Int Tax Public Finance (2012) 19:660676 DOI 10.

1007/s10797-011-9201-0

Taxation and foreign direct investment (FDI): empirical evidence from a quasi-experiment in China
Zhiyong An

Published online: 29 October 2011 Springer Science+Business Media, LLC 2011

Abstract Chinas new Corporate Income Tax Law was passed in March 2007 and took effect on January 1 2008. It terminates the dual corporate income tax regime by removing the preferential tax treatments offered to foreign investment enterprises (FIEs) and unies the corporate income tax regime for FIEs and Chinese domestic enterprises (DEs). This paper uses a difference-in-differences approach to determine whether FIEs are responding to the law by reducing their investment in China. Employing the Chinese Industrial Enterprises Database (20022008) to implement the analysis, we nd that: (1) FIEs are responding to the law by reducing their investment in China; and (2) the magnitude of the response is larger for HongKong-MacauTaiwan (HMT) investment enterprises than that for other FIEs, which supports the claim that some Chinese investors engaged in roundtripping FDI. Our condence in the conclusions are further boosted by the results of a series of placebo tests and two robustness checks: (1) the results of the placebo tests support the claim that the estimated effect is due to the tax reform rather than to other confounding factors; (2) the results of the rst robustness check are consistent with the perception that StateOwned Enterprises (SOEs) might enjoy more favorable treatments from the Chinese government than Private-Owned Enterprises (POEs); and (3) the results of the second robustness check show that incorporating enterprise-specic time trends into the baseline specication of our econometric models does not change the conclusions. Keywords Corporate income tax Foreign direct investment (FDI) Foreign investment enterprise (FIE) Multinational corporation (MNC) JEL Classication H2 H32 H87

Z. An ( ) School of Public Economics & Public Administration, Shanghai University of Finance and Economics, Shanghai 200433, China e-mail: anzy2008@gmail.com

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1 Introduction Cross-border investment by multinational corporations (MNCs) is one of the most salient features of todays global economy so that cross-border investment by controlling entities has acquired a special name, foreign direct investment, and an associated acronym, FDI. Undoubtedly, MNCs invest outside their home country for a wide variety of reasons, among which, access to market, political considerations, labor costs, and proximity to suppliers are frequently mentioned.1 Given these other forces shaping the volume and location of FDI, however, tax laws might still have potential important impact on the patterns of FDI. Studies of the effect of taxation on FDI generally take the view that whatever FDIs benets to MNCs are, they must be balanced against the tax consequences of carrying out FDI. Thus, the incentives concerning FDI are affected by the tax systems of both the MNCs home country and potential host countries. Gersovitz (1987) and Alworth (1988) provide some theoretical treatment of these questions. Previous empirical evidence of the effect of taxation on FDI comes in two forms.2 The rst form is time-series estimation of the responsiveness of FDI to annual variation in after-tax rates of return (e.g., Hartman 1984; Boskin and Gale 1987; Newlon 1987; Young 1988; Slemrod 1990; Auerbach and Hassett 1993, and Swenson 1994), dating back to Hartman (1984). The second form is cross-sectional in nature, employing the very large national or subnational differences in corporate tax rates to identify the effect of taxation on FDI (e.g., Coughlin et al. 1991; Grubert and Mutti 1991; Harris 1993; Ondrich and Wasylenko 1993; Hines and Rice 1994; Hines 1996; Altshuler et al. 1998; Swenson 2001, and Desai et al. 2004). The general consensus of the literature is that taxation does inuence the volume and location of FDI. The papers in the empirical literature on the effect of taxation on FDI have two salient features. First, with recent few exceptions (e.g., Devereux and Freeman 1995 and Hines 1998), they consider almost exclusively U.S. data, either the distribution of FDI in the U.S. or the pattern of U.S. direct investment in other countries, which might be due to two possible reasons: (1) The U.S. economy is the largest economy in the world and thus the focus on the U.S. data might reect the U.S. leadership in both inward and outward FDI; and (2) The U.S. collects and distributes much more, and higher-quality, data on FDI activities than does any other country in the world. Second, most analyses of FDI rely on aggregate data such as ow of funds, the volumes of new enterprise in the U.S., or the operations of foreign subsidiaries in the U.S., which might be due to the lack of disaggregated data. While the aggregate data provide a comprehensive description of overall investment activities, they are less informative if one wishes to analyze individual rm decisions. Chinas new Corporate Income Tax Law was passed in March 2007 and took effect on January 1 2008. It terminates the dual corporate income tax regime by removing the tax preferences offered to foreign investment enterprises (FIEs) by the Chinese
1 Caves (1982) examines many reasons why MNCs invest their resources outside their home country. 2 See Hines (1997, 1999) for a critical review of most of the papers on the empirical evidence of the effect

of taxation on FDI.

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government and unies the corporate income tax regime for FIEs and Chinese domestic enterprises (DEs). In this paper we use a difference-in-differences approach to determine whether FIEs are responding to the law by reducing their investment in China. We employ the Chinese Industrial Enterprises Database (20022008) to implement the analysis. The results of our data analysis reach two conclusions. First, we nd that FIEs are responding to the law by reducing their investment in China. Second, we nd that the magnitude of the response is larger for HongKong-MacauTaiwan (HMT) investment enterprises than that for other FIEs, which supports the claim that some Chinese investors engaged in roundtripping FDI, where capital was moved to Hong Kong, Macau, or Taiwan before it was invested in the mainland of China, to gain the tax preferences offered to FIEs by the Chinese government. In order to increase our condence in the conclusions, we further conduct a series of placebo tests and two robustness checks. The results of the placebo tests and the two robustness checks all boost our condence in the conclusions. First, the results of the placebo tests support the claim that the estimated effect is due to the tax reform rather than to other confounding factors. Second, the results of the rst robustness check are consistent with the perception that State-Owned Enterprises (SOEs) are very different from Private-Owned Enterprises (POEs) in the sense that SOEs might enjoy more favorable treatments from the Chinese government than POEs. Finally, the results of the second robustness check show that incorporating enterprise-specic time trends into the baseline specication of our econometric models does not change the conclusions. Academically, there are at least two points that distinguish our work from the empirical literature on the effect of taxation on FDI. First, our study uses China data, rather than U.S. data employed in almost all of the previous studies. According to the United Nations (1994), China has already emerged as the largest recipient of FDI among developing countries since 1992, and has been the second largest recipient of FDI in the world (only second to the U.S.) since 1993 as a result of its open-door policy dating back to 1978. Thus, the case of U.S. FDI and the case of China FDI not only represent the two most important cases of FDI in the world, but also provide an opportunity to make a comparison of the experience of the most developed economy with that of the largest developing economy in the world. Second, our data is rmlevel data, rather than aggregate data employed in almost all of the previous studies, and hence our study might be more informative in analyzing the effect of taxation on FDI. In terms of policy making, the contribution of our work can be viewed from at least two aspects. First, our work might provide some helpful information for Chinese policymakers. FDI plays an important role in the Chinese economy. Our work sheds some light on the impact of taxation on FDI in China, and thus may help Chinese policymakers to make relevant policies. Second, Chinas new Corporate Income Tax Law is the most profound tax reform of the decade in China. It is very important to evaluate the impact of the law. However, to the best of our knowledge, no rigorous and systematic study has been done to evaluate its impact. Our work makes an attempt in this direction. The remainder of the paper is organized as follows. Section 2 provides background knowledge on Chinas new Corporate Income Tax Law. Section 3 presents our identication strategy and describes our econometric models. Section 4 describes the data

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in detail, and Sect. 5 reports the results of our data analysis. Finally, Sect. 6 briey concludes the paper.

2 Chinas new Corporate Income Tax Law Since the early 1990s, China has maintained a dual corporate income tax regime: one regime for Chinese DEs and the other one for FIEs. Under the dual corporate income tax regime, FIEs enjoy certain preferential tax treatments offered by the Chinese government as compared with DEs. The purpose of the dual corporate income tax regime is to entice foreign investment into China. In order to create a level playing eld and a fair scal environment that promotes competition and transparency for all enterprises in China and in order to increase the sophistication of Chinas tax regime in general, the National Peoples Congress of China drafted and passed the new Corporate Income Tax Law in March 2007. The law came into effect on January 1 2008. Chinas new Corporate Income Tax Law is the most profound tax reform of the decade in China. It terminates the dual corporate income tax regime by removing the preferential tax treatments offered to FIEs by the Chinese government and unies the corporate income tax regime for FIEs and DEs. It is widely expected that the law will have huge impact on FIEs, but basically no impact on DEs.

3 Identication strategy and econometric models As described in the previous section, Chinas new Corporate Income Tax Law has huge impact on FIEs, but basically no impact on DEs. In this paper, we use a difference-in-differences approach to determine whether FIEs are responding to the law by reducing their investment in China. Our treatment group is made up of FIEs, while our control group is made up of DEs. Econometrically, in order to examine whether FIEs are responding to the law by reducing their investment in China, one could estimate the following difference-indifferences model: log Assetsi,t = i + t + log SalesRevenuei,t 1 + log Assetsi,t 1 + Zi,t + (treatment postlegislation)i,t + i,t , (1) where i,t is the econometric error term; i and t are xed effects for enterprise i and year t respectively;3 Zi,t is a vector of control variables that include: (1) a categorical variable that indicates the area (the counterpart in the U.S. is state) where an enterprise is registered and is denoted as Location_IDi,t ; and (2) a categorical variable that indicates the two-digit industry category that an enterprise belongs to and is denoted as Industry_IDi,t . These control variables control for observable differences in the characteristics of enterprises that may affect the level of assets. Controlling
3 In our sample, year t runs from year 2002 to year 2008.

664 Fig. 1 The trends of the total assets of the treatment and control groups (20022008)

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for these observable differences reduces the residual variance of the regression and produces more efcient estimates. In (1), the variable Assetsi,t represents the assets of enterprise i in year t . We use log(Assetsi,t ) as the dependent variable to address the potential nonlinearity problem. In order to check the robustness of our analysis, we employ two alternative measures of enterprise i s assets in year t : (1) the total assets (denoted as TotalAssetsi,t ); and (2) the total xed assets (denoted as TotalFixedAssetsi,t ). In other words, we have two alternative dependent variables: (1) log(TotalAssetsi,t ); and (2) log(TotalFixedAssetsi,t ). We are basically estimating a type of investment equation, with log(Assetsi,t ) as our dependent variable. In the investment literature (e.g., Bond and Cummins 2000; Desai and Goolsbee 2004, and Edgerton 2010), adjustment costs are generally thought to be important, which usually leads to a lagged dependent variable being included. Thus, we include log(Assetsi,t 1 ) as one control variable. Intuitively, we expect the coefcient of log(Assetsi,t 1 ), namely , to be positive and statistically signicant. Prior investment literature also suggests that sales revenue is an important explanatory variable, and hence we include log(SalesRevenuei,t 1 ) as another control variable. Intuitively, we expect the coefcient of log(SalesRevenuei,t 1 ), namely , to be positive and statistically signicant. The variable (treatment postlegislation)i,t equals one when (1) enterprise i is an FIE and (2) year t is year 2008; (treatment postlegislation)i,t is equal to zero otherwise. It might be desirable to include enterprise-specic time trends in the assets as one control variable.4 However, Figs. 1 and 2 show that the trend of the assets of the treatment group and that of the control group basically overlap each other till year 2007 but diverge after year 2007, which implies that there is little difference between the two trends before the reform, and that had not been the reform, there would be little difference between the two trends after year 2007, either. Therefore, we do not include the enterprise-specic time trends in the assets as one control variable in the baseline specication of our econometric models. By inspecting (1), one can see that the coefcient of the variable (treatment postlegislation)i,t , namely , gives us the difference-in-differences estimate of the
4 Please see Wooldridge (2002) for how to implement enterprise-specic time trends and see Dharmapala

and Khanna (2008) for a nice application that allows not only for enterprise and year xed effects, but also for enterprise-specic time trends.

Taxation and foreign direct investment (FDI): empirical evidence Fig. 2 The trends of the total xed assets of the treatment and control groups (2002 2008)

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treatment effect, namely, the differences between the change in log(Assetsi,t ) of the treatment group and that of the control group before and after the law came into effect. We expect to be negative and statistically signicant. In other words, we expect that FIEs are responding to the law by reducing their investment in China. It is claimed that some Chinese investors engaged in roundtripping FDI. By roundtripping FDI, they mean that some Chinese investors moved their capital to Hong Kong, Macau, or Taiwan before they invested their capital in the mainland of China, to gain the preferential tax treatments offered to FIEs by the Chinese government.5 Because HMT investment enterprises are more sensitive to the removal of the preferential tax treatments than other FIEs, we expect to see that the magnitude of the response is larger for HMT investment enterprises than that for other FIEs. In order to test this idea, we estimate the following difference-in-differences model: log Assetsi,t = i + t + log SalesRevenuei,t 1 + log Assetsi,t 1 + Zi,t + 1 (treatment postlegislation)i,t + 2 (treatment postlegislation HMT _Dummy)i,t + i,t . (2) Comparing (2) with (1), one could see that (2) includes one more term, namely, the variable (treatment postlegislation HMT _Dummy)i,t . The variable (treatment postlegislation HMT _Dummy)i,t equals one when (1) enterprise i is not only an FIE, but also an HMT investment enterprise and (2) year t is year 2008; (treatment postlegislation HMT _Dummy)i,t is equal to zero otherwise. By inspecting (2), one can reach three conclusions: (1) 1 gives us the treatment effect for other FIEs; (2) 2 gives us the difference between the treatment effect for HMT investment enterprises and that for other FIEs; and (3) (1 + 2 ) gives us the treatment effect for HMT investment enterprises. We expect both 1 and 2 to be negative and statistically signicant. In other words, we expect that all FIEs are responding to the law by reducing their investment in China, and that the magnitude of the response is larger for HMT investment enterprises than that for other FIEs.

5 Hong Kong and Macau are also on the list of tax havens compiled by Dharmapala and Hines (2009).

666 Table 1 Overview of the Chinese Industrial Enterprises Database (20022008) Year 2002 2003 2004 2005 2006 2007 2008 Sample size 181,557 196,222 279,092 271,835 301,961 336,768 412,212 45,681

Z. An Size of the intersection

4 Data description We employ the Chinese Industrial Enterprises Database (20022008) to implement the analysis. The database embodies information of enterprises whose annual sales revenue is above 5 million RMB. The coverage of the database is identical with that of the industrial sector of the China Statistical Yearbook and with that of the China Industry Economy Statistical Yearbook. The difference is that the Chinese Industrial Enterprises Database is rm-level data, while both the industrial sector of the China Statistical Yearbook and the China Industry Economy Statistical Yearbook are aggregated data along different dimensions. The database is the most complete and most authoritative rm-level database in China. By 2008, the database has included 412,212 industrial enterprises, which accounts for about 95% of the total industrial output value of China. The database contains about 40 general industry categories at the two-digit industry code level, and covers all the 31 areas in the mainland of China, namely, 22 provinces, 5 autonomous regions (namely, Guangxi, Neimeng, Ningxia, Xinjiang, and Tibet), and 4 cities (namely, Beijing, Tianjin, Shanghai, and Chongqing) that report directly to the central government. Each enterprise in the database is identied by a unique enterprise ID. The sample of the enterprises in the database changes year by year, with some enterprises entering the database and some others exiting the database. Table 1 gives the overview of the sample size information of the database. Among all the enterprises, 45,681 enterprises are continuously kept in the database from year 2002 to year 2008. Therefore, the number of observations used in our data analysis is 45,681*7 = 319,767. Because Chinas new Corporate Income Tax Law came into effect on January 1 2008, we use the data for year 2008 as the post-legislation observation, and use the data for other years as the pre-legislation observation. The database provides two types of information for each enterprise. The rst type of information is basically qualitative, including the ID of each enterprise, the location where each enterprise is registered, the industry category of each enterprise, the type of registration of each enterprise, and etc., and is coded according to predened mapping tables. The second type of information is basically quantitative, including for example, almost all the variables on the balance sheet of each enterprise such as sales revenue, sales cost, total assets, total xed assets, total debt, total prot, and etc. The type of registration (denoted as RegistrationType) of each enterprise tells us the type of each enterprise. Table 2 is the mapping table for the type of registra-

Taxation and foreign direct investment (FDI): empirical evidence Table 2 The mapping table for the type of registration Level_1_Code 100 110 120 130 140 141 142 143 149 150 151 159 160 170 171 172 173 174 190 200 210 220 230 240 300 310 320 330 340 190 160 110 120 130 Level_2_Code Level_3_Code Type of Enterprise Domestic Enterprises State-Owned Enterprises Collective-Owned Enterprises Share Cooperative Enterprises Associated Enterprises State-State Associated Enterprises Collective-Collective Associated Enterprises State-Collective Associated Enterprises Other Associated Enterprises Limited Liability Company State-Owned Limited Liability Company Other Limited Liability Company Limited Liability Stock Company Private-Owned Enterprises Private-Owned Company (only one owner) Private-Owned Partnership Company Private-Owned Limited Liability Company

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Private-Owned Limited Liability Stock Company Other Enterprises HongKong-Macau-Taiwan (HMT) Investment Enterprises HMT-Mainland Joint Venture Enterprise Jointly Managed by Mainland and HMT HMT-Owned Enterprise HMT-Owned Limited Liability Stock Company Foreign Investment Enterprises Chinese-Foreign Joint Venture Enterprise Jointly Managed by China and Foreign Countries Foreign-Owned Enterprise Foreign-Owned Limited Liability Stock Company

tion. According to Table 2, we impute the value of treatment as follows: (1) if the RegistrationType of an enterprise is in (210, 220, 230, 240, 310, 320, 330, 340), then we set the value of treatment for the enterprise to be one; and (2) otherwise, we set the value of treatment for the enterprise to be zero. Similarly, we impute the value of HMT _Dummy as follows: (1) if the RegistrationType of an enterprise is in (210, 220, 230, 240), then we set the value of HMT _Dummy for the enterprise to be one; and (2) otherwise, we set the value of HMT _Dummy for the enterprise to be zero.

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5 Results of data analysis Our data analysis is composed of ve parts. Recall that we have two alternative measures of enterprise i s assets in year t (i.e., Assetsi,t ): (1) the total assets (i.e., TotalAssetsi,t ); and (2) the total xed assets (i.e., TotalFixedAssetsi,t ). Correspondingly, in Part (1), we use TotalAssetsi,t as the measure of Assetsi,t to implement the data analysis. In Part (2), we use TotalFixedAssetsi,t as the alternative measure of Assetsi,t to repeat the data analysis in Part (1). In Part (3), we conduct a series of placebo tests to increase our condence in that the estimated effect is due to the tax reform rather than to some other confounding factors. Basically, we run regressions similar to (1) modied by restricting the sample to year 2002 year 2007 and counterfactually supposing that the law took effect on 01/01/2007, 01/01/2006, 01/01/2005, 01/01/2004, and 01/01/2003 respectively. The basic idea is that if the estimated treatment effect were statistically insignicant, then the results of the placebo tests would increase our condence in that the estimated effect is due to the tax reform rather than to other confounding factors. In Part (4), we conduct a robustness check. Among Chinese domestic rms, State-Owned Enterprises (SOEs) are very different from Private-Owned Enterprises (POEs). Therefore, in Part (4), we restrict the control group to SOEs (i.e., the RegistrationType of an enterprise is equal to 110) and to POEs (i.e., the RegistrationType of an enterprise is in (171, 172, 173, 174)) respectively, then estimate equation (1) respectively, and nally compare the corresponding treatment effects. Because it is widely perceived that SOEs might enjoy more favorable treatments from the Chinese government than POEs before the law came into effect, we expect that the magnitude of the treatment effect by restricting the control group to SOEs would be less than that by restricting the control group to POEs. In Part (5), we conduct another robustness check. In the baseline specication of our econometric models, we do not include the enterprise-specic time trends in the assets as one control variable because Figs. 1 and 2 suggest that time trends are unlikely to bias our results. In Part (5), we incorporate the enterprise-specic time trends in the assets as one control variable into (1) and follow the methodology of Wooldridge (2002) and Dharmapala and Khanna (2008) to do the estimation. The results of the ve parts of our data analysis are reported as follows one by one. 5.1 Part (1): Use TotalAssetsi,t as the measure of Assetsi,t to implement the data analysis In this part, we use TotalAssetsi,t as the measure of Assetsi,t to implement the data analysis. First, Fig. 1 plots the trend of total assets of the treatment group and that of the control group. By Fig. 1, one can see two rising trends basically overlapping each other till year 2007. But the two rising trends diverge after year 2007, namely, the control group keeps its original rising trend, while the treatment group switches to a declining trend. Therefore, visual evidence shows that FIEs are responding to the law by reducing their investment in China. Second, we estimate (1) to examine whether FIEs are responding to the law by reducing their investment in China. The regression results are reported in

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Table 3 Results of difference-in-differences regressions (dependent variable (DV): log(TotalAssetsi,t )) Independent variable log(SalesRevenuei,t 1 ) log(TotalAssetsi,t 1 ) (treatment postlegislation)i,t (treatment postlegislation HMT _Dummy)i,t Column 1 0.016*** (t_stat: 8.16) 0.061*** (t_stat: 26.60) 0.137*** (t_stat: 27.43) Column 2 0.016*** (t_stat: 8.15) 0.061*** (t_stat: 26.59) 0.126*** (t_stat: 19.72) 0.021** (t_stat: 2.51) * Statistically signicant at the 10% level ** Statistically signicant at the 5% level *** Statistically signicant at the 1% level The estimated coefcients of categorical control variables are omitted

Column 1 of Table 3. By Column 1 of Table 3, one could reach two conclusions: (1) As expected, the estimated coefcients of log(TotalAssetsi,t 1 ) and log(SalesRevenuei,t 1 ) are both positive and statistically signicant at the 1% level, which intuitively makes sense; and (2) As expected, the estimated coefcient of (treatment postlegislation)i,t is negative at 0.137 and statistically signicant at the 1% level, which implies that FIEs are responding to the law by reducing their investment in China. Finally, we estimate (2) to examine whether the magnitude of the response is larger for HMT investment enterprises than that for other FIEs. The regression results are reported in Column 2 of Table 3. By Column 2 of Table 3, one could reach three conclusions: (1) As expected, the estimated coefcients of log(TotalAssetsi,t 1 ) and log(SalesRevenuei,t 1 ) are both positive and statistically signicant at the 1% level, which intuitively makes sense; (2) As expected, the estimated coefcient of (treatment postlegislation)i,t is negative at 0.126 and statistically signicant at the 1% level, which implies that FIEs (other than HMT investment enterprises) are responding to the law by reducing their investment in China; and (3) As expected, the estimated coefcient of (treatment postlegislation HMT _Dummy)i,t is negative at 0.021 and statistically signicant at the 5% level, which implies that the magnitude of the response is larger for HMT investment enterprises than that for other FIEs. The third conclusion supports the claim that some Chinese investors engaged in roundtripping FDI, where those investors moved their capital to Hong Kong, Macau, or Taiwan before they invested their capital in the mainland of China, to gain the preferential tax treatments offered to FIEs by the Chinese government. In summary, the results of our data analysis in this part reach two conclusions. First, FIEs are responding to the law by reducing their investment in China. Second, the magnitude of the response is larger for HMT investment enterprises than that for other FIEs, which supports the claim that some Chinese investors engaged in roundtripping FDI.

670 Table 4 Results of log(TotalFixedAssetsi,t )) Independent variable log(SalesRevenuei,t 1 ) log(TotalFixedAssetsi,t 1 ) (treatment postlegislation)i,t (treatment postlegislation HMT _Dummy)i,t difference-in-differences regressions (dependent variable

Z. An (DV):

Column 1 0.029*** (t_stat: 11.19) 0.054*** (t_stat: 25.77) 0.167*** (t_stat: 23.60)

Column 2 0.029*** (t_stat: 11.16) 0.054*** (t_stat: 25.76) 0.146*** (t_stat: 16.07) 0.043*** (t_stat: 3.59)

* Statistically signicant at the 10% level ** Statistically signicant at the 5% level *** Statistically signicant at the 1% level The estimated coefcients of categorical control variables are omitted

5.2 Part (2): Use TotalFixedAssetsi,t as the alternative measure of Assetsi,t to implement the data analysis In this part, we use TotalFixedAssetsi,t as the alternative measure of Assetsi,t to repeat the data analysis in Part (1). The results of our data analysis are reported in Fig. 2 and Table 4. By comparing Fig. 2 with Fig. 1 and comparing Table 4 with Table 3, one could see that the two conclusions reached in Part (1) still hold. 5.3 Part (3): The placebo tests One way to check that the estimated effect is due to the tax reform rather than to some other confounding factors is to conduct a series of placebo tests. Our basic methodology of conducting the placebo tests is to run regressions similar to (1) modied by restricting the sample to year 2002 year 2007 and counterfactually supposing that the law took effect on 01/01/2007, 01/01/2006, 01/01/2005, 01/01/2004, and 01/01/2003 respectively. The basic idea underlying our methodology is that if the estimated treatment effect of the placebo tests were statistically insignicant, we would be more condent to say that the estimated effect is due to the tax reform rather than to other confounding factors. The results of the placebo tests are reported in Table 5. By Table 5, one could see that regardless which of the two alternative measures of Assetsi,t is used to conduct the placebo tests, the estimated treatment effects are all statistically insignicant. Therefore, the results of the placebo tests reinforce the conclusion that estimated effect is due to the tax reform rather than to other confounding factors.

Taxation and foreign direct investment (FDI): empirical evidence Table 5 Results of placebo tests Time the law took effect Treatment effect (Measure of Assets : TotalAssets) 01/01/2007 01/01/2006 01/01/2005 01/01/2004 01/01/2003 0.056 (t_stat: 0.37) 0.049 (t_stat: 0.33) 0.043 (t_stat: 0.29) 0.044 (t_stat: 0.29) 0.050 (t_stat: 0.33) * Statistically signicant at the 10% level ** Statistically signicant at the 5% level *** Statistically signicant at the 1% level Table 6 State-owned enterprises vs. private-owned enterprises Control group Treatment effect (Measure of Assets : TotalAssets) State-Owned Enterprises Private-Owned Enterprises 0.044*** (t_stat: 4.97) 0.209*** (t_stat: 36.82) * Statistically signicant at the 10% level ** Statistically signicant at the 5% level *** Statistically signicant at the 1% level Treatment effect Treatment effect

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(Measure of Assets : TotalFixedAssets) 0.164 (t_stat: 0.78) 0.152 (t_stat: 0.73) 0.127 (t_stat: 0.61) 0.128 (t_stat: 0.61) 0.150 (t_stat: 0.72)

(Measure of Assets : TotalFixedAssets) 0.070*** (t_stat: 5.72) 0.250*** (t_stat: 30.87)

5.4 Part (4): State-owned enterprises (SOEs) vs. private-owned enterprises (POEs) In this part, we conduct a robustness check. Among Chinese domestic rms, SOEs and POEs are very different. Especially, there is a deep perception that SOEs might enjoy more favorable treatments from the Chinese government than POEs before the law came into effect. Therefore, we restrict the control group to SOEs and POEs respectively, then estimate equation (1) respectively, and nally compare the corresponding treatment effects. The perception on the difference between SOEs and POEs leads us to the expectation that the magnitude of the treatment effect by restricting the control group to SOEs would be less than that by restricting the control group to POEs. The results are reported in Table 6. By Table 6, one could reach two conclusions. First, whether we use TotalAssetsi,t or TotalFixedAssetsi,t as the measure of Assetsi,t , the magnitude of the treatment ef-

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fect by restricting the control group to SOEs is less than that by restricting the control group to POEs because |0.044| < |0.209| and |0.070| < |0.250|. This result is as expected and intuitively makes sense because it is widely perceived that SOEs might enjoy more favorable treatments from the Chinese government than POEs. Second, whether the control group is restricted to SOEs or POEs, and whether we use TotalAssetsi,t or TotalFixedAssetsi,t as the measure of Assetsi,t , the treatment effects are all negative, which implies that FIEs are responding to the law by reducing their investment in China. 5.5 Part (5): Regression results with enterprise-specic time trends In this part, we conduct one more robustness check. Because Figs. 1 and 2 suggest that time trends are unlikely to bias our results, we do not include the enterprise-specic time trends in the assets as one control variable in our baseline specications. In this part, we incorporate the enterprise-specic time trends in the assets as one control variable into (1). In other words, we estimate the following difference-in-differences model: log Assetsi,t = i + t + log SalesRevenuei,t 1 + log Assetsi,t 1 + Zi,t + (treatment postlegislation)i,t + gi t + i,t . (3) By comparing (3) with (1), one could see that the only difference is that (3) allows for the enterprise-specic time trends, namely, gi t , where gi represents the enterprisespecic growth rate in log(Assets) for enterprise i , while (1) does not. The specication in (3) can be implemented using estimation in rst-order differences (e.g., see Wooldridge 2002 and Dharmapala and Khanna 2008). This involves estimating the following equation: log Assetsi,t = log SalesRevenuei,t 1 + log Assetsi,t 1 (4)

+ Zi,t + + gi + t + ui,t ,

(treatment postlegislation)i,t

where (log(TotalAssetsi,t )) = log(TotalAssetsi,t ) log(TotalAssetsi,t 1 ) and other changes are dened analogously; t is the year effect; and ui,t is the error term. Note that the enterprise effect i in (3) drops out of (4). However, the enterprise-specic time trend gi can be estimated by including an enterprise effect in the estimation of (4). The estimation results of (4) are reported in Table 7. By Table 7, one could see that whether one uses TotalAssetsi,t or TotalFixedAssetsi,t as the measure of Assetsi,t , controlling for enterprise-specic time trends does not change the conclusion that FIEs are responding to the law by reducing their investment in China because the estimated coefcients of ((treatment postlegislation)i,t ) are both negative (equal to 0.044 and 0.020 respectively) and statistically signicant at the 1% level. In summary, one could draw two conclusions from the results of our data analysis. First, in response to the law, FIEs are reducing their investment in China. Second, the law has a larger impact on HMT investment enterprises than on other FIEs, which

Taxation and foreign direct investment (FDI): empirical evidence Table 7 Regression results with enterprise-specic time trends Independent variable Column 1 (DV: (log(SalesRevenuei,t 1 )) (log(TotalAssetsi,t 1 )) (log(TotalFixedAssetsi,t 1 )) ((treatment postlegislation)i,t ) 0.044*** (t_stat: 9.00) * Statistically signicant at the 10% level ** Statistically signicant at the 5% level *** Statistically signicant at the 1% level The estimated coefcients of other control variables are omitted 0.003 (t_stat: 1.43) 0.053*** (t_stat: 20.61) 0.048*** (t_stat: 19.84) 0.020*** (t_stat: 2.71) (log(TotalAssetsi,t ))) Column 2 (DV: 0.002 (t_stat: 0.64)

673

(log(TotalFixedAssetsi,t )))

is consistent with the claim that some Chinese investors engaged in roundtripping FDI. In addition, the results of the placebo tests and two robustness checks are supportive and thus boost our condence in the conclusions. First, the results of the placebo tests support the claim that the estimated effect is due to the tax reform rather than to other confounding factors. Second, the results of the rst robustness check are consistent with the perception that SOEs might enjoy more favorable treatments from the Chinese government than POEs. Finally, the results of the second robustness check show that incorporating the enterprise-specic time trends into the baseline specications has little impact. Having said that, three caveats may apply to our study: (1) Our study focuses on the 45,681 enterprises that are present in the database for all the years from 2002 to 2008. In other words, we use a balanced panel over 20022008. Therefore, our study focuses on the impact of the law along the intensive margin. It might be interesting to investigate the impact of the law along the extensive margin. However, it might be infeasible to do so for two reasons. First, the database does not cover all the enterprises in China because the database embodies information of enterprises whose annual sales revenue is above 5 million RMB. Therefore, if an enterprise disappears from the database, we do not know whether because it exits or because its annual sales revenue is less than 5 million RMB. On the other hand, if an enterprise shows up in the database, we do not know its history (e.g., for how many years has the enterprise been in existence?), either. Second, we nd that a few enterprises whose annual sales revenue is less than 5 million RMB in some years are also included in the database, which implies that this might not be a hard constraint and thus further complicates the problem.

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(2) China joined the World Trade Organization (WTO) in 2001. It is claimed that foreign investment increased after 2001 to take advantage of the new stability in the trade policy environment, which implies that foreign investment may have been higher after 2001. However, four points might allay this concern. First, the baseline specications of our econometric models include enterprise and year xed effects, namely, i and t in both (1) and (2). Second, the visual evidence reported in both Part (1) and Part (2) might be against this concern because there is little difference between the trend of the assets of the treatment group and that of the control group from year 2002 to year 2007. Third, we conduct a series of placebo tests whose results support the claim that the estimated effect is due to the tax reform rather than to other confounding factors. Finally, as a robustness check, we show that incorporating the enterprise-specic time trends into the baseline specications does not change the conclusions. (3) By Table 2, one could classify the enterprises into two groups, namely, DEs and FIEs. The group of FIEs could be further classied into two subgroups, namely, HMT investment enterprises and other FIEs. We nd that the law has a larger impact on HMT investment enterprises than on other FIEs. Besides Hong Kong and Macau, the list of tax havens compiled by Dharmapala and Hines (2009) includes many other countries or regions such as Bahamas, Bermuda, British Virgin Islands, Cayman Islands, Cyprus, Marshall Islands, etc. However, by Table 2, it is infeasible for us to identify these other haven-owned enterprises. Our data analysis essentially includes these other haven-owned enterprises in the subgroup of other FIEs, which implies that we might be underestimating the difference between the impact of the law on haven-owned FIEs and that on non haven-owned FIEs.

6 Conclusion Since the early 1990s, China has maintained a dual corporate income tax regime, under which FIEs enjoy certain preferential tax treatments offered by the Chinese government. Chinas new Corporate Income Tax Law that was passed in March 2007 and took effect on January 1 2008 terminates the dual corporate income tax regime by removing the tax preferences offered to FIEs by the Chinese government and unies the corporate income tax regime for FIEs and DEs. This paper uses a difference-indifferences approach to determine whether FIEs are responding to the law by reducing their investment in China. We employ the Chinese Industrial Enterprises Database (20022008) to implement the analysis. The results of our analysis reach two conclusions. First, the law has driven FIEs to reduce their investment in China. Second, the impact of the law on HMT investment enterprises is bigger than that on other FIEs, which is consistent with the claim that some Chinese investors engaged in roundtripping FDI. The results of the placebo tests and two robustness checks that we conduct further boost our condence in the conclusions.
Acknowledgements The author thanks Alan J. Auerbach, Emmanuel Saez, Feila Zhang, and the anonymous referee for helpful comments. Especially, the author thanks Dhammika Dharmapala, the editor of this journal, for his constructive suggestions and great patience.

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