Local Government Fiscal Stress and Earnings Management: Evidence from China

Abstract

This study examines whether and how fiscal stress in China’s local governments shapes firms’ earnings management. We employ a difference-in-differences approach that utilizes the 2005 abolition of agricultural taxes as an exogenous shock. In the wake of abolition, firms in fiscally stressed counties exhibit a higher propensity for downward earnings management than do their counterparts. In delving into the reasons for this propensity, we identify increased tax enforcement and an increased tax burden as potential contributors. The fiscal shock strengthens firms’ motivation to engage in downward earnings management so they can lessen their tax obligations and secure government subsidies. This effect is higher for privately owned firms and in regions with a high degree of government intervention; high financial constraints and low financial institutional support mitigate it. Overall, our findings highlight how fiscal stress on the local government influences firm-level earnings management and emphasize the critical role that fiscal stress plays in economic outcomes.

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