The effect of geographic proximity on corporate tax avoidance: Evidence from China

Abstract

Exploiting the unique features of China's corporate income tax regime, which requires subsidiaries to submit their own taxes on a stand-alone basis, we examine the effect of intra-group geographic proximity on corporate tax avoidance. Based on a sample of 21,486 Chinese listed observations during the period from 2005 to 2019, we find a positive association between geographic proximity and tax avoidance. Mechanism tests show that geographically proximate firms engage in more related party transactions and that the positive association between geographic proximity and tax avoidance is significant only when the parent firm's statutory tax rate is the lowest of the group. We further find that parent firms' pre-tax earnings increase (decrease) with the propensity of income shifting into (out of) parent firms and that geographic proximity facilitates pre-tax earnings shifting both into and out of parent firms. Additional cross-sectional tests document that the positive effect of geographic proximity on tax avoidance becomes stronger when groups have stronger incentives or more capabilities to avoid taxes, and it becomes weaker when parent firms have other mechanisms to interact with subsidiaries than geographic proximity. Overall, we reveal whether and how intra-group geographic proximity affects corporate tax avoidance through income shifting.