Value‐added export tax policy, credit constraints, and quality: Evidence from China

Abstract This paper examines the effect of an industrial policy in China named the VAT export tax on product upgrading. In particular, we use Chinese transaction data during 2003–2010 to isolate the causal impact of the exogenous variation of VAT refund and within the city‐product quality change in HS6 exported products. Our identification strategy entails the utilization of duality of the Chinese trade system to isolate the impact of the rebate by comparing a group of trade flows exempt from the refund and another that remains eligible. Our results suggest an increase in product upgrading in response to an increase in VAT refund. In this study, we also introduce the credit constraint to understand the change in quality. The industries that are confronted with tighter credit constraints impel firms to settle for low‐quality products. The model demonstrates that VAT refund provided a counterbalance force to credit constraints, thereby prompting firms to adjust quality. By increasing the refund granted to ordinary traders, firms leverage this excess cash flow to invest (in a fixed asset or innovative project) and improve the quality of products. This effect is reinforced for products exported to developed countries, heterogeneous products, or from larger industries. The Chinese policymakers formally introduced environmental objectives under the 10th and 11th FYP, respectively. The Party leaders put substantial weight on promoting products embedded with high‐added value or technological content. At the same time, they underscored the willingness to downscale the export share of energy‐intensive or polluting industries. We evaluate whether environmental and economic concern impacts product upgrading. According to the results of this study, the VAT refund is effective only for products produced in “cleaner” industries, for products necessitating technical skills, a range of know‐how in manufacturing, and high‐level technology or engaging in research and development activities. Our paper introduces a new and unexplored variable in the trade literature. We use the stock of non‐trade barriers to explicate the change in product quality. In the import market, Chinese exporters comply with the change in regulation by making upward adjustments in the quality.