Deleveraging driven by profitability improvement: Evidence from China’s business tax to value-added tax transition

This study examines how tax policy reforms influence corporate capital structure by leveraging China’s business tax to value-added tax (B2V) Reform as a quasi-natural experiment. Using a staggered difference-in-differences design with listed firms’ data from 2009 to 2015, we find that firms affected by the B2V reform reduced leverage by an average of 1.8 percentage points compared to unaffected firms. Profitability gains—primarily from cost reductions made possible by value-added tax’s (VAT’s) deductibility—explain approximately 60% of this deleveraging effect. Heterogeneity analyses reveal that the effect is more pronounced among firms with stronger supply chain bargaining power, underscoring the importance of a firm’s ability to shift tax burdens in shaping financial decisions after the reform. Additional evidence shows declines in both dividend payouts and short-term liabilities during deleveraging, suggesting that the observed profitability improvements were temporary. Overall, these findings provide empirical support for the pecking order theory and underscore the broader capital structure implications of indirect tax reforms.