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1. Introduction
There is a large body of economics, finance, and accounting literature analysing firms’ tax saving activities around changes to tax law (e.g. Feldstein and Summers, 1979; Fullerton, 1984, 1986; Lammersen, 2002; Gordon et al., 2003; Lim and Hyun, 2006; Dyreng et al., 2008; among others). However, the existing literature on firms’ tax saving behaviour around tax policy changes generally measures a firm's effective tax rate (ETR) and rarely examines earnings management activities around changes to tax law. In addition, the existing literature generally deals with OECD countries and rarely examines developing countries. Bahl and Bird (2008) argue that both tax policy and tax administration in developing countries are much different from those in industrialized countries. As a result, the level of taxation, the structure of taxation, as well as firms’ tax saving practices are different from those in industrialized countries.
This paper examines whether firms managed earnings as a result of a tax rate reduction in the recent corporate tax reform in China. To improve competition and provide tax relief for domestic firms, the Chinese 10th National People's Congress passed a new Enterprise Income Tax Law on 16 March 2007. The new law replaces the previous Foreign Enterprise Income Tax Law and the Domestic Enterprise Income Tax Regulation. It abolishes the tax incentives applicable only to foreign enterprises and introduces consistent tax treatments on all forms of enterprise. The new law provides low tax rates to small and low-profit firms as well as to high-tech enterprises, and accelerated deductions on expenses related to R&D activities and green economic activities.
In particular, the new Enterprise Income Tax Law, which took effect on 1 January 2008, provides a unified 25 per cent corporate tax rate to both domestic and foreign enterprises[1], and hence reduces the statutory tax rate for domestic firms from 33 to 25 per cent. It is the largest income tax rate reduction since China imposed a 33 per cent tax rate on domestic firms in 1994. Given this objective of reducing the tax rate for domestic enterprises, it might be fruitful to assess the enterprises’ tax-related activities, including their earnings management during the changes.
Using a sample of listed Chinese real estate firms, I find that firms managed earnings, including...