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Do more financing obstacles trigger tax avoidance behavior? Evidence from Indian SMEs

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Abstract

Using the data from Enterprise Survey, this paper documents the following findings in India. Firstly, we show that firms experiencing higher obstacles in accessing finance are more likely to avoid taxes. We argue that firms try to overcome the cash shortage that results from higher obstacles in accessing finance by reducing taxes paid to the government. Our results are robust across various sub-samples and after controlling for endogeneity problem. Secondly, we show that, for any two firms with similar levels of obstacles in accessing finance, the firm that avoids taxes is more likely to invest than the firm that does not avoid taxes. Lastly, firms headquartered in states/provinces with better institutional infrastructure have weaker relationship between access to finance and tax avoidance.

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Notes

  1. Our arguments are also consistent with pecking order theory of capital structure, as we explain later.

  2. For the purpose of this paper, we make no distinction between legal and illegal tax avoidance. Tax avoidance can be thought of as a continuum that ranges from objectively legal strategies to those of uncertain legality (Hanlon and Heitzman 2010).

  3. Extensive literature is available on lending institutions’ risk assessment procedures, financing and investment decisions-making, and credit techniques. Influential papers (such as, Berger and Udell 1992; Cressy 1996; Stiglitz and Weiss 1981) in this literature serve as a good starting point.

  4. The original thesis of the pecking order theory postulates that financing preference of a firm is partially driven by its position in its lifecycle (Myers 1984).

  5. External sources start with family and friends funding, then trade credit, venture capital and/or angel financiers (He and Baker 2007), then debt financing, and finally issuing equity (Wu et al. 2008).

  6. The pecking order theory is supported by a large body of empirical evidence (see above), but has been challenged by some researchers. Gregory et al. (2005) suggests that more mature firms typically amass larger amount of retained profits than start-ups and hence can successfully use these internal means more successfully. Earlier, Helwege and Liang (1996) fails to find significant relation between seeking external financing and the presence of shortage in internal sources.

  7. In these economies, due to reasons outlined above having to do with legal and economic infrastructure, tax avoidance is more prevalent than in developed economies (Fisman and Wei 2004).

  8. We choose to focus on a single market rather than multiple markets in order to isolate a myriad of factors at the national level that may contaminate our results. Furthermore, India is a typical developing country that has the added advantage of being large and market-oriented, which increases the generalizability of the study results.

  9. Since 2005, the survey has been conducted at the firm level in 125 countries that exhibit various institutional backgrounds and economic practices. Firms surveyed vary in their size, age, ownership characteristics, tax compliance activities, etc., making this dataset suitable for examining our hypothesized relations. The availability of sensitive tax compliance information in the survey encouraged its use in various research studies (see for example, Beck and Demirguc-Kunt 2006; Lee and Weng 2013).

  10. Datasets on SMEs are mostly derived from surveys, such as the World Bank Economic Survey and Investment Climate Assessments or by national agencies such as the U.S. Federal Reserve Boards and central banks. As such, the data are limited in validity and generalizability and focused on credit financing.

  11. The logit and probit models are both appropriate when attempting to model a dichotomous dependent variable and both methods yield similar inferences. The differences between models arise in their definition of functions. While the logit model uses the cumulative distribution function of logistic (non-normal) distributions, the probit model uses the cumulative distribution function of standard normal distributions. In most cases, there are no significant differences between the two models but the logit model yields less complex interpretation.

  12. Main idea behind using instrument is that it should be correlated with the endogenous variable (FINANCE) and at the same time it must be uncorrelated with the error term (and the dependent variable). The correlation of our instrument with the endogenous variable is very high. It is very unlikely that firms without audited financial statements will get access to finance. However, the correlation between our instrument and the tax avoidance behavior is insignificant. The F-test after the first stage regression also indicates that our instrument is valid.

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Authors and Affiliations

  1. Paseka School of Business, Minnesota State University, Moorhead, MN 56563, USA

    Mohamed A. Elbannan

  2. Faculty of Commerce, Cairo University, Giza 12613, Egypt

    Mohamed A. Elbannan

  3. School of Business, ADA University, Baku, Azerbaijan

    Omar Farooq

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  1. Mohamed A. Elbannan
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  2. Omar Farooq
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Correspondence to Mohamed A. Elbannan.

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Elbannan, M.A., Farooq, O. Do more financing obstacles trigger tax avoidance behavior? Evidence from Indian SMEs. J Econ Finan 44, 161–178 (2020). https://doi.org/10.1007/s12197-019-09481-9

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