Short-run costs, Long-run Growth: bunching at tax thresholds among Chinese service firms

Threshold-based tax incentives are common, but conditioning eligibility on a threshold can induce firms to bunch below it, raising the concern that such incentives keep firms small. Using matched administrative tax and business registration data from China, with a baseline sample over 2009–2016 and firm survival tracked through 2019, we study a preferential corporate income tax policy for small service firms and ask whether bunching merely reflects short-run adjustment or also shapes subsequent growth. We document significant bunching below the taxable-income thresholds. In the bunching year, firms in the bunching region report net profit margins 0.09–0.16% points lower than the counterfactual without bunching, together with lower reported operating revenue and higher reported deductible costs, especially labour-related expenses. In subsequent years, however, the same firms display higher productivity, larger scale, and lower exit risk. These findings suggest that short-run strategic adjustment around tax thresholds need not translate into persistent size suppression. More broadly, the consequences of threshold-based incentives depend not only on where the threshold is set, but also on how the tax base is defined.