Finance Research Letters xxx (xxxx) xxxx

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Finance Research Letters

journal homepage: www.elsevier.com/locate/frl

Does industrial clustering mitigate the sensitivity of firm relocation

to tax differentials? The role of financing
Jin Yang , Chuanli Zhou
⁎

School of Public Finance and Taxation, Southwestern University of Finance and Economics, 555 Liutai Avenue, Wenjiang District, Chengdu, China

ARTICLE INFO ABSTRACT

Keywords: This paper tests the impact of agglomeration forces on the sensitivity of firm relocation to tax
Firm location differentials and examines the financing effects of clustering. Using data from the Annual Survey
Agglomeration economy of Chinese Industrial Firms, we provide evidence that local tax differentials are positively asso-
Financial development ciated with the probability of local firms’ migration, but this relationship is attenuated in counties
with higher levels of industrial clustering. Further analysis shows that the effect of industrial
JEL classifications:
clustering is stronger in regions with less efficient financial markets. These findings support the
G2
theoretical prediction that agglomeration economies can reduce the effects of tax differentials on
H32
R3 firm relocation by providing alternative sources of financing.

1. Introduction

Tax incentive is a critical determinant of firms’ location, and migration is one of the most important strategies with which firms
react to tax regulation (Giroud and Rauh, 2019; Rathelot and Sillard, 2008; Riedel, 2018; Wu et al., 2007). However, migration not
only changes the tax rates faced by a firm, but also changes its interconnectedness with other firms in terms of the industrial
clustering of a geographically proximate group of firms. Indeed, industrial clustering is shown to bring many advantages to firms,
such as labor market pooling, specialized supplies, technological spillovers, and financial access (Porter, 1998; Glaeser and
Gottlieb, 2009; Long and Zhang, 2011).
To explore how agglomeration forces affect firm mobility, several theoretical studies have incorporated agglomeration economies
into tax competition models (Kind et al., 2000; Ludema and Wooton, 2000; Baldwin and Krugman, 2004). The key theoretical
hypothesis derived from these new economic geography models is that agglomeration rents will lead to spatial concentrations of
interconnected firms, which cannot be dislodged with small tax differentials. While the extant empirical literature mostly focuses on
the impact of tax differences on firms’ location, fewer studies use firm-level data to test how industrial agglomeration affects the
sensitivity of firms’ migration decisions to tax differentials (Brülhart et al., 2012). Moreover, prior studies have been mostly limited to
the direct effects of industrial agglomeration on firms’ mobility; very little is known about the mechanisms potentially at work (Jofre-
Monseny et al., 2011).
This study attempts to fill some of the gaps in the literature by examining whether industrial clustering can offset the effect of tax
differentials on firm migration and exploring the financing effects of clustering in China. As the largest emerging economy, China
provides us a unique institutional setting. First of all, effective tax rates vary substantially across different regions in China, as local
governments compete with each other to attract investment by offering favorable tax incentives (e.g. tax exemptions, tax breaks, and
tax rebates) (Liu and Martinez‐Vazquez, 2014). Like many transition countries, China began its economic reforms in the absence of

⁎
Corresponding author.
E-mail address: yangjin@swufe.edu.cn (J. Yang).

https://doi.org/10.1016/j.frl.2020.101681
Received 4 May 2020; Received in revised form 27 June 2020; Accepted 30 June 2020
1544-6123/ © 2020 Elsevier Inc. All rights reserved.

Please cite this article as: Jin Yang and Chuanli Zhou, Finance Research Letters, https://doi.org/10.1016/j.frl.2020.101681
J. Yang and C. Zhou Finance Research Letters xxx (xxxx) xxxx

well-functioning financial institutions. China's rapid industrialization increasingly relies on industrial clustering which plays an
essential role in supporting firm entry and growth (Long and Zhang, 2011).
Our study contributes to the literature in several ways. First, to the best of our knowledge, this study is among the first to use firm-
level data to examine how industrial agglomeration affects the sensitivity of firms’ migration decisions to tax differentials. In a
pioneering paper, Brülhart et al. (2012) use industry-level data to show that firm births in Swiss municipalities are less sensitive to tax
differentials in more spatially clustered sectors. Second, our work adds to the growing literature on the financing effects of industrial
agglomeration by showing that the financing effects provided by industrial agglomeration are a significant determinant of firm
location (Zhang and Hu, 2014; Cainelli et al., 2019).

2. Research design

2.1. Sample and data sources

We combine multiple data sources in this study. The firm-level data used is an unbalanced panel of the Annual Survey of Chinese
Industrial Firms (ASCIF) from 1998 to 2007, compiled by China's National Bureau of Statistics.1 ASCIF data comprises an annual
survey of two types of manufacturing firm in China: all state-owned enterprises (SOEs), and non-SOEs with annual sales over five
million RMB. On average, the sample accounts for over 95% of China's total annual output in the manufacturing sector covering
mining, manufacturing, and public utilities. The county-level macroeconomic variables come from the China Statistical Yearbook.

2.2. Empirical models

We estimate the following fixed effects model to test whether industrial clustering is able to mitigate the effect of tax differentials
on firm migration:
migrationi, t , s, j = 1 tax differentialst , j + 2 tax differentialst , j × clustert , j + 3 clustert , j + Controli, t , s, j + i + t + s + j + µ i, t , s , j
(1)
where the dependent variable migrationi,t, s, j is a dummy variable indicating whether firm i in industry s located in county j migrated
to another county in year t. Migration is identified by a change in the firm's address and is verified by the change in administrative
division code.
As firms may compare the tax burden between the new location and their current location when making relocation decisions, we
follow Borck and Pflüger (2006) and Rathelot and Sillard (2008) and use tax differentials between different regions to measure
interjurisdictional tax competition. Specifically, as firm migration most often occurs within provinces in our study, tax differentialst,j
is defined as the difference in average tax rates between county j and other counties in the same province. Given that firms may
combine both contemporary and historical tax information when making their relocation decisions, we use the average tax differ-
entials over the previous three years in our empirical tests.
To measure the degree of industrial clustering at county level, we adopt the industrial proximity index proposed by
Hausmann and Klinger (2007). They constructed a proximity matrix to measure the interconnectedness of firms within a small region
by using similarity among their inputs, which is a key feature of clustering (Porter, 1998). Following Long and Zhang (2011), we
construct county-level industrial proximity using the Hausmann-Klinger product proximity matrix. First, we aggregate firm em-
ployment, output, and assets to the cell level, where a cell is defined as a combination of the county and the four-digit CIC industry
code. Second, for each industry in a county, we calculate its proximity to all other industries located in the same county using the
Hausmann-Klinger product proximity matrix. Then we get the average proximity for each industry, using the size of the other
industries in each pair as the weight. Finally, we compute the county-level industry proximity as the average proximity of all the
industries in that county, weighted by the size of each industry. To check the robustness of our results, we follow Long and
Zhang (2011) and construct three industrial proximity measures by using assets, employment, and output as weights to adjust for the
size of each industry.
As a firm may evaluate the degree of industrial clustering in the potential new location relative to its current location when
making a relocation decision, we construct our industrial clustering measure by subtracting the average industrial proximity of other
counties in the same province from a county's industrial proximity index. To mitigate the concern of reverse causality, we use a
county's average industrial proximity over the previous three years in our empirical tests.2
The set of control variables include firm characteristics (firm age, logarithm of fixed assets, firm ownership, and export rate) and
county characteristics (gross regional product (GRP) per capita, population, and secondary industry percentage). In addition, we
control for firm fixed effects and industry, year, and provincial fixed effects. To avoid overestimation, standard errors are clustered at

1
The post-2008 ASCIF data is less reliable as firm information is severely misreported or missed in the recent data in circulation. As a result, we
choose to use 1998-2007 data in our study.
2
To check whether our estimation results are affected by firm migration, we conduct a robustness test by excluding the firms that changed
locations in our sample period in the calculation of the industrial proximity. We find that our findings are quite robust. We do not report these results
to save space, but they are available upon request. Due to the difficulty in finding a good instrument, our approach may not completely rule out the
possibility of reverse causality. We remind readers to take caution in interpreting the related findings.

2
J. Yang and C. Zhou Finance Research Letters xxx (xxxx) xxxx

Table 1
Summary statistics.
Variable Obs. Mean Std.Dev. Min. Max.

Migration dummy 1432,515 0.1662 0.128 0 1

County tax differentials 1432,515 0.00351 0.0278 −0.169 0.515
Cluster_asset 1432,515 0.000484 0.0238 −0.140 0.351
Cluster_employment 1428,197 0.000404 0.0205 −0.144 0.385
Cluster_output 1432,482 0.000151 0.0231 −0.140 0.360
Firm age 1432,515 9.230 10.50 0 100
Log fixed asset 1432,515 8.320 1.500 5.560 11.20
Export rate 1432,515 0.175 0.344 0 1
GRP per capita 1432,515 27,889 18,707 2153 93,687
Population 1432,515 686 451 39.70 2849
Secondary industry percentage 1432,515 0.505 0.0888 0.157 0.897
Fiscal decentralization 1432,515 3.610 2.540 1.080 13

county level. Table 1 presents summary statistics of the main variables.

For convenience of interpreting the regression coefficients and implementing instrumental variable estimations, we estimate
Eq. (1) by linear probability model. We also check the robustness of our estimation results by using logistic regression, and we find
that the marginal effects are quite close to our results.3

3. Empirical results

3.1. Mitigating effect of industrial clustering

We conduct the first test by estimating Eq. (1), in which both tax differentials and industrial clustering measures are in level form.
As shown in Table 2, the coefficient of county tax differentials is positive and statistically significant, implying that a higher local tax
burden increases the probability of a firm moving elsewhere. Moreover, the coefficients of the interaction terms are negative and
statistically significant whenever the cluster measures are weighted by firm assets, employment, or output, indicating that the
positive relationship between tax differentials and firm migration behaviors is attenuated in counties with higher levels of industrial
clustering. In addition, the mitigating effects are far from trivial. Take the estimate of columns (1), for example: one standard
deviation (0.0278) increase in the degree of industrial clustering relative to other counties in the same province reduces the prob-
ability of local migration by about 7.4%. In summary, the results in Table 2 confirm the theoretical prediction that firm mobility is
less sensitive to local tax differentials in regions with higher degrees of industrial agglomeration.

3.2. Role of financing effects

As pointed out in previous studies, one key advantage of clustering in developing countries with underdeveloped financial
markets is that it helps firms to alleviate financial constraints by enhancing trade credit and reducing capital entry barriers (Long and
Zhang, 2011; Zhang and Hu, 2014; Cainelli et al., 2019).
To test the financing effects of industrial clustering, we measure the degree of financial inefficiency by computing the standard
deviation of the logarithm of the firm value added/total asset ratio at the county level, which captures variations in the marginal
product of capital (Hsieh and Klenow, 2009). Table 3 presents the results by dividing the sample into counties with high financial
inefficiency and low financial inefficiency, based on the sample median. It shows that the mitigating effect of industrial clustering is
mainly concentrated in regions with less efficient financial markets, which indicates that the financing effect is an important channel
through which industrial clustering reduces the impact of tax differentials on firm migration.

3.3. Endogeneity and instrumental variable estimation

To address the endogeneity concern, we use local fiscal decentralization as an instrumental variable for local tax differentials. On
one hand, fiscal decentralization, which is primarily determined through bargaining between central and local governments, should
not have any direct effects on firms’ migration behaviors, satisfying the exclusion restriction. One the other hand, higher fiscal
decentralization grants local governments more autonomy to retain fiscal revenue, which motivates local governments to set lower
local tax rates relative to neighboring counties in order to compete for investment. Table 4 shows that our results are robust after we
address the endogeneity issue.

3
Logistic regression results are reported in appendix Table 5. To address the concerns that migration might be rare events in our sample, we
estimate our baseline model using Poisson regression and the find the results are robust even when migration is considered as rare events. Poisson
regression results are present in appendix Table 6. We thank the anonymous referee for pointing out this issue.

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J. Yang and C. Zhou Finance Research Letters xxx (xxxx) xxxx

Table 2
Mitigating effects of industrial clustering.
(1) (2) (3)

Variables Independent variable: migration dummy

County tax differentials 0.319*** 0.324*** 0.313***
(0.0256) (0.0265) (0.0257)
County tax differentials*Cluster_asset −2.671***
(0.370)
Cluster_asset −0.0363
(0.0558)
County tax differentials*Cluster_employment −2.522***
(0.351)
Cluster_employment 0.0297
(0.0621)
County tax differentials*Cluster_output −3.737***
(0.220)
Cluster_output 0.0326
(0.0441)
Control variables Yes Yes Yes
Firm fixed effects Yes Yes Yes
Industry fixed effects Yes Yes Yes
Year fixed effects Yes Yes Yes
County fixed effects Yes Yes Yes
Observations 1432,515 1428,197 1432,482
R-squared 0.012 0.012 0.012

Notes: Standard errors are clustered at county level and reported in parentheses. Significance levels 0.1, 0.05, and 0.01 are indicated by *, **, and
*** respectively.

Table 3
Role of financing.
(1) (2) (3) (4) (5) (6)

Independent variable: migration dummy

Variables High financial inefficiency Low financial inefficiency
County tax differentials 0.275*** 0.275*** 0.283*** 0.180** 0.204** 0.168**
(0.0321) (0.0355) (0.0330) (0.0437) (0.0499) (0.0428)
County tax differentials*Cluster_asset −7.114** −5.774
(3.458) (4.647)
Cluster_asset −0.529 0.684
(0.330) (0.461)
County tax differentials*Cluster_employment −8.021*** −6.715
(1.041) (4.751)
Cluster_employment −0.474** 0.742
(0.228) (0.540)
County tax differentials*Cluster_output −9.839*** −8.892**
(0.441) (3.809)
Cluster_output −0.479* −0.665*
(0.245) (0.382)
Control variables Yes Yes Yes Yes Yes Yes
Firm fixed effects Yes Yes Yes Yes Yes Yes
Industry fixed effects Yes Yes Yes Yes Yes Yes
Year fixed effects Yes Yes Yes Yes Yes Yes
County fixed effects Yes Yes Yes Yes Yes Yes
Observations 680,856 678,227 680,821 751,499 749,810 751,502
R-squared 0.017 0.016 0.017 0.022 0.022 0.022

Notes: Standard errors are clustered at county level and reported in parentheses. Significance levels 0.1, 0.05, and 0.01 are indicated by *, **, and
*** respectively.

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J. Yang and C. Zhou Finance Research Letters xxx (xxxx) xxxx

Table 4
Instrumental variable regressions.
(1) (2) (3)

Variables Independent variable: migration dummy

Panel A: Second stage results
County tax differentials 3.982*** 5.133*** 2.585***
(0.948) (0.357) (0.217)
County tax differentials*Cluster_asset −158.3***
(16.75)
Cluster_asset 0.223
(0.396)
County tax differentials*Cluster_employment −139.3***
(11.16)
Cluster_employment 0.427
(0.474)
County tax differentials*Cluster_output −213.7***
(14.41)
Cluster_output 0.299***
(0.0252)
Panel B: First stage results County tax differentials
Fiscal decentralization −0.0015*** −0.0013*** −0.0015***
(0.0001) (0.0001) (0.0001)
F statistics 17.15 17.13 17.13
Control variables Yes Yes Yes
Firm fixed effects Yes Yes Yes
Industry fixed effects Yes Yes Yes
Year fixed effects Yes Yes Yes
County fixed effects Yes Yes Yes
Observations 1432,515 1428,197 1432,482
R-squared 0.021 0.019 0.021

Notes: Standard errors are clustered at county level and reported in parentheses. Significance levels 0.1, 0.05, and 0.01 are indicated by *, **, and
*** respectively.

4. Conclusion

This paper helps to enrich the literature by empirically testing the theoretical implications of agglomeration forces on firm
mobility. We provide evidence that industrial clustering can significantly reduce the effect of tax differentials on firm migration,
especially for firms in areas with less efficient financial markets. Our findings carry several implications. First, our study
highlights the role of agglomeration economies in mitigating tax competition, which suggests that local governments can pro-
mote clustering development through policies such as the creation of industrial park as an alternative strategy to reduce in-
terjurisdictional tax competition. Second, our findings suggest that it is important to consider the underlying financing effects
when managers relocate their firms for tax reasons. This is especially important for firms in developing countries with under-
developed financial systems.

CRediT authorship contribution statement

Jin Yang: Conceptualization, Methodology, Validation, Resources, Data curation, Writing - review & editing, Supervision,
Funding acquisition. Chuanli Zhou: Software, Formal analysis, Validation, Writing - original draft.

Acknowledgments

This work was supported by the National Natural Science Foundation of China (Grant No. 71803157), MOE (Ministry of
Education in China) Project of Humanities and Social Sciences (Grant No. 18YJC790196).

Supplementary materials

Supplementary material associated with this article can be found, in the online version, at doi:10.1016/j.frl.2020.101681.

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J. Yang and C. Zhou Finance Research Letters xxx (xxxx) xxxx

Appendix

Table 5., Table 6

Table 5
Estimation results using logistic regression.
(1) (2) (3)

VARIABLES Independent variable: Migration dummy

County tax differentials 5.646*** 6.079*** 5.617***
(0.431) (0.425) (0.432)
County tax differentials* Cluster_asset −79.93***
(16.39)
Cluster_asset −0.0798
(0.594)
County tax differentials* Cluster_employment −141.3***
(18.87)
Cluster_employment 0.709
(0.661)
County tax differentials* Cluster_output −95.54***
(16.84)
Cluster_output 1.335**
(0.605)
Control variables Yes Yes Yes
Firm fixed effects Yes Yes Yes
Industry fixed effects Yes Yes Yes
Year fixed effects Yes Yes Yes
County fixed effects Yes Yes Yes
Observations 1432,515 1428,197 1432,482
Pseudo R2 0.2022 0.2027 0.2024

Notes: Standard errors are clustered at county level and reported in parentheses. Significance levels 0.1, 0.05, and 0.01 are indicated by *, **, and
*** respectively.

Table 6
Estimation results using Poisson regression.
(1) (2) (3)

VARIABLES Independent variable: Migration dummy

County tax differentials 4.915*** 5.241*** 4.885***
(0.388) (0.383) (0.390)
County tax differentials* Cluster_asset −61.44***
(14.41)
Cluster_asset 0.108
(0.542)
County tax differentials* Cluster_employment −103.0***
(16.53)
Cluster_employment 0.719
(0.597)
County tax differentials* Cluster_output −75.00***
(14.88)
Cluster_output 1.333**
(0.552)
Control variables Yes Yes Yes
Firm fixed effects Yes Yes Yes
Industry fixed effects Yes Yes Yes
Year fixed effects Yes Yes Yes
County fixed effects Yes Yes Yes
Observations 1432,515 1428,197 1432,482
Log likelihood −24,369.305 −23,951.059 −24,353.965
Prob > chi2 0.0000 0.0000 0.0000

Notes: Standard errors are clustered at county level and reported in parentheses. Significance levels 0.1, 0.05, and 0.01 are indicated by *, **, and
*** respectively.

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J. Yang and C. Zhou Finance Research Letters xxx (xxxx) xxxx

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