A Typology of Tax Compliance in Developing Economies: Empirical Evidence from China's Shoe Industry

• Author: Xin He,Huina Xiao
• Date: 01 April 2019
• Published date: 01 April 2019
• DOI: http://doi.org/10.1111/lapo.12126

A Typology of Tax Compliance in Developing

Economies: Empirical Evidence from China’s

Shoe Industry

XIN HE and HUINA XIAO

Drawing on fieldwork investigations of shoe manufacturers in southeastern China, this article

provides empiricalevidence for understanding these businesses’ taxpayingpractices. We find that

since business taxpayers largely regardtax law as illegitimate, instrumental considerations domi-

nate these taxpayers’ decisions topay or not pay taxes. We then incorporate “structuralopportu-

nities for evasion”and “perceived costs of evasion” to develop a two-by-two matrixto understand

the following typesof behavior: aggressive evasion, obliged compliance, strategic compliance, and

reciprocal compliance. We argue that this matrix explains why value added tax fraud is wide-

spread in China while voluntary compliance is rare. It also helps to illuminate compliance more

generally in developing economies.

It is no secret that tax evasion is rampant in China. According to a New York Times

report, “In China, businesses have to give out invoices called fapiao (发票) to ensure that

taxes are being paid. But the fapiao—the very mechanism intended to keep businesses

honest—is sometimes the key to cheating on taxes” (Ding 2015). In general, business

taxpayers adopt two strategies to evade value added tax (VAT). First, they provide false

input values. They either collect illegal input tax invoices to offset the tax charged or else

avoid keeping in put records. Second, taxpayers avoid issuing output tax invoices in

order to hide revenue. These two strategies lead to an enormous illegal fapiao market in

China. Advertisements for unused official invoices are sent by fax, through text mes-

sages, and from street fliers (Rarboza 2013). Sellers usually provide tax invoices for the

business taxpayers of various sectors. This style of tax evasion is replicated by millions

of companies across China.

China is no exception among developing countries, where tax evasion is often perva-

sive (see Martinez-Vazquez and McNab 2000; Alm and Marinez-Vazquez 2003, 2007).

For example, the VAT compliance rate is between 45–77 percent in Latin America, com-

pared with 70–85 percent in Organization for Economic Cooperation and Development

countries (Bergman 2010).

Xin He presented an earlier version of this article at Stanford Law School on November 3, 2017. He appreci-

ates the comments he received from that audience. Special thanks to the taxpayers and tax professionals who

kindly granted us interviews. The authors are also grateful for the comments by the editor and the anonymous

reviewers of Law & Policy.

Address correspondence to: Huina Xiao, Macau University of Science and Technology, Faculty of Law, Avenida

Wai Long, Macau. Email: hpxiaohuina@gmail.com; Telephone: 852-5442-7968.

LAW & POLICY, Vol. 41, No. 2, April 2019

©2019 The Authors

Law & Policy ©2019 The University of Denver/Colorado Seminary

doi: 10.1111/lapo.12126

ISSN 0265-8240

Existing studies on the issues of tax compliance in developing countries highlight the

importance of institutions (e.g., Torgler 2004a; Bird, Martinez-Vazquez, and Torgler

2008; Torgler and Schneider 2009). As Alm and Martinez-Vazquez (2007, 55) suggest,

“institutions matter everywhere, but they are especially decisive in developing and transi-

tion countries where their quality is generally lower than in developed countries.” Cui

(2011) and Li (2016) argue that institution-building is key for China to establish effective

taxation. Winn and Zhang (2013) document the Golden Tax Project in China, which

according to them has reduced VAT fraud. They also argue for more legitimacy or tax

morale. Bird, Martinez-Vazquez, and Torgler (2008, 68) contend, for example, that to

secure higher compliance or increase tax revenues, “a more legitimate and responsive

state is likely an essential precondition.” Consequently, to enhance tax compliance,

developing countries should reduce corruption while improving public participation,

governance quality, enforcement, and services (e.g., Torgler 2004a; Alm and Martinez-

Vazquez 2003, 2007).

Many studies cover the widespread noncompliance in developing countries (e.g.,

Fjeldstad and Semboja 2001; Alm and Martinez-Vazquez 2003, 2007; Berman 2010), but

few studies have focused on the behavior patterns of taxpayers within their institutional

environments.

1

How exactly do taxpayers view and react to tax laws and their enforce-

ment? What factors shape taxpaying behavior in developing countries where the law lacks

legitimacy? What motivations and opportunities contribute to taxpayers’ behavior pat-

terns? What are the dynamicsbetween taxpayers and the tax authorities?

Drawing on fieldwork investigations of shoe manufacturers in Southeast China, this

article provides empirical evidence for understanding taxpaying practices in China as well

as a general conceptual framework for regulatory compliance. Based on in-depth inter-

views with thirty-five shoe companies, we argue that both structural opportunities for

evasion and perceived costs of evasion, shape tax compliance. We have developed a two-

by-two matrix to understand the following behaviors: aggressive evasion, obliged compli-

ance, strategic compliance, and reciprocal compliance. We argue that this framework

explains why VAT fraudis widespread in China while voluntary compliance is rare.

I. STUDYING TAX COMPLIANCE IN SOUTHEASTERN CHINA

In China, VAT was formally adopted in 1994, and from 1994 to 2014, it contributed on

average 56.92 percent of annual tax revenue and 8.21 percent of gross domestic product

(GDP) (National Bureau Statistics of China 1995–2015). Every registered business pays

VAT based on the difference between the values of output (sales) and input (purchases)

(Ebrill et al. 2001).

The Invoice Credit, under which each seller passes the purchaser an invoice showing

the amount of tax charged, is critical to VAT administration (Ebrill et al. 2001). Tax

invoices are shown to tax authorities as the formal evidence of input and output taxes.

There are two types of invoices in China: the specialized VAT invoice (Zengzhishui

Zhuanyong Fapiao [增值税专用发票]) and the general VAT invoice (Zengzhishui Putong

Fapiao [增值税普通发票]). The specialized invoice can only be used by VAT taxpayers

who calculate VAT based on both input and output values. Once a taxpayer issues a tax

invoice, the tax authorities will receive the information and automatically incorporate it

into calculations. Small and individual businesses (Getihu [个体户]) can only issue gen-

eral VAT invoices, which cannot be used for deductions.

2

We conducted our fieldwork in County Q, one of the pioneers in the Chinese shoe

manufacturing industry. Since economic reforms were initiated in the late 1970s, the

©2019 The Authors

Law & Policy ©2019 The University of Denver/Colorado Seminary

He and Xiao EMPIRICAL EVIDENCE FROM CHINA’S SHOE INDUSTRY 243