Tax hikes, ESG crowding out, and the underleverage puzzle: Evidence from China’s Golden Tax Phase III reform

This paper revisits the corporate “underleverage” puzzle by integrating ESG considerations. We identify a new mechanism: tax hikes deteriorate ESG performance, raising borrowing costs and offsetting the benefits of debt tax shields. Exploiting China’s Golden Tax Project Phase III (GTP-3) reform as a quasi-natural experiment, we show that enhanced enforcement increased effective tax rates but reduced net debt financing. The reform also led to significant declines in ESG performance and corresponding increases in debt costs. These effects are most pronounced among firms with weaker pre-existing ESG profiles. Our findings highlight how ESG-financing interactions can overturn conventional tax-leverage predictions and help resolve the underleverage puzzle.