From The Hill
Sen. Elizabeth Warren (D-Mass.) recently proposed a tax on financial accounting income, which she calls her “Real Corporate Profits Tax.” This is a bad idea that will create many problems.
Warren is correct that public companies in the U.S. calculate income under (at least) two different sets of rules.
First, there are Generally Accepted Accounting Principles (GAAP) written by the Financial Accounting Standards Board (FASB). These rules are meant to reflect the economic performance of the business so that shareholders, among others, can evaluate the firm and its management.
Second, corporations calculate profits according to the Internal Revenue Code, created by Congress, to determine taxable income. The Internal Revenue Code is meant to raise revenue for the government, and in some cases, to change the ways companies behave — encouraging investment and research and development (R&D), for example.
Warren claims that lobbyists have distorted the tax code as a result of their undue influence, but the biggest reason why firms may pay no tax despite having financial accounting income is not the result of some shady backroom deal. Rather, it is Congress making conscious decisions to create the tax law in order to try to change taxpayer behavior.
For example, on the individual tax side, Congress has incentivized energy-efficient property through the Residential Energy Credit. Sen. Warren saved $13,936 in taxes in 2018 as a result of this credit. Warren’s tax savings were not the result of some nefarious tax planning, but rather her legally using the tax incentives that Congress created.
Likewise, there are many items that result in firms having book income but paying no taxes, such as the R&D tax credit, tax-exempt bonds, accelerated depreciation, etc. These items have broad support in Congress.
These differences are not secrets; all differences between book income and taxable income are disclosed to the IRS every year on Schedule M-3, and material differences are disclosed in financial statements.
If Congress has determined it no longer wants to change corporate behavior using the tax code, it should merely eliminate these items. Politically, such elimination would be difficult because they have such broad bipartisan support.
Because these items have such support, Warren would prefer to tax book income instead of fixing what she perceives as the real underlying problem. However, this “solution” is short-sighted.
First, public firms will have incentives to lower reported financial accounting income and report performance to shareholders and creditors using other means.
If Senator Warren tries to address the issue of firms releasing non-GAAP numbers by trying to tax those amounts, it is difficult to see how this would be enforced. Would every mention of some type of earnings in a conference call or press release be tracked down and taxed by the IRS?
Second, Congress will also respond. Rather than curing any perceived lobbying problem, taxing financial accounting income will cause the same lobbying that distorts the tax code to influence financial accounting.
The FASB was established separately from the U.S. government (and is not funded by the government) with the intent to avoid the influence of Congress on the accounting standards. A sound financial accounting and reporting system is essential to a well-functioning capital market.
To run the risk that lobbyists and Congress would be able to unduly influence the financial accounting system is simply irresponsible. The possibility that Congress would interfere with the FASB is not hypothetical.
When the FASB proposed requiring the recording of stock option compensation expense for financial accounting, Congress was lobbied by constituents and in turn put pressure on the FASB. The FASB compromised on a solution of disclosure rather than recognition, which was remedied several years later.
The influence of Congress on FASB would almost certainly increase if financial accounting income was taxed. As a result, the usefulness of financial accounting to investors and creditors would be damaged.
Furthermore, this is not a new idea. Rather, it is a throwback to a failed Reagan-era tax. In 1986, Congress created a tax based in part on financial accounting income: the book untaxed reported profits (BURP) adjustment to the corporate alternative minimum tax.
The book adjustment was mercifully abandoned shortly after its adoption. Research on this adjustment and other instances of book-tax conforming policies generally show that firms manage earnings downward and information is lost to the capital markets.
Read the full post at The Hill.
Michelle Hanlon is the Howard W. Johnson Professor and a Professor of Accounting at the MIT Sloan School of Management
Jeff Hoopes is an assistant professor of accounting at the University of North Carolina’s Kenan-Flagler School of Business.