Corporate income taxes and firms financing decisions the case of vietnamese tax incentives

ABSTRACT Based on the tax incentives policy enacted by Vietnamese Government in the year 2004, this paper applies Difference in Difference method and compares the debt- equity ratio of t

UNIVERSITY OF ECONOMICS ERASMUS UNIVERSITY ROTTERDAM

VIETNAM THE NETHERLANDS

VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

CORPORATE INCOME TAXES AND FIRMS’ FINANCING DECISIONS: THE CASE OF VIETNAMESE TAX INCENTIVES

BY

PHAM NGUYEN QUANG HOA

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

VIETNAM THE NETHERLANDS

VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

CORPORATE INCOME TAXES AND FIRMS’ FINANCING DECISIONS: THE CASE OF VIETNAMESE TAX INCENTIVES

A thesis is submitted in partial fulfilment of the requirement for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

BY

PHAM NGUYEN QUANG HOA

ACADEMIC SUPERVISOR

Prof Dr NGUYEN TRONG HOAI

HO CHI MINH CITY, December 2017

CERTIFICATION

This is to certify that this thesis entitled “Taxes and Corporate Financial Decisions: The Case of Vietnamese Tax Incentives”, which is submitted by me in fulfillment of the requirements for the degree of Master of Art in Development Economics to Viet Nam – The Netherlands Programme (VNP) To the best of my knowledge, my thesis does not infringe on anyone’s copyright nor violate any proprietary rights and that any ideas, techniques, quotation, or any other material from the work of other researchers in my thesis, published or otherwise, are fully acknowledge in accordance with the standard referencing practices

PHAM NGUYEN QUANG HOA

of this thesis

I also would like to thank my co-supervisor Dr Truong Dang Thuy for his enthusiastic support, availability and constructive suggestion, which help me overcome the challenge and high-pressured situation during the time of research

I would like to express my gratitude to all lecturers of the Vietnam- Netherlands Program who have provided an interesting lesson to build my economic knowledge during this program Besides, completing this work would have been difficult if it is not supported by my best friends I am indebted to them for their help Moreover, I wish to thank all my friends who are in VNP 21 who share unforgettable memories in this program

Finally, there are also words of deep gratitude for my family who support and encourage me when I implement my postgraduate studies

Pham Nguyen Quang Hoa

December, 2017

ABSTRACT

Based on the tax incentives policy enacted by Vietnamese Government in the year 2004, this paper applies Difference in Difference method and compares the debt- equity ratio of treatment and un-treatment (control) companies before and after this policy to determine the impact of corporate taxes’ change on firm’s capital structure The treatment group is state enterprises and otherwise is control group The data is collected in the period from 2001 to 2007, therein data related

to the period 2001- 2003 is pre-treatment data and those in the period 2004-2007

is post- treatment date Similar to prior capital’s literature, the empirical results expose that that taxation actually has impact on leverage The measured impact is approximately -4.1 percentage point, meaning that with the introduction of incentive tax policy, the debt ratio of companies reduces more than 4 percentage point The evidences also indicate that the large companies absorb the effect of tax change more than Small and Medium Enterprises and also are high significant level

LIST OF TABLES

Table 1: Variables’ definitions and measurement 23

Table 2: Descriptive Statistics and Means Differences for the period 2001-2007 28

Table 3: Descriptive Statistics and Means Differences for the year 2003 29

Table 4: Impact of Taxation on Company’s Capital Structure 34

Table 5: Small and Medium Enterprises versus Large Companies 36

LIST OF FIGURES

Figure 1: The mechanism of the relationship between taxes change and financial

structure 18

Figure 12: The difference between two groups after exogenous event 22

Figure 3: Common trend over time Figure 3- Panel A: Leverage 30

Figure 3- Panel B: Assets 30

Figure 3- Panel C: Labor 46

Figure 3- Panel D: Liquidity Ratio 46

Figure 3- Panel E: Investment 47

Figure 3- Panel F: Tangibility 47

Figure 3- Panel G: Profitability 48

Figure 3- Panel H: ROE 48

Figure 3- Panel I: Profit Margin 49

Figure 3- Panel K: Inventories Turnover 49

Figure 4- Bivariate Analysis Figure 4- Panel A: Leverage- Assets 50

Figure 4- Panel B: Leverage- Labor 51

Figure 4- Panel C: Leverage- Liquidity Ratio 52

Figure 4- Panel D: Leverage- Investment 53

Figure 4- Panel E: Leverage- Tangibility 54

Figure 4- Panel F: Leverage- Profitability 55

Figure 4- Panel G: Leverage- ROE 56

Figure 4- Panel H: Leverage- Profit Margin 57

Figure 4- Panel I: Leverage- Inventories Turnover 58

Formatted: Font: Not Bold, Font color: Auto

LIST OF APPENDICES

ANNPENDIX A1: FIXED EFFECT TEST 59 ANNPENDIX A2: RANDOM EFFECT TEST 60 ANNPENDIX A3: HAUSMAN TEST 61

CONTENS

CHAPTER 1 INTRODUCTION 10

1.1 Problem statement 10

1.2 Research objectives 12

1.3 Organization of the study 12

CHAPTER 2 LITERATURE REVIEW 14

2.1 Tax changes 14

2.1.1 Tax changes are observed over a long period 14

2.1.2 Tax change is considered as an exogenous event 15

2.2 Measurements of capital structure and several elements have impact on capital structure 17

2.2.1 Measurements of cC apital structure 17

2.2.2 The impact of several elements on capital structure 18

2.3 Two main methodologies and empirical results regarding the effect of tax changes on capital structure’s decision in prior researches 21

2.3.1 Two main methodologies in prior researches 21

2.3.2 Empirical results in prior researches’ summary 22

2.4 Chapter remark 24

CHAPTER 3: DATA AND METHODOLOGY 27

3.1 Data source 27

3.2 Empirical model 28

CHAPTER 4: RESULTS AND DISCUSSION 34

4.1 Descriptive statistics 34

4.2 Bivariate analysis 36

4.3 Regression results 42

4.3.1 Impact of Corporate Tax Incentives on firms’ capital structure 42

4.3.2 Impact on Small and Medium Enterprises versus Large Companies 45

4.3.3 Discussion of research results 47

CHAPTER 5: CONCLUSION AND POLICY IMPLICATIONS 50

5.1 Conclusion 50

5.2 Policy implications 51

5.3 Limitation of the study 52

REFERENCES 54

ANNPENDIX 72

CHAPTER 1 INTRODUCTION 1.1 Problem statement

If a business has used debt in its capital structure and the amount of the debt within the permitted level that the lenders cannot demand a higher interest rate, it will take advantage from the debt tax shield Since the cost of lending (proxied

by interest) is deducted before calculating taxable profits, reduce profits, thereby, reduces the corporation tax of income that businesses must pay Some studies found the empirical evidences to support that taxes do effect on capital structure However, it exists not less debates around this theory From the very first days of capital theories, Modigliani and Miller (1958), Miller (1977) and DeAngelo and Masulis (1980) desired to measure the impact of debt tax shield on corporate financial decisions They found the evidences suggesting that the more companies use debt to finance business, the more their own capital structures change related to tax benefit To the recent papers (Panier, Perez-Gonzales, and Villanueva, 2012; Princen, 2012; Faccio, Xu, 2015; …), these authors supply empirical results that tax benefit from debt tax shield effects firms’ leverage Princen (2012) used Difference in Difference model for the period 2001- 2007 to present that an equal tax treatment between debt and equity encouraging companies to use 2-7 percent less debt than a traditional tax system Panier, Perez-Gonzales and Villanueva (2012) approached in another aspect that is the equity ratio (the ratio between equity value and total assets) and showed the equity ratio of Belgium firms substantially rising from 32.6 percent in 2004 and

2005 to 34.2 percent in two following years In this case, 2004 is the year the tax reform had been valid

Vietnamese corporate tax rules can be considered as a traditional tax system (Graham, 2003) Companies are taxed on their profits (the business income less the costs to generate that income) Those business that related costs included in the interest paid as return to the creditors Since these interest expenses reduces taxation income (tax deductibility) However, the returns to shareholders or

dividends are included in the taxable base and are taxed On November 16th

2004, Vietnamese government enacted the Decree No.187/2004/NĐ-CP

regarding to “Transferring state enterprises to joint stock companies” There was

a preferential tax policy (corporate tax) applied for state enterprises performing equitization Particularly, according to Term 1, Article 36 of this Decree, after- equitization enterprises are entitled to the incentives exactly like new business establishment according to the current Vietnamese law which is the Decree No.164/2003/NĐ-CP valid on December 22nd 2003 regarding “Detailed

regulations on the implementation of corporate income tax law” Whereby, the

income corporate tax ratio for business establishments was 28 percent (Term 1, Article 9) and preferential tax ratio applied for new business establishments was 10-20 percent depending on geographical areas and industry fields (Term 33) Hence, the income corporate tax ratio for state enterprises performing equitization was reduce 08-18 percent after the introduction of Decree No.187/2004/NĐ-CP Several forms of equitization that companies might conduct including: firstly, maintaining the current state capital and issuing more firms’ shares; secondly, selling a part of state capital and associated with issuing more firms’ shares; thirdly, selling all state capital and associated with issuing more firms’ shares On February 14th 2007, the Decree No 24/2007/NĐ-CP

(from the Term 2, Article 46) regarding “Detailed regulations on the

implementation of corporate income tax law” had rejected the tax incentives for

state enterprises transferring joint stock companies as ruled in the Term 1, Article

36 of Decree No 187/2004/NĐ-CP Therefore, the joint stock companies that had been established from equitization state enterprises before the expired date of the Decree No 24/2007/NĐ-CP expired, continued to take advantage from tax incentives for the remained time By the other word, the state enterprises transferring joint stock companies established after February 14th 2007 could not have benefit from tax intensives

This study develops a model to investigate the impact of this tax reform on Vietnamese firms’ leverage The empirical results from this model display that further to preferential tax rates, companies reduce their own leverage Difference

in Difference identification strategy is used to compare the leverages of two groups, therein state enterprises are determined the treated group and the remaining companies play the control group The period of time from 2001 to

2007 is divided into two stages, the sample related to the period 2001 to 2003 belongs to the pre-treatment data and those in the period 2004- 2007 is the post-treatment data

Deriving from the controversy surrounding the effect of tax changes on firms’ capital structures and an ideal historical event in Vietnam as mentioned above, this study desires to answer these questions following: First, does it exist the relationship between preferential tax policy and corporate financing decisions and if it does exist, is it a positive or negative relationship? Second, does the Large Companies or Small and Medium Enterprises (SMEs) adjust their own leverage ratios more to the tax changes?

1.2 Research objectives

There are two crucial research objectives of this study

Firstly, investigating the effects of preferential tax policytax changes on companies’ capital structures

Secondly, determining which type of companies respond their own financial decisions to tax changes more, among Large Companies and SMEs

1.3 Organization of the study

The remainder of this study is organized as follows In chapter 2, I review several previous researches including the main approaches to define the tax changes; several measurements of capital structure and listing some different elements that have impact on capital structure’s decision; briefly describing two popular methodologies applied in regressions and accentuating the empirical results

regarding the effect of tax changes on capital structure’s decision Chapter 3 is research methodology and data This chapter discusses the identification strategy and establishes empirical specification Chapter 4 reports the main regression results and Chapter 5 concludes the discussions

CHAPTER 2 LITERATURE REVIEW

This chapter includes four sections which will follow the introduction from this chapter mentioned above Firstly, I summarize two main approaches that previous researchers applied to define the tax changes Secondly, I desire to list several different the measurements of leverage ratios or debt ratios (proxied for the capital structure) Not only the tax changes but also abundant elements were found in previous literatures that have impact on capital structure’s decision and they are also listed in this part Thirdly, I list two popular methodologies applied

in regressions including Ordinary Least Square (OLS) and Difference in Difference (DID) I also accentuate the empirical results regarding the effect of tax changes on capital structure’s decision that I observe in prior researches The final part of this section is chapter remark

2.1 Tax changes

Tax changes or tax reforms play the independent variable in the causality between them and capital structure To measure the impact of tax changes on firms’ capital structures, there are properly two main approaches being applied in various previous studies Firstly, tax changes over a long period of time in a particular country or area are observed to examine whether if there is any correlation with firms’ capital structures Secondly, tax changes or tax reforms are considered an exogenous event and the companies’ financial decisions are researched before and after a tax reform in a particular country

2.1.1 Tax changes are observed over a long period

A considerable contribution about this approach can be mentioned is belonged to Faccio and Xu (2015) They noticed that there are 84 changes in corporate tax rates and 298 changes in personal tax rates among OECD countries from 1981 to

2009 There are three benefits from using of a multitude of shifts in statutory tax rates, both at the corporate and at the personal level, particurlarly,confirming the impact of tax changes on financial decision of firms throughout the time- series

proofs , thus, reducing the risk of a spurious result; solving the problems arising from personal taxes apart appraise the influence of diverse kinds of taxes on firms’ leverage; and taking advantages from the number of tax changes within long period of time causes increasing the quality of data and the reliance of empirical results

In the year 2015, in attempt to illustrate that taxes are an important determinant

of capital structure choice of firms, Heider and Alexander based on 121 changes

in state’s corporate income tax rates across US states, including tax increases and tax cuts over the period 1989- 2011 to point out several empirical analyses have been implemented to contribute these arguments Exactly 16 years ago from the foregoing authors, Roger and Lee (1999) who were the pioneers in that kind of research inferred the degree to which firms of different sizes do change their financial structures in response to tax incentives, based on the abundant changes

in tax structures and small corporations face much lower marginal tax rates than larger firms in a long period of time from 1954 to 1995 Tax changes mostly take their actual values in the empirical models of these studies

2.1.2 Tax change is considered as an exogenous event

There was a tax reform that was adopted in the year 2006 by Belgian Government called Notional Interest Deduction (NID) Belgium firms and foreign firms permanently established in Belgium are allowed to deduct a notional return of their book value of equity This reduction is the 10-year Belgian government bond rate in average of the year (t- 2), It is limited with maximum value at 0.5 percent and cannot vary more than 1 percentage point annually This tax regime leads to a reduction in tax discrimination between debt and equity This tax reform in Belgium in 2006 seems to be an ideal exogenous event for abundant authors developing their researches Not only Panier, Perez-Gonzales and Villanueva (2012) but also Katrien, Cauwenberge and Christiaens (2012) applied this event However, each research has different samples from each other For example, the samples of Panier et al are Belgian companies while

Katrien et al focused on small and medium entrepreneurs In addition, one another author- Princen (2012) also accessed directly this event under a tittle- Allowance for Corporate Equity (ACE) which is similar to Notional interest deduction (NID)- an equity tax relief This tax system attributes a similar tax deductibility to the return on equity as the generally implemented deductibility for interest expenses of debt As such, tax neutrality between two main sources of finance is ensured and corporate taxation no longer favors debt over equity

In 2013, Lin and Flannery based on the 2003 tax cut named The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) in US for checking how taxes can influence on firms’ leverage Regarding this tax reform, there are the declines in dividend tax rates (from 38.6 percent in maximum to 15 percent) and capital gains tax rates in long- term (from 20 percent in maximum to 15 percent) applied

to the personal investors This event can be considered as an exogenous event and generates a perfect condition to examine the effect of individual taxation on capital structure’s choices

Returning back to a further past, in 1997- 1998, a tax reform had been implemented in Italy (Staderini, 2001), termed Dual Income Tax (DIT) and taxed interest payment through the New Regional Tax on Value Added (IRAP) Particularly, DIT system taxation which was introduced in 1997 reduced the tax rate of 19 percent to the taxable income representing the opportunity cost of equity (shareholder’s fund) The normal rate of 37 percent is applied to income exceeding cost In 1998, the new tax on business activity was introduced (named IRAP) replacing the prior tax system (ILOR) It based on the value added and had a rate of 4.25 percent, the taxation of profit was reduced from 53.2 percent to 41.25 percent (37+4.25) The new regime reduced being in favor of debt in firms’ behavior

More than two decades ago, there was an extremely legendary tax reform in US

1986 that inspired to the scientific communication to implement the workouts regarding to the relationship between taxes and financial structures’ companies

This is The Tax Reform Act 1986 (TRA) in US that changed the tax regime which lowered the corporate tax rate (reducing the value of tax shields to firms) and cut personal tax rates (Givoly, Hayn, Ofer, and Sarig, 1992) According to Gordon and Jeffrey (1991), this action seemed to be the most extensive change in the US tax law since the World War II To the beginning, the maximum tax rate was cut from 46 percentage in 1986 to 40 percentage in 1987 and 34 percentage

in 1988 and thereafter This rate was now applied to income over $75.000, instead of $100.000 Tax changes in the empirical models of these studies are commonly proxied by a dummy variable which takes value one for the period after tax change and zero for otherwise

2.2 Measurements of capital structure and several elements have impact

on capital structure

2.2.1 easurements of cC apital structure

Capital structure is proxied by firm’s leverage ratios or debt ratios Leverage ratios are the influent factors in the causality between taxes changes and capital structures There are abundant measurements of leverage ratios according to every scientist’ss points of views

In the initial period when the question whether taxes affect corporate financing decisions had been raised, firm’s debt ratio is calculated as sum of annual book value of long term debt divided by sum of long-term debt and the market value of equity (Bradley, Jarrell and Kim, 1984) This formula had been applied in a variety of afterward analysis, typically, Givoly, Hayn, Ofer, and Sarig (1992) with a research regarding to The Tax Reform Act 1986 (TRA)

Several arguments appeared from which value is suitable for calculation and whether lead to exact results, book value or market value It seems to be a difficult issue caused the different angles in scientific communication and the samples’ characteristics that they collected However, book value with some advantages including the ability to effortlessly exploit from financial statements

is usually favored Roger and Lee (1999); Staderini (2001); Katrien,

Cauwenberge and Christiaens (2011); Princen (2012) and Lin and Flannery

(2013) also measured leverage equals the average book debt over average book

assets The combination between book value and market value had been defined

to improve the robustness as can be seen in the analysis of Frank and Goyal

(2009) with a variety of ratios like total debt over market value of assets, total

debt over book value of assets, long-term debt over market value of assets and

long-term debt over book value of assets; or the contribution of Heider and

Ljungqvist (2015) consisting of long- term book leverage, total book leverage

and long-term market leverage with similar formulas A remarkable feature that

could be noticed is a different calculation for leverages as the value of equity

divided total assets instead of contrary as usual It can be seen in studies of

Panier, Perez-Gonzales and Villanueva (2012) and Schepens (2016)

2.2.2 The impact of several elements on capital structure

Besides the purpose related to determine the main relationship between tax

changes es and firms’ leverage, several independent variables have been added in

the regressions according to capital structure literatures

Firm size  please give a subtitle for each element that you would like to

consider

Firm size

The most popular factors that are easily observed are is firm size (usually

measured by logarithm of total assets) Firm size in this regression has a positive

relationship with leverage, which would reflect the stable cash flows of bigger

firms and they seem to use more debt to maximize the benefit from tax shields

(Marsh, 1982) Studies of Schepens (2016), Lin and Flannery (2013), Princen

(2011) also show the similar effect Gorden and Lee in a research in 1999

inferred the degree to which firms of different sizes do change their financial

structures in response to tax incentives The empirical results denote that taxes

Formatted: Font: Bold Formatted: Font: Bold Formatted: Font: Bold, Italic

have strong effect on debt levels In particular, taxes have large effect on leverage

of smallest and largest firms and much less effect on intermediate firms

Firm size?Labor

Labor (number of employees) is also a factor seem to have negative impact on

capital structure Serfling (2013) found that firms lower their debt financing when

they confront higher labor costs One of the reasons might be higher employee

costs also lead to higher financial distress cost Therefore, firms tend to induce

their leverage ratios

Liquidity ratio

Liquidity ratio that usually calculated by total assets value excluding inventories

dividing total debt has negative effect on leverage That means the more liquid

assets firms have, the less they use debt to finance their operation Titman, S and

Wessels (1988) supposed firm with low liquidity might have high bankruptcy

cost when they fall into the financial distress that can happen with too high

leverage ratio Hence, liquidity is expected to have a negative impact on debt

ratio

Investment

Another pretty significant factor can be counted here is the investment value that

calculated by the differential fixed assets value between this year and the

previous year It can be a negative relationship between investment value and

firms’ leverage because with the high value of investment, firms’ managers tend

to deduct protective activities regarding the leverage ratio They fear of facing

financial distress associated with invested opportunities Hence, lowering debt in

capital structure might be their choices It has been applied in Princen (2012);

Klemm and Parys (2011); Frank and Goyal (2009); Chirinko and Wilson (2008)

Tangibility

Tangibility equals to tangible assets (net property, plant, and equipment) divided

by total assets that usually has the negative impacts on leverage One of a reason

Formatted: Font: Bold Formatted: Font: Italic Formatted: Font: Bold

Formatted: Font: Bold, Italic

Formatted: Font: Bold, Italic

Formatted: Font: Bold, Italic, Font color: Auto

to explain is the deductible expenses after tax from depreciation may have

stronger influence than debt financing (Princen, 2012)

Profitability

Profitability (Ratio of earnings before interests, taxes, depreciation and

amortization (EBITDA) to book value of total assets) appears in a mass of studies

of Schepens (2016), Lin and Flannery (2013), Princen (2011), Katrien,

Cauwenberge and Christiaens (2011), Frank and Goyal (2009), etc According to

Rajan and Zingales (1995), causes companies tend to have a favor of using

retaining earning for profitability target, leverage may have the negative

correlation with profitability

ROE

ROE (Return on Equity) is calculated by net income (earning before tax) returned

as a percentage of shareholders’ equity usually has the positive effect on

leverage, it refers that the more the return on equity firms possess, the more they

tend to increase their leverage The similar effect can be seen in studies of Lin,

and Flannery (2013), Princen (2011), etc

Profit margin

Profit margin is the ratio of net income (earning before tax) to total sales It

frequently has negative impact on firms’ leverage ratio which might be explained

by profitable firms tend to finance their operating activities by retained earning

rather than debt (Yogendraraja and Thanabalasingam, 2011) This regression can

be defined in studies of Princen (2012), Schepens (2016), etc

Inventories turnover

Inventories turnover (measured by inventories value divided total sales) and

capital structure tend to interact with each other, since material and cash flow

managements are two basic factors of businesses According to Hu, Li and Sobel

(2011), capital creates material and cash reverse comes from turnover (sales of

commodities) Hence, this circulation generates the interaction between

operational decisions (including inventories management) and financial decision

Formatted: Font: Bold, Italic

Formatted: Font: Bold, Italic

Formatted: Font: Bold, Italic

Inventories turnover is decided to add in this study’s regression to control the

impact of operational activities on firms’ leverage

Net operating loss

Net operating loss (NOL) indicates the “negative profit” for tax purposes as can

be called tax losses carryforward which can reduces companies’ tax expense for

the next financial year This element appears in the research of Princen (2012)

and has the negative impact on firms’ leverage In this study’s regression, NOL is

a dummy variable, takes the value one if the company is loss- making and zero in

other case

Macro- economic indicators

In addition, some macro- economic indicators have been frequently added in the

regressions to control macro- economic conditions including inflation proxied by

the annual percentage of inflation in consumer prices as measured by the World

Bank and GDP Growth is the annual percentage of GDP per capita growth as

measured by this same institution (Princen, 2012) In a contribution of Gajurel

(2006), this author indicated that there is a negative relationship between GDP

growth and short- term debt ratio but a positive relation with long- term debt

ratio Furthermore, Gajurel also show the consistent empirical results regarding

the relationship between inflation and short- term, long- term debt ratio

2.3 Two main methodologies and empirical results regarding the effect of

tax changes on capital structure’s decision in prior researches

2.3.1 Two main methodologies in prior researches

A common methodology to examine the impact of tax changes on capital

structure is Ordinary Least Square (OLS) Suppose that there is causality between

the cause and the effect (a change in X leads to a change in Y), they are taxes

changes and firms’ leverage in this case It can be seen in the researches related

to taxes change over a long period of time (Faccio and Xu, 2015; Phan, 2011)

Formatted: Font: Bold, Italic

Formatted: Font: Bold, Italic Formatted: Font: Bold, Italic, Font color: Auto

Another methodology that can be seen in variety of analyses regarding researching the companies’ financial decisions before and after tax reform in a particular country is Difference in Difference (DID) In this case, tax reform (or tax change) plays the exogenous event that may be represented by a dummy variable, takes value one for the period of time after tax reform and zero value for the period of time before tax reform Commonly, tax reform only affects a certain group of enterprises that can be seen as treatment group Companies that are not affected play as un-treatment or control group, so there is an underlying difference between these groups The impact of tax policy may be evaluated from the different leverage ratios of two groups before and after tax reform This methodology is applied in series of prior researches such as Panier, Perez-Gonzales and Villanueva (2013); Princen (2012) and Kestens, Cauwenberge and Christiaens (2012)

2.3.2 Empirical results in prior researches’ summary

Most of previous researches seem to have several similar results that tax

changeses do have effects on firms’ financial leverage However, the specific impacts are not consistent, some studies represent the positive relationship besides that others show the negative correlation between tax changes and firms’ leverage

Studies represent positive relationships:

A study of Heider and Ljungqvist in 2015 also proved taxes are an important determinant of capital structure choice of firms Over the period 1989- 2011, there are 121 changes in state’s corporate income tax rates across US states, including tax increases and tax cuts, the authors applied DID approach to examine the effect of changes in state’s corporate income tax rates on firms’ leverage Data in this research consists of all US companies from 1989- 2011 The group of firms experiencing a tax change in their home state is treated firms and others not subject to a tax change in their home state are control group, for

comparison Specifically, they found that firms increase long-term leverage in response to the increase in tax rates, and beside that, they remain their leverages when tax rates fall

In a contribution in 2013, Lin and Flannery compared companies’ leverages in

2002 and 2004 after a US tax decline in 2003 to examine the impact of personal taxes on firms’ debt ratio With the application of DID method, they found that a company that the last owner was a person decreased its book leverage value approximately 5 percentage points compared to the average value of the whole sample (19.9 percent) in 2002 in respond to the tax change This empirical result stated obviously that the individual taxation reduces firm leverage

There is a series of analysis paying attention on tax reform event in 2006 in Belgium and they virtually have similar results that Belgium companies’ leverage significantly responds to changing tax incentives, particularly, corporations are

no longer favors using debt over equity in their capital structures so they decrease their financial leverage (Panier, Perez-Gonzales and Villanueva, 2013; Princen,

2012 and Kestens, Cauwenberge and Christiaens, 2012)

Likewise, Staderini (2001) verified the role of tax changes on corporation financial structure, in this case the tax changes are tax reform in 1997-98 (reducing the tax rates) Data is collected in the period of time 1992- 1998 and divided into 2 groups: Firms posse the requirements required by law to use the DIT tax system (group 1) and another one The empirical results show that firms reduced their leverages as the response to tax changes

Driving from the Tax Reform Act of 1986 in US, Givoly, Hayn, Ofer, and Sarig (1992) and Gordon and Mackie-Mason (1991) found that the association between leverage and corporate tax rates is positive and provide various incentives to increase debt finance Furthermore, there is a substitution effect debt and non- debt tax shields and personal tax rates affect firm’s leverage

Studies represent negative relationships

Schepens (2016) investigated the impact of tax on the capital structure decisions

of financial institutions by applied DID approach Based on a tax reform was introduced in Belgium in 2006, this author collects the data of Belgium banks (treatment group) and European banks (control group) between 2003- 2007 The period 2006- 2007 is post treatment His first crucial finding is that tax shields have a significant impact on bank capital structure decisions, particularly, increasing the equity ratio The second result is the impact of the change in tax treatment is driven by an increase in bank equity and not by a reduction of activities

Studies represent both positive and negative relationships

Faccio and Xu in a research the year 2015 based on the changes in corporate tax rates and personal tax rates among OECD countries from 1981 to 2009 (184 and

298 changes, respectively) to test the effect of tax changes on firms’ financial decision This study indicated that capital structure choices are affected by both corporate and individual taxes: there is a positive relationship between corporate taxes and there is a negative relationship between personal dividend taxes and firms’ leverage in contrary

Phan (2011) investigated the impact of income tax regime on capital structures of Vietnamese listed firms in the period from the year 2005 to June 2010 By applied the OLS method and the samples including 219 listed firms in Ho Chi Minh Stock Exchange (HOSE), the empirical results indicated that personal income taxes have significantly negative influence on Vietnamese debt ratios and there is a positive relationship between corporate income taxes and both long and short- term debt ratios in the year 2008

2.4 Chapter remark

In this study’s background, Vietnamese tax reform in the year 2004 is a suitable

to research the difference between firms’ financial decisions before and after this event by using DID methodology This tax reform is a preferential tax policy or

tax incentives Particularly, the income corporation tax rates for businesses had

been 28 percent before tax reform, and after that they decreased to 10 – 18

percent applied for state enterprises performing equitization The state enterprises

might play the role as the treatment group and the remaining companies which

are not affected by this tax policy is the control group The year 2004 is the time

this tax reform was valid, so the period of time before 2004 is the time

pre-treatment and after 2004 is the time post-pre-treatment Figure 1 below briefly

describes the mechanism of the relationship between tax changes and financial

structure. Please draw a map for your conceptual framework which tell us your

key relationship together with your controlled elements already discuss in this

chapter

Formatted: Font color: Text 1

Formatted: Font color: Text 1 Formatted: Font color: Text 1

Figure 1 : The mechanism of the relationship between taxes change and

financial structure

CAPITAL STRUCTURE

+Debt ratio/leverage + Equity ratio

Firm's characteristics

(number of employees) Balance sheet

Firm size, Liquidity ratio, Investment and Tangibility

Income statement

Profitability, ROE, Profit margin, Inventories turnover Net Operating Loss

Macroeconomic factors

Iinflation and GPD growth

Tax changes

+ Exogenous

evenr (DID)

+ Changing over

long time (OLS)

Formatted: Font color: Text 1 Formatted: Font color: Text 1 Formatted: Font color: Text 1

Formatted: Line spacing: 1,5 lines

CHAPTER 3: DATA AND METHODOLOGY

Introduce this chapter by a short paragraph like the previous chapter In this

chapter, I present the data source applied in this research regarding describing the

data collection in details and how to classifyselect data accordingly

Furthermore, Differences in Differences (DID) method is clearly described to

investigate the impact of tax changes on capital structure in Vietnam Several

estimations are also used including Fixed Effect, Random Effect and Hausman

test

3.1 Data source

Annual financial data used in this study are collected from the survey of

Vietnamese Small and Medium Enterprises (SMEs) in 2013 which is

implemented by Center Institute Economic Management (CIEM) The quality of

Vietnamese firms’ data is likely high due to this data set was recommended by

the prestigious professors and pre-graduate students of VNP- a project combined

between the International Institute of Social Studies belongs to Erasmus

Rotterdam University and The University of Economics in Ho Chi Minh city

(UEH) from 1994

The database contains data for approximate 135,000 companies from the year

2001 to 2007 which gathers all types of enterprises and their annual financial

information Tax new regime was enacted by Vietnamese government on

November 16th 2004 and invalid on February 14th 2007, therefore, the data

related to the 4 years period from 2004 to 2007 are the post- treatment data As

constructing a relatively balanced panel data, sample is also selected from the

period 2001- 2003 which are the pre-treatment data Cause the objects effected

by the tax reform were state companies who were implementing equitization

procedure, those be state companies in the end of the year 2003 are considered

the treatment group and the rest of sample is classified the control companies or

Formatted: Font: 13 pt Formatted: Normal, Justified, Space Before: 0 pt, Line

spacing: 1,5 lines

Formatted: Font: 13 pt

Formatted: Font: 13 pt, Not Bold

un-treatment group According to the previous arguments, the enterprises which operate in the real estate industry, financial institutions such as banks, insurance companies should be omitted from the sample due to their different financial characteristics from those active in the industrial segment Eliminating observations possessing the ratio of book value of fixed assets or book value of total debts over total assets is more than 100 percent or less than 0 percent is applied to control the results not driven by the outliers Observations with missing data overtime are also removed After satisfying these selection requirements, the sample includes 230 unique firms for treatment group and 680 firms for control group and there are seven observations each company The causal relationship between capital structures and tax regime which is measured

in this empirical analysis also demands several control variables regarding to firms’ financial indices Working with diversifying financial statements of various types of companies, book values should be adopted to construct variables (both control and dependent ones) Along the way, macroeconomic factors are utilized in the regression to ensure the impact of these exogenous shocks not distort the empirical results The most common elements that may be remarked in capital structure literature (Princen, 2012) are Inflation and GDP growth Inflation is the annual percentage of inflation in consumer prices and GDP growth is the annual percentage of GDP per capita growth They are all assembled from the institution World Bank (WB)

3.2 Empirical model

As mentioned above in the part 3 of Literature Review section, one One of the popular approaches to measure the impact of tax reform on capital structure that I mentioned in the part 3 of Literature Review section is Difference in Difference (DID) Similar to the researches of Princen (2012) or Panier, Perez-Gonzales and Villanueva (2013) …, I define that tax change in the year 2004 in Vietnam is an exogenous event, the firm’s leverage ratio could be seen as a function of tax- related factor Simultaneously, dividing sample into two groups: treatment group

(the state enterprises which be affected by tax reform) and control group comprising from the rest of sample which are not state companies can compare the years before and after the adoption of the tax reform for both groups by applied DID Therefore, in this study I estimate the effect of tax reform by using DID methodology with the equation (1) below:

𝑌𝑖𝑡= 𝛼 + 𝛾𝑆𝐸𝑖+ 𝜆𝑇𝑡+ 𝛿𝑋𝑖𝑡+ 𝜌𝑇𝐴𝑋𝑖𝑡+ 𝑠𝑖𝑡(1)

Where:

+ 𝑌𝑖𝑡 (Financial leverage): the ratio of financial debt (long- term debt and loans)

to total assets (Rajan and Zingales (1995)) of company i in year t

+ 𝑆𝐸𝑖 (State Enterprise) be a fixed effect dummy (equal to one if a state enterprise (the treatment group), equal to zero if a non-state enterprise (the un-treatment group),

+ 𝑇𝑡 (or Time) be a fixed year effect dummy (equal to one if after the tax reform (2004-2007), equal to zero if before the tax reform (2001-2003)

+ 𝑇𝐴𝑋𝑖𝑡 (proxied for SEi * Tt) is a dummy variable, takes one if the observation

is a state company and if it is done after the tax reform, zero otherwise

+ γ are time-invariant firm effects, λ are firm-invariant time effects The coefficient ρ captures the variation in the outcome of interest of the treated group (relative to the control group) in the years after the tax reform (relative to the years before the tax reform) Hence, it measures the marginal difference between the pre-and post-period with respect to the introduction of tax changes and determines the economic importance of this difference γ is expected to negative and significant Figure 2 demonstrates visually the difference between two groups after exogenous event

There is an obstacle that should be concerned in this empirical strategy While determining tax reform is an evident exogenous event, other contemporary combination events may significantly distort results In particular, if these events

characteristics vary around the adoption of the change of tax regime, γ could be biased This issue is handled partly because the firm leverages of state enterprises (treatment group) are tested relatively to those of un-state enterprises (control group) Two groups are obviously exposed to industry and external shocks similar

C counterfactual

B Control

Figure 12 : The difference between two groups after exogenous event

+ According to the previous capital structure researches, several individual control variables (𝑋𝑖𝑡) should be applied in the model Beside the abundant financial indices of firms, a few factors such as inflation index and GDP growth ratio are also included in the regression to control the macroeconomic shocks

These indicators have their own values corresponding to each year in the period

of time of data Some main covariates of the model are detailed as Table 1 follows:

Table 1: Variables’ definitions and measurements

Unit

Expected impact on leverage

Positive

Labor The number of labor People Negative

Liquidity ratio (Total assets- Inventories)/

Debt

Negative

Investment

(Fixed asset of the current year

- Fixed asset of the previous year)/ Fixed asset of the previous year

Negative

Tangibility

Book value of tangible fixed assets over Book value of total assets

Negative

Profitability

Ratio of earnings before interests, taxes, depreciation and amortization (EBITDA) to book value of total assets

Profit margin Net income (earning before

tax)/ total sales

Negative

Negative

Inflation The annual percentage of

inflation in consumer prices Percentage

Positive/Negative

GDP growth The annual percentage of GDP

per capita growth Percentage

Positive/Negative

Fixed effect (FE) and Random effect (RE) are also applied in the regressions to controls for all time-invariant differences between the control variables, therefore, the estimated coefficients of the FE and RE models cannot be biased because of omitted time-invariant characteristics Hausman Test is also put into practice to decide which model is preferred

CHAPTER 4: RESULTS AND DISCUSSION

This section includes four parts The first is descriptive statistics of variables The

second describes briefly the bivariate analysis Two main regression results are

presented in part 3 and the last one discusses about those empirical results

4.1 Descriptive statistics

The descriptive statistics for all firms are presented in Table 2 This table reports

means, standard deviations, the maximum and minimum value for all the

variables applied in the regression Data from the treatment group, control group

and the whole sample are showed in columns I, II and III respectively

Table 2 compares the characteristics of the treatment and the control companies

for the whole period (2001- 2007) and shows the differences in mean values

between two groups for their profile balance sheets and profitable indices

According to profile information, the treatment group seems to have obviously

more employees than the control one (468 comparing to 58) As can be seen

from the balance sheet part, there are several significant differences between both

groups Particularly, the average value of assets is approximately 126 billion

dong and 42 billion dong for treatment and un-treatment group respectively It

can be explained easily cause as mentioned above, the treatment group is the

collection of the state enterprises in Vietnam which frequently posse larger scale

than private ones The measurements also indicate that the leverage of treated

firms (62 percent) is slightly larger than the leverage of control group (54

percent) As to the profit and loss account, the companies belonging to the

un-treatment group are more profitable than the treated ones This can be proved by

the differences between the profitable indices of both groups, they are all larger

for the control companies

With the structure similar to Table 2, Table 3 also presents the summary statistics

for all companies in both groups for the year 2003 This is the year prior to the

changes of tax regime valid As can be observed, the differences between two

Formatted: Line spacing: 1,5 lines

groups for the whole period and the year 2003 have parallels in relevant aspects

As regard to the profile characteristics, companies in treated group seem to have considerably more number of employees than the ones in un-treatment group (875 versus 58) Likewise, Table 3 highlights the consistent differences in value

of assets between both groups for the whole period and the year 2003 In the year

2003, the state enterprises (treatment group) tend to have larger asset than the other ones (105 billion dong and 13 billion dong, respectively) In addition, without surprising, the leverage of treatment firms is larger than control firms (62 percent and 54percent, respectively) Table 3 also provides suggestive evidence that firms in control group are more productive than treated ones, particularly, they all posse better profitable indices

According to previous section, the difference in difference method is applied in the regression of this study Therefore, graphical analysis is also used to determine the annual common trend of leverage Figure 23, Panel A displays the average value of leverages’ evolution of both groups for the time period from

2001 to 2007 Furthermore, this figure also shows the visualization of the remaining control factors used in this analysis (Figure 23- Panel B to I) As can

be seen from the chart, the average leverage of treatment and control groups before the year 2004 that the tax reform introduced follow a familiar increasing gradually trend From the year 2004 on, the leverage of two groups have the opposite tendencies which are upward regarding to treatment group and downward for control one This may subsidize the empirical evidence in order to demonstrate the impact of preferential tax policy on Vietnamese companies’ capital structures Focusing on the next year after treatment time (year 2005) in Figure 23, beyond leverage, the value of assets also has different change between two groups: increasing more strongly related to treatment group after the year

2004 (Panel B) The reason might come from the forms that state enterprises performed equitization as mentioned above such as issuing more firms’ shares

4.2 Bivariate analysis

As one of an initial test before examining the impact of tax changes, bivariate analysis is used to determine the empirical relationships between leverage (dependent variable) and several control regressors (control variables) and to what extent these two variables are able to change simultaneously Since both dependent and control variables in this study are numerical, the scatter plot may

be applied popularly Figure 3 4 shows the scatterplots of leverage against control factors seamlessly Generally, the majority of scatterplots graphs have random distributions

Table 2: Descriptive Statistics and Means Differences for the period 2001-2007