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CFS021002HK-ZWE391-ql
Does competition encourage unethical
behavior? the case of corporate profit
hiding in China
Hongbin Cai, UCLA
Qiao Liu*, HKU
Geng Xiao, HKU
Presentation at the International Conference on
Corporate Governance in Asia and China
March 11, 2005
THE SHLEIFER HYPOTHESIS (2004) – DOES COMPETITION ENCOURAGE
UNETHICAL BEHAVIOR?
Several cases discussed in Shleifer (2004)
 Competition encourages the employment of
child labour
 Competition promotes widespread corruption
 Competition leads to excessive executive
pays (e.g., Dick Grasso’s retirement package).
 Competition facilitates earnings
manipulations
 Competition forces universities to get
involved in commercial activities
Milgrom and Roberts’ (1992) analysis of the
moral hazard problem in S&L crisis
If firms use unethical or
illegal behaviour as
instruments to gain
competitive advantages,
then COMPETITION
may be neither efficiency
improving nor welfare
enhancing?
THE LITERATURE DIFFERS IN THE ROLE OF COMPETITION
Different voices
Research applauding competition
 “The best of all monopoly profits is a quite
life” (Hicks, 1935); “Monopoly is a great enemy
to good management” (Adam Smith).
 Michael Porter (1990) – competition leads to
competitive advantage.
 Holmstrom (1982); Nalebuff and Stiglitz
(1983); Hart (1983); Hermalin (1992) –
competition induces better managerial efforts
and reduces corporate slack, therefore,
competition improves efficiency
 Nickell (1996); and Fee and Hadlock (2000)
– provide empirical support for efficiency
improvement argument
 Milgrom and Roberts (1992) – competition
worsens moral hazard problem in S&L industry
Cummins and Nyman (2004) – competition
makes firm reluctant to act on private information
that is unpopular with consumers, which leads to
socially undesirable outcomes
Harris (1998) – firms are not willing to disclose
segment information due to competition concern
Schmidt (1997) – competition squeezes
monopoly rents and increases liquidation
probability, its overall role on efficiency is
unclear
 Scharfstein (1988) – the impact of
competition on efficiency depends on managers’
utility function
Although most economists are
prone to the first view,
No consensus… yet!
WE FOCUS ON CORPORATE PROFIT HIDING IN CHINA BECAUSE…
Mounting evidence around the world
 The internal Revenue Services estimated that
about 17% of income tax liability is not paid;
the figures for most other countries is probably
higher (Slemrod and Yitzhaki, 2000).
 There is a widening divergence between
book income and tax income, which can be
taken as a sign of profit hiding (Desai, 2002).
 Underground economy accounts for 15% of
GDP in Poland, 50% of GDP in Russia and
Ukraine (Johnson, Kaufmann, McMillan, and
Woodruff 2003).
Informal economy accounts for 56% of Peru’s
business activities and 60-80% of Peru’s total
employment (De Soto 1989, 2000)
Why China?
 In China, the China National Audit Office
uncovered RMB 13.39 billion in unpaid or
underpaid tax in 2002 based on a nation-wide
investigation of 788 companies selected at
random (AWSJ, Sept. 20, 2004)
There is a large variation both in terms of
competitiveness across industries and locations
in China, and in terms of profit reporting
practices
The database we have makes it possible for us
to estimate the extent of profit hiding at the firm
level
QUESTIONS TO BE ADDRESSED IN THE PAPER
• Does competition per se enhances firms’ incentives to
truthfully report their profits?
• Do firms’ profit-reporting propensities to competitive
pressures vary cross sectionally?
• If they do, what factors explain the cross-firm
variations? How do we justify them economically?
A SNAPSHOT OF OUR FINDINGS
• Firms in more competitive industries tend to hide more
profits, all else equal
• Firms positioned unfavorably in competitive environments,
such as smaller firms, firms facing higher corporate tax
rates, firms facing more severe financing constraints, and
private/collective firms, display stronger propensities to
hide profits
• Our empirical results are robust to a number of sensibility
checks
AGENDA FOR THE REST OF THE PRESENTATION
• Motivation
• A simple model and and testable hypothesis
• A test for profit hiding
• Empirical evidence
• Extension and conclusion
A SIMPLE MODEL
The model set-up
Results
‹
In a market with n strong firms and m weak firms, a
firm with a certain realized profit, decides to report a
profit, resulting in after tax profit
The reported profits for the strong firms
and weak forms are respectively:
‹
The firm invests all the after tax profits to maintain
competitive advantage, the payoff is given by
We can prove the following results
The firm chooses optimal reported profits to solve the
following problem
TESTABLE HYPOTHESIS
Hypothesis 1: Competition per se enhances firms’
incentive to hide profits (Proposition 1)
Hypothesis 2: Firms in dis-advantageous positions are
more likely to be affected by competitive pressures and
demonstrate stronger incentives to hide profits, where
dis-advantageous market positioning could be sorted
according to size, effective income tax rate incurred,
external financing constraints, past performance, and
ownership type. (Propositions 2 and 3)
AGENDA FOR THE REST OF THE PRESENTATION
• Motivation
• Theories and testable hypothesis
• A test for profit hiding
• Empirical evidence
• Extension and conclusion
WE NEED TO OVERCOME TWO EMPIRICAL CHALLENGES…
How to measure competition?
The IO literature provides several
measures of the extent of competition in
the product market. In the paper, we use
the following four measures:
1. The number of firms operating in a given
2.
3.
4.
industry (LOGN)
Herfindal index (H-Index)
Market share (sales) accounted for by the
top four firms (CONCEN)
Industry average ratio of pre-tax firm
profit to total sales (PMARGIN)
We define an industry/market in three
different ways: 2-digit code, 3-digit code,
and 2-digit – region industry.
How to measure the extent of
corporate profit hiding?
A conceptually and empirically
daunting task given that: (1)
conceptually, it is difficult to
define profit hiding? (2)
empirically, nobody knows for
sure what a firm’s true profit is,
let alone the extent of profit
hiding?
WE PROPOSE A NOVEL APPROACH IN THIS PAPER
Our intuition
We first compute a firm’s corporate profit in the
national income account and use it to proxy for
true profits
PRO = Y – MED – FC – WAGE – CURR,
Our empirical design
Let RPRO stand for reported profits, we have
where
where Y is the gross value of output, MED is the
value of intermediate inputs, FC is financial
charges, WAGE is the size of wage bill, and
CURR denotes current depreciation.
We then assume the following
Thus, we test whether β in the above equations
have expected sign
DATA AND KEY VARIABLES
Data source
Key variables
RPRO – reported accounting profit from the NBS
database
• The National Bureau of Statistics of China (NBS)
PRO – the computed corporate profit in the
national income account , which is a proxy for
earnings shock
collect accounting information from the large and
medium industrial firms each year in compliance
with the Statistics Law
FINANCE – financial charges / total assets
• The NBS database covers around 20,000 large
RSALE – total revenue / total output
and medium industrial firms for the period from 1995
to 2002
•The main purpose of the database is to understand
the firms’ operations and most importantly, to
compute the key components of GDP.
• Our empirical design only imposes a moderate
data demand. The NBS database therefore fits into
our design pretty well
TAX – income tax paid / pre-tax reported profit
TA – total assets
LNLABOR – logarithm of the number of
employees
Four competition measures H-Index, CONCEN,
LOGN, and PMARGIN are defined earlier
THE EXTENT OF COMPETITION ACROSS INDUSTRIES – TABLE 1
LOGN
PMARGIN
Petroleum Extraction
Petroleum Extraction
Petroleum Extraction
Gas Production
Gas Production
Timber Logging
Chemical Fiber
Tobacco
Nonferrous Mining
Tobacco
Timber Logging
Printing
Petro Processing
Ferrous Mining
Coal Mining
Pressing Ferrous
Chemical Fiber
Nonmetal Mining
Transport equipment
Petro Processing
Medical
Ferrous Mining
Nonferrous Mining
Ferrous Mining
Coal Mining
Rubber
Ordinary Machinery
Level of Competition
H-Index
Two observations: (1) enough cross-industry
variations in the extent of competition; (2) the various
measures yield consistent ordering.
AGENDA FOR THE REST OF THE PRESENTATION
• Motivation
• Theories and testable hypothesis
• A test for profit hiding
• Empirical evidence
• Extension and conclusion
MODEL SPECIFICATION
We specify the empirical model as follows:
We test whether β1 has the
expected sign and check
its economic magnitude.
TESTING HYPOTHESIS 1
RESULTS IN TABLE 3 PROVIDE SUPPORT FOR HYPOTHESIS 1
Main results in Table 3
Unresolved issue
 The four competition measures defined at
different market levels yield consistent result –
competition decreases the sensitivities of
reported profits to profits in the national income
account.
 Do different firms respond uniformly to
competitive pressures?
 Economically, all else equal, a one standard
deviation increase in H-Index (2-digit level) lead
to 0.01 yuan increase in RPRO, per one yuan
increase in PRO.
All else equal, a one standard deviation
increase in PMARGIN (2-digit level) lead to
0.031 yuan increase in RPRO, per one yuan
increase in PRO.
 All else equal, a one-standard deviation
increase in LOGN (2 digit level) decreases
RPRO by 0.042 yuan, per one yuan increase in
PRO
How about the firms positioned
dis-advantageously in
competition?
• Where a level playing field and major components of institutional
infrastructure are missing, firms with dis-advantageous market
positions may display stronger propensities to hide profits
(Hypothesis 2).
• We measure a firm’s market position by its size (LNLABOR), its
past performance (LROA), its actual income tax rate incurred
(TAX), the extent of its financing constraint (FINANCE), and
finally its ownership status (OWN).
MODEL SPECIFICATION II
We specify the empirical model as follows:
We test whether β2 has the
expected sign and check
its economic magnitude.
FIRMS DO NOT RESPOND TO COMPETITION UNIFORMLY – TABLE 4
MAIN RESULTS FROM TABLEs 4-6
Firm Characteristics
Impact on Incentives
to hide profits
Firm Size
Negative
A one standard deviation increase in
LNLABOR reduces the sensitivity to
competition (PMARGIN) by 31.55%.
Tax rate
Positive
A one standard deviation increase in
TAX increases the sensitivity to
competition (PMARGIN) by 18.75%.
Past Performance
Negative
A one standard deviation increase in
LROA reduces the sensitivity to
competition (H-Index) by 35.5%.
Financing Constraint
Positive
A one standard deviation increase in
Finance reduces the sensitivity to
competition (H-Index) by 54.15%.
Ownership Status
Positive
Private or collective firms’ sensitivities
to competition (PMARGIN) is 61.78%
higher than that of SOEs.
Economic significance
AGENDA FOR THE REST OF THE PRESENTATION
• Motivation
• Theories and testable hypothesis
• A test for profit hiding
• Empirical evidence
• Extension and conclusion
USING DIFFERENCED PROFITS
FURTHER ROBUSTNESS CHECKS
Back up
THE LITERATURE PROPOSES SEVERAL WAYS TO ESTIMATE THE
EXTENT OF PROFIT HIDING (or TAX NONCOMPLIANCE)
1. Infer the level of profit hiding (tax evasion, or the size of
informal economy) from data on measurable quantities, such
as currency demand (Gutmann, 1977; Feige, 1979), usage of
electricity (Johnson, Kaufmann, and Shleifer, 1997), or book
income/tax income (Desai, 2002).
2. Survey – obtaining information on profit hiding based on
questionnaires filled out by survey respondents (most of the
research done by World Bank, also see Johnson et al (2000)).
3. Missing imports – based on the import and export data
reported by Chinese and Hong Kong customs on the same
product (Fisman and Wei, 2004).
4. The sensitivities of reported profits to industry performance
(Bertrand, Mehta, and Mullainathan, 2002)
5. Field study (De Soto, 1989, 2000).
6. Using data obtained from the IRS’ Taxpayer Compliance
Measurement Program (TCMP) (Clotfelter, 1983; Feinstein,
1991)
Different viable
but imperfect
approaches
exist!
SUMMARY STATISTICS OF KEY VARIABLES– TABLE 3
Variable
# of Obs.
Mean
Std. Dev.
Min.
Max.
H-Index
177,086
0.0030094
0.0071224
0
0.1759418
CONCEN
177,086
0.0712516
0.0565898
0
0.7200878
LOGN
175,529
8.694323
1.7514715
4.317488
9.635935
PMARGIN
177,086
0.1381942
0.0430451
-0.1849917
0.5116481
RPRO
173,850
0.0034599
0.0681159
FINANCE
173,850
0.0246053
0.0232475
-0.064546
0.2872358
LNLABOR
177,086
6.573779
1.060439
3.401197
12.4454
PRO
173,850
0.0421978
0.1394945
-0.8163884
4.096725
RSALE
173,850
0.9926414
0.5259726
0.0183393
25.50651
TAX
115,742
0.279705
0.2257525
-35.00000
30.39202
LROA
126,226
0.001541
0.0655454
-0.5952935
1.241384
TA
177,086
340.5912
156.0571
0.701
91,500
-0.6895571
1.386437
CONCERN #1: THE FORMALS THEMSELVES FIRST GIVE INFORMALITY
ROOM TO DEVELOP …
Insights
• Emerging entrepreneurs have to work outside of
legal (formal) system, or in other words, go
underground, since the formal system deliberately
excludes them
• These extralegal entrepreneurs are by no means a
small and marginal sector of our society (in Peru,
they account for 60-80 percent of the nation’s
population)
• However, they want to live under the rule of formal
system. The biggest obstacle to them is the existing
formal system. In the face of this obstacle, new
entrepreneurs hold their assets outside of the
formal system (i.e., hiding revenues)
• How to surface the informal sector of our economy
pose a grave challenge to the existing system and
the future of our economy, especially for countries
with weak institutional infrastructure, or countries in
transitions.
CONCERN #2 – FIRMS THAT HAVE BEEN CONSISTENTLY DISCRIMINATED
MAY BEHAVE DIFFERENTLY
Personal highlights
 Started with 1000 chickens and 500 pigs in 1985; became
one of the top 500 private enterprises in China in 1995 (#344)
with total assets over RMB 100 million.
 Successfully created a model that was later called “Dawu
model”: never borrow from banks (because you cannot), borrow
directly from you fellow villagers. Has borrowed RMB159.89
million directly from more than 3185 households
 Political activist who spoke on behalf of Chinese peasants
- Sun Dawu, Founder and ex-CEO of
Dawu Group (大午集团)
My group’s fixed assets amount to
over RMB 100 million, but I could
not get any bank loans.
--- Sun Dawu
 Arrested and charged with a crime called “illegal deposit
taking” in early 2003; his case immediately drew tremendous
amount of media attention, which made him a hero, of course
in China’s informal sectors
 Rumoured that President Hu Jingtao intervened; sentenced
to 3 years in prison or 4 years on probation; released on
October 30, 2003.
 His eldest son succeeded him and became the CEO of
Dawu Group; his first priority, as he claimed, is to establish
good relationship with local government and try to get loan from
the banks, which his father had failed for the past 8 years
SEVERAL OPEN ISSUES
• How to define the scope of a product market? Is two-digit
industry too broad a way of specifying a market? How about
local protectionism?
• Do the sensitivities between RPRO and PRO capture things
beyond profit hiding? What other alternatives are out there?
• The endogeneity concern about the level of competition?
• The endogeneity concern about other firm characteristics?
SUMMARY AND FURTHER RESEARCH
SUMMARY
• We propose a novel empirical design to
test for the evidence of profit hiding in
China. We find that the propensity to hide
profit increases when competition n the
product market gets fiercer.
• We find firms with dis-advantageous
market positions (e.g., small firms,
industry laggards, firms facing high tax
rates, firms facing tighter financing
constraints, and private and collective
firms) are more sensitive to competitive
pressures.
• Policies used to promote competition
should be accompanied by policies to
level playing field, especially in China.
Future work
• Tie in the loose ends.