Alternative corporate governance: Does tax enforcement improve the performance of mergers and acquisitions in China?

• Published date: 01 July 2023
• Author: Liguang Zhang,Liao Peng,Xinhong Fu,Zhe Zhang,Yunchen Wang
• Date: 01 July 2023
• DOI: http://doi.org/10.1111/corg.12485

ORIGINAL ARTICLE

Alternative corporate governance: Does tax enforcement

improve the performance of mergers and acquisitions in

China?

Liguang Zhang

1

| Liao Peng

2

| Xinhong Fu

1

| Zhe Zhang

3

| Yunchen Wang

1

1

College of Management, Sichuan Agricultural

University, Chengdu, China

2

School of Accountancy, Southwestern

University of Finance and Economics,

Chengdu, China

3

DeGroote School of Business, McMaster

University, Hamilton, Ontario, Canada

Correspondence

Zhe Zhang, DeGroote School of Business,

McMaster University, Hamilton, Ontario L8S

4L8, Canada.

Email: zhanz418@mcmaster.ca

Yunchen Wang, College of Management,

Sichuan Agricultural University, No.211,

Huimin Road, Chengdu city, Sichuan Province,

China.

Email: wangyc8684@qq.com

Funding information

System Science and Enterprise Development

Research Center of Sichuan, grant/award

number: Xq22C15; National Social Science

Fund of China, grant/award numbers:

18CGL016

Abstract

Research Question/Issue: We study whether tax enforcement can function as a cor-

porate governance mechanism in emerging countries with weak tax enforcement. In

the case of China, we examine whether and how external monitoring by tax authori-

ties constrains insiders' opportunistic behavior in corporate mergers and acquisitions

(M&As).

Research Findings/Insights: We employ the implementation of the third stage of the

China Tax Administration Information System (CTAIS-3) as a quasi-natural experi-

ment and adopt a difference-in-differences (DID) approach. We find that strengthen-

ing tax enforcement by CTAIS-3 can improve the efficiency of M&As by reducing

agency problems in the decision-making process. Our conclusions remain unchanged

under a series of robustness checks. Moreover, the results show that the impact is

mainly observed in regions with stronger local government taxation motivation and

in firms with poorer internal or external governance and poorer accounting

information.

Theoretical/Academic Implications: We find that strengthening tax enforcement can

improve M&A decisions even in emerging markets, which provides direct evidence

for the predictions from theory that tax authorities play a governance role in super-

vising corporate insiders. Our paper also extends the literature on the determinants

of M&A performance from the perspective of tax authorities.

Practitioner/Policy Implications: This study has policy implications for governments

around the world to improve corporate governance by strengthening tax enforce-

ment. The Chinese government applying advanced information technology to tax

enforcement can provide a reference for other countries.

KEYWORDS

corporate governance, CTAIS-3, M&A performance, tax enforcement

1|INTRODUCTION

Although Dyck and Zingales (2004) and Desai et al. (2007) discovered

that tax enforcement plays a governance role in supervising corporate

insiders in developed markets, it is still unclear whether and how tax

enforcement plays a governance role in supervising corporate insiders

in emerging markets due to their weak legal enforcement (Cai &

Liu, 2009) and, in particular, weak tax enforcement (Lin et al., 2018).

We examine whether and how tax enforcement affects the perfor-

mance of corporate mergers and acquisitions (M&As) by constraining

Received: 28 July 2021 Revised: 15 July 2022 Accepted: 19 July 2022

DOI: 10.1111/corg.12485

Corp Govern Int Rev. 2023;31:647–666. wileyonlinelibrary.com/journal/corg © 2022 John Wiley & Sons Ltd. 647

agency costs. Following Dyck and Zingales (2004) and Desai et al.

(2007), tax enforcement in a corporate governance role has gradually

received more academic attention. Due to its tax claim on firm profits,

the government is essentially the largest minority shareholder for

many companies. Consequently, as in the case of external share-

holders, the government is motivated to monitor the behavior of

insiders via the tax authority (Desai et al., 2007). Tax authorities can

obtain information by inspecting the company's financial accounts

and tangible assets and effectively supervising self-interested behav-

ior such as related transactions and resource transfers by insiders,

thereby alleviating agency problems and increasing firm value (Desai

et al., 2007; Mironov, 2013). Prior literature shows that in developed

markets, tax enforcement can improve the quality of financial reports

(Hanlon et al., 2014; Mason & Williams, 2022), alleviate information

asymmetry, and decrease the cost of both debt financing

(Guedhami & Pittman, 2008) and equity financing (El Ghoul

et al., 2011) as well as the risk of a stock crash (Bauer et al., 2021).

Although previous research has reached convincing conclusions, they

mainly focus on the information function of tax administration, that is,

decreasing information asymmetry. It remains unclear exactly how or

through which channel tax enforcement plays a governance role and

further affects firm value.

In this paper, we directly examine the effect of tax enforcement

on the shareholder wealth effects of corporate M&A. M&A is the larg-

est form of corporate investment, having a crucial impact on future

corporate performance and shareholder wealth (Gaspar et al., 2005).

Nevertheless, insiders do not always make shareholder value-

maximizing M&A decisions. They have incentives to extract private

benefits at the expense of shareholders through M&As (Jensen, 1986;

Lang et al., 1991). For example, to gain more power and a higher social

reputation (Jensen, 1986), to gain higher compensation (Bliss &

Rosen, 2001; Khorana & Zenner, 1998), or to specialize their human

capital (Shleifer & Vishny, 1989), managers have incentives to initiate

M&As even though the projects would not increase or may even dam-

age firm value. Moreover, many M&As also aim to divert corporate

resources towards controlling shareholders (Cheung et al., 2009; Lei &

Song, 2011).

It is well documented that tax enforcement curtails related party

trades (Desai et al., 2007) and mitigates information asymmetry

(Hanlon et al., 2014; Mason & Williams, 2022). Therefore, we predict

that strict tax enforcement improves M&A decisions, enhancing M&A

performance. On the one hand, tax administration offices can use

their information advantages to combat M&A activities in which

insiders divert resources towards themselves. On the other hand, by

mitigating information asymmetry, tax enforcement enhances investor

supervision, increases the efficiency of M&A decisions, and ultimately

improves the performance of M&As.

The implementation in 2013 of the third stage of the China Tax

Administration Information System (CTAIS-3) provides an opportunity

to identify exogenous changes in tax enforcement. Following Xiao

and Shao (2020) and Zhang et al. (2022), we test a difference-in-

differences (DID) model to establish a causal relationship between tax

enforcement and M&A performance. Using a sample of 5587

acquisitions initiated by A-share listed companies in China between

2007 and 2019, we perform a staggered DID model and find that

strengthening tax enforcement improves M&A decisions and M&A

performance. Specifically, following the implementation of CTAIS-3 in

the local area, acquisition announcements made by bidder firms gen-

erate higher abnormal bidder returns. These results are robust to

including control variables such as firm characteristics and local eco-

nomic conditions. The results of parallel and placebo tests support the

validity of the DID model.

Further analyses show that the effect of tax enforcement in

improving M&A performance is more pronounced when (i) the bidder

is located in a region where the local government has stronger incen-

tives to strengthen tax enforcement, (ii) the bidder's internal and

external corporate governance is poor, (iii) the bidder faces greater

information asymmetry and thus higher monitoring costs for external

investors, and (iv) both the bidder and the target are located in regions

with stricter tax enforcement. Finally, our results are further sup-

ported by the finding that bidders make fewer irrelevant diversified

M&As and related party M&As (i.e., an M&A between a listed com-

pany and its controlling companies) following the implementation of

CTAIS-3, suggesting a higher quality of M&A decisions.

Two papers are close to ours. Xu et al. (2011) find that regional

tax enforcement efforts reduce corporate agency costs in state-

owned enterprises (hereafter SOEs), while their governance role is lim-

ited for non-SOEs. Different from their paper, our study shows that

tax enforcement can effectively function as a governance role in the

M&A activities of non-SOEs. In addition, CTAIS-3, as a quasi-natural

experiment, mitigates the endogeneity issues that were not resolved

in Xu et al. (2011). Another related paper is Zhang et al. (2022), who

find that the CTAIS-3 pilot can improve investment efficiency from

the perspective of information asymmetry. In contrast, we focus on

the governance role of tax enforcement in corporate M&A activities.

Our paper contributes to the literature and policy-making in sev-

eral ways. First, our findings contribute to the literature on the gover-

nance role of tax enforcement in emerging markets. We provide

evidence that strict tax enforcement improves the quality of M&A

decisions and thus M&A performance in China. Since M&As serve as

an essential means for insiders to extract private benefits at the

expense of shareholders (Jensen, 1986; Lang et al., 1991;

Malmendier & Tate, 2008; Morck et al., 1990), our study sheds light

on how tax enforcement plays a role in corporate governance mecha-

nisms and how tax enforcement is related to shareholder wealth.

Second, our study contributes to the literature on the determi-

nants of M&A performance from the tax authority's perspective.

There is a rich stream of literature on how M&A performance is influ-

enced by the market for corporate control (Masulis et al., 2007), insti-

tutional investors (Chen et al., 2007; Ferreira et al., 2010), analyst

coverage (Chen et al., 2015), information asymmetry between bidder

and target firm (Marquardt & Zur, 2015; Martin & Shalev, 2017;

McNichols & Stubben, 2015), and executive equity incentives (Datta

et al., 2001). Nevertheless, little is known about how M&A perfor-

mance is affected by tax enforcement. We extend the literature by

showing that tax enforcement has a positive impact on M&A

648 ZHANG ET AL.