Tax Enforcement as a Corporate Governance Mechanism: Empirical Evidence from China

• DOI: http://doi.org/10.1111/j.1467-8683.2010.00831.x
• Date: 01 January 2011
• Author: Junsheng Zhang,Weichu Xu,Yamin Zeng
• Published date: 01 January 2011

Tax Enforcement as a Corporate Governance

Mechanism: Empirical Evidence from China

Weichu Xu, Yamin Zeng, and Junsheng Zhang*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study f‌irst measures tax enforcement efforts for 35 tax regions within China, then analyzes

the role of tax enforcement as a corporate governance mechanism by examining whether regional tax enforcement efforts

reduce two types of agency costs in Chinese listed f‌irms.corg_83125..40

Research Findings/Insights: Using archivaldata from a pooled sample of 917 listed f‌irms with total 3,668 observations from

2003 to 2006 in China, we f‌ind the following results: (1) regional tax enforcement efforts reduce corporate agency costs

between shareholders and managers and agency costs between blockholders and minority shareholders; (2) by reducing

two kinds of agency costs, tax enforcement efforts improve a f‌irm’s market performance; and (3) the governance role of tax

enforcement efforts is more signif‌icant for state-controlled f‌irms than for entrepreneur-controlled f‌irms.

Theoretical/Academic Implications: This study suggests that tax enforcement can act as a corporate governance mecha-

nism. Tax authorities not only have the ability to increase national tax revenue, but also play a positive role in decreasing

agency costs, including agency costs between shareholders and managers and those between block shareholders and

minority shareholders.

Practitioner/Policy Implications: This study offers a new insight to policy makers interested in transforming economies

that corporate governance build-up should be multidimensional. Besides the traditionally internal governance mechanisms

represented by boards of directors and external governance mechanisms represented by takeover markets, tax enforcement

is also an important corporate governance mechanism. The enforcement power of tax authorities could be better utilized to

supervise f‌irm operations in emerging markets.

Keywords: Corporate Governance, Tax Enforcement, China

INTRODUCTION

Among a wide variety of corporate governance mecha-

nisms throughout the world (Judge, 2010), previous

studies on corporate governance mechanisms focus on

boards of directors (Hermalin & Weisbach, 1998), manage-

ment incentives (Murphy, 1999), blockholders (Shleifer &

Vishny, 1986), hostile takeover and voting proxy (Jensen,

1993), creditors supervision (Diamond, 1984) and investor

protection (La Porta, Lopez-de-Silanes, Shleifer, & Vishny,

2002). Since Berle and Means (1932) advanced the separation

of ownership and control, there havebeen literally hundreds

of studies on the corporate governance mechanisms. Those

studies, however, generally ignore one important external

mechanism of f‌irms – tax enforcement. Taxes are compul-

sory payment levied on all citizens by state or sovereign

regions in order to transfer resources from personal usageto

public usage. Besides tax laws and tax rates, tax enforcement

is an important force to inf‌luence f‌irms. For example, during

collecting taxes, tax authorities have the right to audit f‌irm

accounting books, and they have incentives to supervise

f‌irms from any behavior that harm tax revenue.

Though several studies have argued that taxes inf‌luence

the interests and behavior of different stakeholders (e.g.,

Graham, 2003), only a few studies investigate the effects of

tax on corporate governance. As early as 1932 Berle and

Means suggested that a progressive tax system was an

explanatory factor for the dispersed ownership in US f‌irms.

Morck (2003) observed that pyramid-ownership structure

was not uncommon for US f‌irms before the tax reform

during 1935–36, but after that period these pyramid f‌irms

almost disappeared. He believed that the newly-levied divi-

dend taxes could explain why there were so few pyramid-

ownership f‌irms and almost no cross-shareholding in US

f‌irms after the reform. Morck and Yeung (2005) showed that

*Address for correspondence: Junsheng Zhang, School of Accountancy, Central Uni-

versity of Finance and Economics, Beijing 100081, China. E-mail: junya@126.com

25

Corporate Governance: An International Review, 2011, 19(1): 25–40

© 2010 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2010.00831.x

once the progressive tax on the dividend was abandoned in

Belgium, France, Greece, and Portugal during the 1980s,

pyramid-ownership f‌irms also appeared. Though tax laws

and tax rate are discussed in the studies above, tax enforce-

ment has been neglected until recently. Desai, Dyck, and

Zingales (2007) used the case of a Russian company to

examine the effects of tax enforcement on corporate value,

and f‌ind that corporate stock prices were increased during

the time of President Vladimir Putin (2000–08), who tried to

enhance tax enforcement. They showed that an increase in

tax enforcement can reduce managerial diversion and

increase the market value of a company.

This paper is built upon previous work of Desai et al.

(2007) but from a quite different perspective. While Desai

et al. (2007) examined the relationship between tax enforce-

ment and corporate governance, they did not regard tax

enforcement intrinsically as a kind of corporate governance

mechanism. This paper makes a contribution to the litera-

ture by proposing that tax enforcement is one kind of gov-

ernance mechanism and use archival data to empirically

analyze the role of tax enforcement efforts in relieving

agency costs. Also, Desai et al. (2007) did not measure tax

enforcement directly but used the lead of President Putin as

a signal for an increase of tax enforcement in Russia, while

we measure tax enforcement efforts for 35 tax regions of

China, providing empirical support for further studies.

More importantly, we consider not only agency costs

between shareholders and managers, but also those between

blockholders and minority shareholders, which is a much

bigger concern in emerging economies. Last, considering the

fact that many f‌irms in China are controlled by the state and

these f‌irms have a quite different motivational structure

from entrepreneur-controlled f‌irms, we also examine

whether the effects of tax enforcement on agency costs vary

with f‌irm ownership types.

To examine the role of tax enforcement as a corporate

governance mechanism in an important emerging economy

(i.e., China), we f‌irst construct an index of tax enforcement

efforts for different regions within this country. Then, we

analyze the effect of tax enforcement on two different kinds

of agency costs in Chinese listed companies: (1) agency costs

between shareholders and managers; and (2) agency costs

between blockholders and minority shareholders. Third, we

examine the ultimate effect of tax enforcement on f‌irm

market performance.

Our data reveals that tax enforcement efforts reduce both

agency costs between shareholders and managers and those

between blockholders and minority shareholders, especially

for state-controlled f‌irms. Specif‌ically, in regions with

greater tax enforcement efforts, managers reduce f‌irm oper-

ating expenses, selling and administrative expenses, and

discretionary selling and administrative expenses. And in

those regions, blockholders are also less likely to expropriate

capital from listed f‌irms and make related-party transactions

with f‌irms. Our further analyses f‌ind that the corporate

market-to-book ratio (MTB) is higher in regions with greater

tax enforcement efforts, and the value effect of tax enforce-

ment is also larger for state-controlled f‌irms. In one word,

tax enforcement in China plays a positive role in lessening

two kinds of agency problems and improving f‌irm perfor-

mance, especially for state-controlled f‌irms.

LITERATURE REVIEW AND

HYPOTHESES DEVELOPMENT

According to modern f‌irm theories, shareholders own

residual claims since they assume residual risks. Based on

Berle and Means (1932) work, managers are the agents of

shareholders when ownership is separated from control. In

this principal-agent relationship, shareholders rely on man-

agers to maximize their interests. Unfortunately, due to the

problems of moral hazard and asymmetric information, it is

necessary for shareholders to monitor or supervise the man-

agers via certain mechanisms. Traditionally, there are two

different kinds of supervision mechanisms – internal and

external (Jensen, 1993). Internal mechanisms include board

of directors, large shareholders, and management incen-

tives. External mechanisms include hostile takeover, contest

of voting proxy, creditors’ supervision, and product market

competition.

In recent years, the potential governance role of taxes has

attracted attention. From the perspective that taxes are a

compulsory fee levied by government on f‌irm’s prof‌its, the

government in essence is a special and important f‌irm

shareholder (Desai et al., 2007). Government has the

similar right on company’s cash f‌low with other prof‌it-

sharers, yet its right is more powerful and strongly sup-

ported by laws. For example, the Taxes Collection Act in

China specif‌ies that tax authorities have the right to check

f‌irm’s accounting books, business vouchers, report forms,

and related materials, and verify the commodities, goods,

or other assets at manufacturing factories, off‌ice buildings,

or warehouses. Besides, the act states that tax authorities

can take away taxpayers’ previous accounting books or

related materials for further investigation.

Since taxes authorities can audit f‌irm’s accounting books

in the process of collecting taxes, tax enforcement is an

important external force to supervise and monitor f‌irm

operations. To protect their own revenues, tax authorities

as powerful government enforcement units, have both the

motivation and ability to monitor any behavior that can

potentially harm tax revenue. Threatened by this external

force, managers have to restrain their harmful behavior like

transferring assets or stealing resources. In addition, the

amount of taxes collected from f‌irms is positively related to

the tax rate and f‌irm’s prof‌it. Assuming the tax rate

remains constant during a certain period, the amount of a

f‌irm’s tax liability is mainly determined by a f‌irm’s prof‌it-

ability. Tax authorities need f‌irms to improve their prof‌it-

ability in order to fulf‌ill the annual tax collection budget. It

is believed that tax-collecting authorities would use taxes

to supress the discretionary behavior of managers in order

to improve f‌irm performance. In this sense, tax enforce-

ment can play an important role in supervising and moni-

toring managers. Based on the above arguments, we

propose the f‌irst hypothesis:

H1a: Tax enforcement efforts help to reduce agency costs

between shareholders and managers in China.

In China, most listed f‌irms are controlled by the state (Liu

& Sun, 2005) and state-controlled f‌irms are managed very

differently from entrepreneur-controlled f‌irms (Shen & Lin,

26 CORPORATE GOVERNANCE

Volume 19 Number 1 January 2011 © 2010 Blackwell Publishing Ltd