Presentation on theme: "Accounting, Economics, and the Tax System Joel Slemrod October 13-14, 2006 Sidney Winter Lecture Series University of Iowa."— Presentation transcript:
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 book- income ramifications of real decisions matter.
For investment and other decisions, economists need to consider not only tax- adjusted 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. At whom to direct deterrence instruments, corporation or managers? 2. How best to design enforcement policy toward suppliers of tax shelters, given the organization of that industry? 3. What is the relationship between accounting rules/enforcement and tax rules/enforcement? 4. 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.