China's Value-Added Tax Reform, Firm Behavior and Performance

China reformed value-added tax (VAT) by removing investment from the tax base in northeastern provinces in 2004, which is a "natural experiment" of its tax system. Using difference-in-differences method, this paper for the first time investigates the impact of VAT reform on China firms' fixed asset investment, employment behavior, innovative activities, and productivity, and furthermore discusses the impact of firm behavior on industrial structural upgrade and employment with a firm-level panel data of large and medium-sized manufacturing enterprises in China. We find that VAT reform significantly promotes firms' fixed asset investment, and increases firms' capital-labor ratio and productivity; while enhancement of firms' productivity is mainly achieved by means of substituting labor with capital, rather than independent technology innovation; meanwhile, VAT reform distinctly decreases employment. Our findings have essential policy implications on the extension of VAT reform in the entire China.