Inquiry Letters and Tax Aggressiveness

• Published date: 01 July 2023
• Author: Yewei Wu,Bofu Zhang
• Date: 01 July 2023
• DOI: http://doi.org/10.1111/cwe.12491

©2023 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 37–65, Vol. 31, No. 4, 2023 37

Inquiry Letters and Tax Aggressiveness

Yewei Wu, Bofu Zhang*

Abstract

This study examined the impact of inquiry letters on corporate tax aggressiveness based

on the special inquiry system in Chinese stock exchanges. It found that the receipt of

inquiry letters significantly inhibited tax aggressiveness. The channel through which

inquiry letters worked involved a monitoring effect on related-party transactions.

The disincentive effect of inquiry letters on corporate tax aggressiveness was mainly

found in f‌i rms with overseas operations, low-quality of internal control, and weak tax

enforcement. Examining the textual information in inquiry letters, the results show that

more questions and the demand for a specif‌i c opinion from the auditor led to a greater

disincentive ef‌f ect. The level of detail in f‌i rms’ reply letters weakened this disincentive

ef‌f ect. Finally, the disincentive ef‌f ect of tax aggressiveness was more pronounced when

inquiry letters pointed to tax-related issues.

Keywords: disincentive ef‌f ect, inquiry letters, related party transactions, tax aggressiveness

JEL codes: E44, M40, M41, M42

I. Introduction

Corporate tax aggressiveness is a common phenomenon around the world. Governments

and scholars have been actively exploring ef‌f ective means to curb it. Currently, there are

two main approaches to the governance of tax aggressiveness. One way is government-

led tax aggressiveness governance practices, which mainly include domestic tax

enforcement and international tax governance systems (Hoopes et al., 2012). The

ef‌f ectiveness of tax enforcement relies on the capacity and ef‌f orts of the tax authority

(Bahl, 1972). However, it is dif‌f‌i cult to improve the capacity of tax authorities – mainly

the number of such authorities and tax enforcement techniques – in a short period of

time. The ef‌f orts of tax authorities are inf‌l uenced by many factors such as government

goals and government–business relationships (Wu et al., 2012; Geng et al., 2023).

*Yewei Wu, PhD Candidate, School of Economics and Management, Tongji University, China. Email:

lemon_yewei@163.com; Bofu Zhang (corresponding author), PhD Candidate, School of Economics and

Management, Tongji University, China. Email: zhangbofu2020@gmail.com. The authors thank the editors,

reviewers, and Yunxia Bai for their helpful comments. The authors appreciate the f‌i nancial support from the

National Natural Science Foundation of China (No. 72272108).

Yewei Wu, Bofu Zhang / 37–65, Vol. 31, No. 4, 2023

©2023 Institute of World Economics and Politics, Chinese Academy of Social Sciences

38

Relying solely on government actions to suppress corporate tax aggressiveness is

therefore insuf‌f‌i cient.

The other approach is to improve corporate governance. Desai et al. (2007) point

out that strengthening the supervision of management can effectively curb corporate

tax aggressiveness. Thus, third-party institutions, including auditors and analysts, can

ef‌f ectively curb aggressive tax avoidance (Donohoe and Knechel, 2014). The corporate

governance structure is deeply ingrained within a firm, making it challenging to

anticipate a swift transformation from a “bad” to a “good” state in terms of disciplining

its behavior. Tax aggressiveness can bring cash flow to the firm, which reduces the

incentive of the shareholders to monitor tax aggressiveness; third-party institutions,

including auditors and analysts, have economic ties with firms, resulting in a lack of

independence and limited ef‌f ectiveness in monitoring corporate tax aggressiveness.

Firms tend to avoid taxes through complex and ambiguous transactions (Weisbach,

2002), so improving the quality of corporate information can curb tax aggressiveness

effectively (Balakrishnan et al., 2019). The annual report inquiry letter is a letter

from the Shanghai and Shenzhen stock exchanges to inquire about the information

disclosure problems in the annual financial reports and request listed firms to reply

to the information disclosure problems by a deadline, which can effectively curb the

irregularities of corporate information disclosure and improve the quality of information.

The question is: can the annual report inquiry letter play a role in curbing tax aggressive

behavior?

The annual report inquiry letter has the following advantages in curbing tax

aggressiveness: (i) The tax authority calculates income tax based on the f‌i rm’s f‌i nancial

reports. Most of the annual report inquiry letters are related to misstatements, errors in

f‌i nancial transactions, and incorrect accounting estimates, which are closely related to

the tax enforcement behavior of the tax authority. (ii) Local governments, tax authorities,

auditors, analysts, and other third-party institutions are all connected financially

with the listed firm, and their lack of independence leads to limited suppression

of tax aggressiveness by such entities. The Chinese stock exchanges are vertically

managed and have greater independence. The annual report inquiry letters issued by

the exchanges can reveal the problems of financial information more thoroughly and

fully, thus inhibiting tax aggressiveness. (iii) The annual report inquiry letter is a public

document, and the stock exchanges are more transparent in supervising tax-aggressive

behaviors. In summary, the annual report inquiry letter should be able to curb corporate

tax aggressiveness. However, the annual report inquiry letter is a regulatory tool based

on corporate accounting standards, which are dif‌f erent from the standards applied by the

tax authority. This dif‌f erence may lead the annual report inquiry letter to play a role in