Does Tax Deduction Relax Financial Constraints? Evidence from China’s Value-Added Tax Reform

Financial constraint is a major obstacle for firm growth, especially in developing countries where credit is scarce. This paper explores the role of tax policy in relaxing firms’ financial constraints by exploiting the exogenous shocks from China’s value-added tax (VAT) reform in 2009. We find that VAT reform significantly reduces effective VAT rate, which in turn improves both internal and external financing capacity for firms through the increase in liquidity, cashflow and commercial credit, and through the decrease in borrowing cost as well. The findings are robust to alternative specifications but show heterogeneity across ownerships, firm sizes, regions and between export and non-export firms. Our analysis suggests tax deduction is useful to relax firms’ financial constraints.