Transcript Accounting, Economics, and the Tax System

Accounting,
Economics, and
the Tax System
Joel Slemrod
October 13-14, 2006
Sidney Winter Lecture Series
University of Iowa
Accounting
If everyone knows everything, financial
accounting is not needed.
Information is central to the efficient
operation of companies that are, primarily
for technological reasons, too large for
managers to be owners.
What public companies report about their
operations is important.
Economics
Focused on what companies do, such as
their investment, R&D, hiring.
The real behavioral response to tax policy is
a central concern.
All behavioral responses are symptoms of
inefficiency. This includes real responses
and reporting responses. The latter are, in
general, more elastic, but not of a different
nature.
Tax System
In modern tax systems, businesses are central,
both because some tax liabilities are triggered by
business income, and because businesses remit
taxes triggered by payment/receipt of labor
income, retail sales, etc.
Public companies must report about income to two
classes of audience: 1) shareholders, creditors,
etc., and 2) the IRS. The former is a public report,
while the latter is (still) a private report.
Income reported in financial statements
differs from taxable income because of 1)
intended differences in the definition of tax
base, 2) different degrees of conservatism,
and 3) intention to mislead (in opposite
directions).
Optimal tax theory is a theory based on
information. Yet firms are essentially absent
from this theory.
Why We Need to Talk
There is evidence that corporations will
forego real income in order to increase book
income.
If book income matters, then the bookincome ramifications of real decisions
matter.
For investment and other decisions,
economists need to consider not only taxadjusted but also book-income-adjusted
returns and costs.
Also, book choices may have real
ramifications.
One example is accelerated depreciation
versus rate cuts.
Corporate Tax Noncompliance

The IRS estimates a corporate
underreporting rate of 15.5% ($37.5
billion) in 1998, compared to 12.5% for
individuals.

Tax shelters (very complicated
transactions designed to exploit loopholes
and provide unintended tax benefits) have
been estimated to cost another $15.5
billion in 1998.

There is a growing gap between book
income on financial statements and tax
income.

Since 1996 IRS enforcement resources
have dropped drastically. FTEs fell by 26
percent between 1996 and 2001. Audit
ratio for corporations with assets over
$250 million fell from 51.7 percent to 33.0
percent.
The Demand for
Corporate Tax Evasion

The standard Allingham-Sandmo model says
that evasion is a gamble like any other, and
demand will depend on the probability of being
caught and punished, the punishment, and the
potential evader’s risk aversion.

It has been applied to individuals almost
exclusively.

Should risk aversion matter for big,
publicly-owned corporations?

Do recent models of intrinsic motivation
and civic virtue apply?

If managers are virtuous, should they
repress this and focus on maximizing
share value?

What are the implications of the separation
of ownership and control?

Surveys of tax managers suggest an
increase in attention (i.e., use in
determining compensation) to tax savings
and effective tax rate, much less to
“accuracy.”

In some models, penalties imposed on the
tax manager are more effective, because
penalties on the owners are diluted when
they are conveyed to decision-makers via
changes in the compensation contract.

One policy implication: public disclosure of
tax payments could backfire if it facilitates
benchmarking of tax managers’
performance.

Research goal: integrate fact that
corporations make reports to public and to
the IRS, and divergences provide
information. This relates to the proposed
new M-3 schedule that is designed to
make differences between the two reports
more transparent to the IRS.
Empirical Evidence

Among small corporations, publicly-traded and
regulated ones have higher compliance.

Corporations with more incentivized executive
contracts are more likely to undertake earnings
management and accounting fraud.

Among small corporations, noncompliant
companies are much more likely to be managed
by executives who have understated personal
taxes (even excluding business-related taxes).
This suggests that managerial preferences play
a role in determining company noncompliance.
The Supply of Corporate Tax
Evasion: The Industrial
Organization of the Tax Shelter
Business
The Allingham-Sandmo model presumes
that the supply of evasion opportunities is
elastic. But there is a tax shelter sector with
specialized information that produces and
markets tax shelters.
Why did it grow beginning in 1990’s?

Growth in sophisticated financial
instruments.

Consolidation of tax shelter business in
Big 5 (now 4!) accounting firms that can
amortize cost of development over many
purchasers.

Court decisions favoring more literal
reading of tax laws.
Policy Responses

Require disclosure for “suspicious”
transactions.

Quickly react to abusive transactions.

But Hines (2002) suggests that, unless tax
law changes can be made retroactive, a
highly reactive policy may just encourage
the rapid development of innovative new
techniques. It might be better to
immediately publicize tax avoidance
techniques to reduce first-mover premium.
Supply Meets Demand

Relative demand and supply elasticity will
determine incidence (effect on taxpayers
versus effect on shelter providers) of
changes in tax policy, including tax
enforcement policy.

Which side of a transaction remits tax may
matter, contrary to standard theory. One
of the principal arguments for the
corporation income tax is that it is an
efficient way to withhold tax on behalf of
shareholders.

The proliferation of tax shelters challenges
this notion, due to economies of scale
related to tax shelters.
Why Should We Care?
1.
Incidence. But note the difference
between incidence of a tax on all
corporations and the incidence of an act
of successful evasion.
2.
Efficiency (resource cost). Inter-sectoral
distortions arose when sector-specific
characteristics facilitate avoidance.
Compliance costs that amount to over
$25 billion annually.
3. But could cracking down on corporate
tax evasion decrease corporate
investment? That depends on the
relationship between the marginal cost of
avoiding taxes and the volume of
investment a firm undertakes. Is
avoidance inframarginal?
Summary of Policy Issues
1.
2.
3.
4.
At whom to direct deterrence
instruments, corporation or managers?
How best to design enforcement policy
toward suppliers of tax shelters, given
the organization of that industry?
What is the relationship between
accounting rules/enforcement and tax
rules/enforcement?
What is optimal disclosure to the IRS and
to the public?
Research Agenda

The relationship between sheltering and
real decisions.

Cross-sectional determinants of corporate
evasion and sheltering.

How accounting rules, tax rules, and
enforcement affect both reporting and real
decisions.