Political connections and tax-induced earnings management: evidence from China

Abstract

We use the occasion of a change in tax policy that raised the tax rate for many of the listed companies in China to examine tax-induced earnings management (TEM) from the perspective of political connections. We find that when the tax rate increased, only those affected firms with politically connected management engaged in TEM. This suggests that, in addition to motivation for managing earnings, capability of influencing tax authorities is also an important determinant of TEM. We also find that TEM helped the firms with politically connected management to reduce their tax burden.

Keywords:

• China
• earnings management
• effective tax rate
• political connections
• tax policy

JEL Classification:

• G32
• G38
• H26
• M41

Acknowledgements

We appreciate comments and suggestions from two anonymous reviewers and workshop participants at Cardiff University and Peking University. Liansheng Wu and Jason Xiao acknowledge financial support from the National Natural Science Foundation of China (No. 71025003 and No. 71002005) and the National Social Science Foundation of China (No. 11AZD010).

Notes

1. But Lin and Bo (2012) do not find any evidence that government intervention helps in reducing the firm's financial constraints on investment.

2. It is true that taxable income and book income are different in China. Taxable income is based on the tax law and the book income is based on the accounting standards. However, their quantitative difference is very small because of the following reasons. (1) Both taxable income and book income are accruals-based. (2) Taxable income is based on the tax law, but the law does not give a specific definition for many incomes and the accounting standard is used to calculate the taxable income, for example, the difference between costs of finished goods inventory and costs of work-in-process inventory. (3) In reality, the taxable income is usually calculated through adjusting the book income, and the adjustment is usually small. For most of the public firms in China, there are no deferred tax assets and deferred tax liabilities in their balance sheets, and the underlying reason is that the taxable income is equal to the book income.

3. There were 27 provinces and 4 autonomous districts in China during the period from 1999 to 2005.

4. When we divide the sample into two sub-samples by the median of ROA, we find that the relationship between political connections and earnings management among FLTRT firms is more pronounced in firms with good performance.