Do Political Connections Weaken Tax Enforcement Effectiveness?

Abstract

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.

Regional favoritism and tax avoidance: evidence from China

“…Lin et al . () further document that the reason why political connections lead to greater tax avoidance is that they can weaken tax enforcement effectiveness. Our paper differs from these studies in our research questions: we focus on whether government leaders (collectors) patronize entire regions with biased taxation, whereas these studies investigate firms (payers) that voluntarily cultivate political connections for rent seeking…”

CEO hometown ties and tax avoidance‐evidence from China's listed firms

“…Therefore, the tax system in China increases firm incentives to use their political connections to obtain preferential tax treatment. Previous research has documented that CEOs use their college ties and workplace ties to local government officials to obtain favourable tax policies and to avoid corporate tax (Kim and Zhang, ; Lin et al ., ). In this paper, we focus on a new measure of political connection, hometown ties, and examine the effect of hometown ties on tax avoidance in China.…”

“…Lin et al . () measure political connection by college ties. In this paper, we compare the effect of hometown tie with college tie and workplace tie on corporate tax avoidance.…”

“…The consequences of rent‐seeking and the resultant distortion of resource allocation in favour of politically connected firms have long been a concern for economists (Fisman et al ., ). Prior literature has studied the factors that impact corporate tax avoidance and association between political connections and corporate tax avoidance (Kim and Zhang, ; Lin et al ., ). Gul et al .…”

“…Lin et al . () measure political connection by college ties. The impact of hometown ties between a CEO and local government officials on tax avoidance is largely unknown in the academic literature.…”