Tax Avoidance by Capital Reduction : Evidence from Corporate Tax Reform in Japan

A new size-dependent tax system was introduced in Japan on April 1, 2004. We exploit this exogenous institutional change as a natural experiment and empirically examine how firms endogenously reacted to a size-dependent tax system in terms of both financial and real activities. Using a large-scale firm-level data over the period from 1996 to 2006, we test several hypotheses obtained from our theoretical model based on financial constraints faced by firms. From our empirical analyses, we obtain the following results that are consistent with the theoretical model. First, firms that originally held stated capital above the threshold set by the new tax system were more likely to reduce their stated capital to the threshold's level or below after the announcement of the new tax system. Second, firms with lower labor productivity, and smaller asset size were more likely to do so. Finally, firms that reduced their stated capital showed ex-post lower growths in asset size and sales, and the magnitude of which became larger over time. These results suggest that the size-dependent policy induced endogenous capital reduction of a group of firms, which resulted in their lower growth