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This paper examines whether ties to politicians by corporate boards of directors weaken the effectiveness of tax authorities in constraining tax avoidance in China. We use a unique data set to measure geographic time‐variant tax enforcement, including the probability of income tax audit, the expertise of tax officers, and the consequences of underreporting tax liabilities. Based on a sample of 11,121 firm‐years from 2003 to 2013, we find that the deterrent effect of the probability that a firm's taxable income understatement will be detected and lead to heavy penalties is significantly undermined if the board is politically connected. To enhance our analysis, we use opportunities for income shifting, the most likely mechanism through which Chinese firms avoid taxes on an ongoing basis, to illustrate how connected boards exert power to unwind the constraining effect of tax enforcement. Overall, our results suggest that a board's ties to politicians can be a significant challenge to the effective enforcement of tax compliance in a politically controlled economy.

March 2015 HKUST IEMS working papers are distributed for discussion and comment purposes. The views expressed in these papers are those of the authors and do not necessarily represent the views of HKUST IEMS.

This study examines how public and private firms in China respond to the 2008 statutory tax rate reduction from 33 percent to 25 percent. Using a proprietary dataset of private firms, we find that private firms report significantly more income-decreasing current accruals than do public firms in 2007, the year prior to the tax rate reduction. These negative accruals were substantial and material, both compared with public firms and compared with 2008 accruals. By shifting their taxable income from a high- to a low-tax year, private firms save about 8.58 percent of their total tax expenses in 2007. Our results suggest that countries contemplating tax rate changes should expect material inter-temporal income shifting by private firms when they predict the short-term effects of changes in the tax rate on revenue. JEL Classifications: H25; M41.