Evading by any Means? VAT Enforcement and Payroll Tax Evasion in China

Abstract

We study how the enforcement of value-added tax (VAT) affects Chinese firms’ evasion of payroll tax, which is collected by weakly empowered agencies. Using the central government’s 2005 repeal of the agricultural tax to measure fiscal squeeze and subsequent enforcement effort of VAT collection, our instrumental variable estimation finds that the VAT enforcement leads to a significant increase in the payroll tax evasion. Examining firm heterogeneity and real responses suggests that increased payroll tax evasion mainly stems from cost optimization by small and cash-constrained private firms. Our paper echoes a growing literature to highlight the importance of understanding compliance spillover across taxes.