By Mihir A. Desai
One of the oft-overlooked aspects of President George W. Bush’s plan to provide dividend tax relief is the selective awarding of those benefits to shareholders of corporations that pay federal taxes. In other words, firms that report profits to capital markets but don’t report profits to tax authorities, an increasingly common outcome, wouldn’t share in the benefits. In the process, comparisons between the income reported to capital markets and tax authorities would become much more transparent.
While this proposal is laudable, Bush’s dividend tax plan opens the door to a more fundamental reconsideration of corporate reporting: Should corporations be allowed to report their income in two distinct ways to investors and to tax authorities? Several countries other than the U.S. enforce so-called “book-tax conformity” to varying degrees so that results are reported uniformly to these two audiences. Recent trends suggest that now is an opportune time for the U.S. to revisit the rules that allow firms to describe their economic activity in different ways to these two audiences.
Imagine if you were allowed to represent your income to the IRS on your 1040 in one way and on your credit application to your mortgage lender in another way. You might, in a moment of weakness, take the opportunity to frame your economic situation in a particularly favorable light to your prospective lender and go to fewer pains to do so with the IRS. Indeed, you might take great liberties to portray your economic situation in two divergent ways that would serve your best interests. While guilt and shame and the possibility of detection might deter you, you might find yourself coming up with all kinds of curious rationalizations for why something is income (to the lender) or an expense (to the tax authorities).
In fact, you do not have this opportunity and for good reason. Your lender can rest assured that the 1040 they review in deciding whether you are credit-worthy would not overly inflate your earnings given your desire to minimize taxes. Similarly, tax authorities can rely on the use of the 1040 for other purposes to limit the degree of income understatement given your need for capital. In that sense, the uniformity with which you are forced to characterize your economic situation provides a natural limit on opportunistic behavior that serves the interests of prospective lenders and tax authorities. Indeed, given the resulting uncertainty over what your true income is, you might even benefit from being forced to characterize your income in a uniform way.
While individuals are not faced with this perplexing choice of how to characterize your income depending on the audience, corporations do find themselves in this curious situation. Dual books for accounting and tax purposes are standard in corporate America and, judging from recent analysis, are the province of much creative decision-making. Firms’ characterizations of income to investors and to tax authorities have increasingly diverged during the 1990s for reasons that we still don’t fully understand. While the overstatement and manipulation of accounting earnings by firms has come to light, there is growing concern over a parallel development in the underreporting, or creative shielding, of income to tax authorities. As such, both investors and tax authorities seem to be losing out in this system. With the ongoing crisis in confidence in firms’ reported profits, firms too may be losing out as their portraits of economic health are increasingly being questioned.
This dual system has had a historic rationale. Separate tax books allow for differential accounting of expenses that can provide a fiscal policy tool without distorting the way in which income is reported to capital markets. While historically relevant, this argument has outlived its usefulness for several reasons. For starters, these different definitions of such expenses no longer account for much of the difference between book and tax income. Other factors—such as the peculiar accounting treatment of stock option compensation, differential treatment of overseas income, subsidiary income and pension obligations—account for large amounts and a large fraction remains unaccounted for. With the growing globalization of firms and the demographic twist we are working through continuing unabated, these wedges (and consequent discretionary opportunities) are clouding the true picture of how firms are actually performing. As such, enforcing uniformity would reduce uncertainty over what true profits are thereby furthering the interests of unsure investors, tax authorities and firms.
It is true that firms are forced to do some minimal reconciliation on their tax forms and accounting statements do contain well-buried footnotes that similarly try to reconcile these figures. Yet, these reconciliations provide very limited detail (in tax forms) or are completely opaque to even the most nuanced analysts (take a look at the tax footnotes of any major corporation). As such, a minimal solution would be the clarification and elaboration of these differences in public documents. More generally, a wholesale revisiting of the rationale for departing from book-tax conformity seems long overdue.
How could this happen? Three very realistic possibilities exist through regulatory, legislative or market channels. The newly constituted accounting board could propose and enforce this through the Securities and Exchange Commission. Congress could pass legislation that might please tax authorities, firms, and shareholders (how often does that happen?). Finally, a firm could voluntarily characterize their income in this way and stand out as a market leader. Regardless of the mechanism, financial reporting is a setting where reading off of the same page would prove to have numerous virtues.
Mihir A. Desai is an assistant professor of Business Administration at Harvard Business School.