Does competition encourage unethical behavior? the case of corporate profit hiding in China

1. 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

2. 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 If firms use unethical or illegal behaviour as instruments to gain competitive advantages, then COMPETITION may be neither efficiency improving nor welfare enhancing? Milgrom and Roberts’ (1992) analysis of the moral hazard problem in S&L crisis

3. THE LITERATURE DIFFERS IN THE ROLE OF COMPETITION Different voices Research applauding competition • 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 • “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 Although most economists are prone to the first view, No consensus… yet!

4. WE FOCUS ON CORPORATE PROFIT HIDING IN CHINA BECAUSE… Mounting evidence around the world 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 • 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)

5. 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?

6. 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

7. 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

8. A SIMPLEMODEL 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 firm invests all the after tax profits to maintain competitive advantage, the payoff is given by The firm chooses optimal reported profits to solve the following problem The reported profits for the strong firms and weak forms are respectively: ‹ ‹ We can prove the following results

9. 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)

10. AGENDA FOR THE REST OF THE PRESENTATION • Motivation • Theories and testable hypothesis • A test for profit hiding • Empirical evidence • Extension and conclusion

11. WE NEED TO OVERCOME TWO EMPIRICAL CHALLENGES… How to measure the extent of corporate profit hiding? 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: • The number of firms operating in a given 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. 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?

12. WE PROPOSE A NOVEL APPROACH IN THIS PAPER Our intuition Our empirical design • 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, • 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 Let RPRO stand for reported profits, we have where Thus, we test whether β in the above equations have expected sign

13. DATA AND KEY VARIABLES Data source Key variables • The National Bureau of Statistics of China (NBS) collect accounting information from the large and medium industrial firms each year in compliance with the Statistics Law • The NBS database covers around 20,000 large 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 RPRO – reported accounting profit from the NBS database PRO – the computed corporate profit in the national income account , which is a proxy for earnings shock FINANCE – financial charges / total assets TAX – income tax paid / pre-tax reported profit RSALE – total revenue / total output TA – total assets LNLABOR – logarithm of the number of employees Four competition measures H-Index, CONCEN, LOGN, and PMARGIN are defined earlier

14. THE EXTENT OF COMPETITION ACROSS INDUSTRIES – TABLE 1 Level of Competition Two observations: (1) enough cross-industry variations in the extent of competition; (2) the various measures yield consistent ordering.

15. AGENDA FOR THE REST OF THE PRESENTATION • Motivation • Theories and testable hypothesis • A test for profit hiding • Empirical evidence • Extension and conclusion

16. MODEL SPECIFICATION • We specify the empirical model as follows: We test whether β1 has the expected sign and check its economic magnitude.

17. TESTING HYPOTHESIS 1

18. RESULTS IN TABLE 3 PROVIDE SUPPORT FOR HYPOTHESIS 1 Unresolved issue Main results in Table 3 • 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. • 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 • Do different firms respond uniformly to competitive pressures? How about the firms positioned dis-advantageously in competition?

19. 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).

20. MODEL SPECIFICATION II • We specify the empirical model as follows: We test whether β2 has the expected sign and check its economic magnitude.

21. FIRMS DO NOT RESPOND TO COMPETITION UNIFORMLY – TABLE 4

22. MAIN RESULTS FROM TABLEs 4-6 • Impact on Incentives to hide profits • Firm Characteristics • Economic significance • Negative • Positive • Negative • Positive • Positive • A one standard deviation increase in LNLABOR reduces the sensitivity to competition (PMARGIN) by 31.55%. • A one standard deviation increase in TAX increases the sensitivity to competition (PMARGIN) by 18.75%. • A one standard deviation increase in LROA reduces the sensitivity to competition (H-Index) by 35.5%. • A one standard deviation increase in Finance reduces the sensitivity to competition (H-Index) by 54.15%. • Private or collective firms’ sensitivities to competition (PMARGIN) is 61.78% higher than that of SOEs. • Firm Size • Tax rate • Past Performance • Financing Constraint • Ownership Status

23. AGENDA FOR THE REST OF THE PRESENTATION • Motivation • Theories and testable hypothesis • A test for profit hiding • Empirical evidence • Extension and conclusion

24. USING DIFFERENCED PROFITS

25. FURTHER ROBUSTNESS CHECKS

26. Back up

27. THE LITERATURE PROPOSES SEVERAL WAYS TO ESTIMATE THE EXTENT OF PROFIT HIDING (or TAX NONCOMPLIANCE) • 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). • 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)). • Missing imports – based on the import and export data reported by Chinese and Hong Kong customs on the same product (Fisman and Wei, 2004). • The sensitivities of reported profits to industry performance (Bertrand, Mehta, and Mullainathan, 2002) • Field study (De Soto, 1989, 2000). • Using data obtained from the IRS’ Taxpayer Compliance Measurement Program (TCMP) (Clotfelter, 1983; Feinstein, 1991) Different viable but imperfect approaches exist!

28. SUMMARY STATISTICS OF KEY VARIABLES– TABLE 3

29. 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.

30. 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 • 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 • - 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

31. 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?

32. SUMMARY AND FURTHER RESEARCH SUMMARY Future work • 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. • Tie in the loose ends.