Does Competition Encourage Unethical Behavior? The Case of Corporate Profit Hiding in China

Abstract

This paper investigates whether market competition enhances firms’ incentives to hide profits. We develop a theoretical model of firms’ profit hiding behavior in competitive environments and derive several testable hypotheses. We then test the model using a database that covers more than 20,000 large-and-medium-sized industrial firms in China during the period 1995-2002. Our findings show that firms in more competitive market environments – as well as firms in relatively disadvantageous positions – hide a larger share of their profits. This suggests that policies intended to promote competition should be accompanied by policies aiming at strengthening institutional infrastructure and at leveling playing fields.