance, with less diversified products, and in faster-changing industries
Using cross-border M&A and offshoring activities as alternative measures of tax reduction, we find that firms are more likely to acquire targets in low-tax regions, engage in suspected transfer pricing activities, as well as relocate to states with lower tax rates
Our results also show that firms reduced their aggressive tax-saving activities when tariffs on imports from China were increased during the recent U.S.-China Trade Dispute and firm with higher import competition reduced more tax reduction activities after the 2017 tax cut
