Tax Administration, Differential Effective Tax Rates, and Resource Misallocation

Abstract

Tax administration is fundamental to ensuring government revenue and economic governance. A key challenge in tax administration policy design is to achieve tax neutrality and minimize distortions to market mechanisms. In China, value-added tax (VAT) is the largest tax category, but the inconsistencies in tax administration have long prevented it from being fully neutral, resulting in large differences in the effective VAT rates among manufacturing firms in China, which contribute to resource misallocation and productivity losses.

This paper incorporates tax administration and tax evasion into an analytical framework of resource misallocation to investigate the mechanisms through which tax administration leads to differential effective tax rates and resource misallocation across firms. The theoretical analysis reveals that the greater the disparity in tax administration intensity among firms within an industry, the higher the dispersion of firms’ effective tax rates and productivity, resulting in resource misallocation and productivity losses. We employ a firm-level dataset of 2011–2015 nationwide tax surveys and use the implementation of the Golden Tax Phase III Project as a quasi-natural experiment. Using a staggered difference-in-differences (DID) design, the empirical evidence demonstrates that the Golden Tax III Project significantly reduces the dispersion of firm productivity and improves resource allocation efficiency across firms within the industry. The reduction in the dispersion of effective value-added tax rates serves as an important mechanism for enhancing resource allocation efficiency.

The structural adjustment of firms’ effective tax rates, along with the effects on preventing tax evasion and ensuring preferential tax treatment, collectively contribute to the decrease in the dispersion of the effective value-added tax rates, leading to improved resource allocation efficiency.

This paper contributes to existing literature in two key aspects. First, we integrate tax administration and tax evasion into the resource misallocation framework, providing a comprehensive theoretical explanation for the observed dispersion in effective tax rates and its impact on resource misallocation across firms in China. Second, by exploring the exogenous policy shock of the Golden Tax Phase III Project, we provide causal evidence on the effect of tax administration on differential effective tax rates and resource misallocation, contributing new insights into evaluating the tax administration reform.

The findings of this study provide clear policy implications for improving China’s tax administration system, highlighting the importance of consistency in tax administration and the need to reduce dispersion in firms’ effective tax rates while narrowing the gap between effective and statutory tax rates. Ensuring tax administration consistency is essential for reducing resource misallocation and promoting long-term productivity growth. Additionally, as a successor to the Golden Tax Phase III Project, the Golden Tax Phase IV (Smart Taxation) should be expedited to further modernize tax administration, effectively enhancing China’s tax capacity by applying digital technology and realizing the digitalization of tax governance.