Does tax deduction relax financing constraints? Evidence from China's value-added tax reform

Financial constraint is a significant 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 China's value-added tax (VAT) reform that was initiated in 2004 and completed in 2009. We use a quasi-experimental method and Annual Survey of Industrial Firms (ASIF) data from 2000 to 2009 to estimate the VAT reform's policy effects on financial constraints. We show that the VAT reform significantly improves firms' external financing capacity by decreasing borrowing costs and promoting commercial credit. 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. •We explore the causality between tax deduction and financial constraints in the context of a large developing country.•We consider both formal and informal external financial constraints.•We use quasi-experiment method by exploiting the variations of China's VAT reform.•We provide rich robustness checks and heterogeneity analysis.