Taxing “book” income may result in worse information for shareholders and creditors.
Corporate accountants know all sorts of perfectly legal, low-audit-risk opportunities for reducing tax burdens for their clients. However, many companies do not take advantage of these low-risk opportunities because they require that “book” income also reflect lower income values to shareholders. This method, referred to as “conforming tax avoidance,” comes with an unflattering portrait of corporate performance.
“It’s been very hard for people to study this type of activity because we haven’t had a good measure to isolate it from other behaviour. In order to talk about the cost of a policy, e.g. raising or lowering your tax rate, you have to first be able to measure it," says Kelly Wentland, associate professor of accounting at the Donald G. Costello College of Business at George Mason University.
Wentland and her co-authors’ recently published paper in the European Accounting Review that derives a way for estimating conforming tax avoidance when statutory tax rates change. Using this approach, they find an important (unintended) cost of tax rate changes. They find that firms opt to inflate their pre-tax “book” income numbers for shareholders when tax incentives to keep conforming numbers are low. Their findings suggest that: 1) companies are willing to engage in conforming tax avoidance when tax rates are high enough and 2) the book numbers shareholders rely on may be overstated following corporate tax rate cuts.
Wentland’s co-authors were Sebastian Eichfelder and Nadine Kalbitz of Otto-von-Guericke-Universität Magdeburg, Germany, and Martin Jacob of WHU – Otto Beisheim School of Management, Germany.
The researchers gathered data on 112,980 EU-based firms and their corporate tax rates (federal and local) for the period 2005-2020. Their purpose was to measure conforming tax avoidance through changes in accounting practices triggered by statutory tax changes. They used a difference-in-differences technique comparing companies subject to tax rate changes relative to those with stable rates. This technique is designed to account for differences in “normal” profitability, etc. among the firms in question.
The inverse relationship between corporate tax rates and pre-tax “book” income is interpreted as firms engaging in conforming tax avoidance. In terms of magnitude, the study finds that a 1-percentage point cut in the statutory tax rate corresponds with firms inflating pre-tax book earnings (all else being equal) by 1.1 percent.
Wentland and her co-authors also performed follow-up tests focused on determining the main types of activity used to inflate “book” income following tax rate cuts. They isolated three important channels — discretionary cash flows, reserve accounts, and the book value of inventory.
The existence of these three channels — alongside indications that the channels are being widely used — suggests that “book” income is not immune to the incentives driving tax avoidance. Simply put, it is not inherently more truth-telling than taxable income.
Wentland says their paper could contribute to debates around tax policy that are ongoing in several countries. “Our results echo a consistent concern that is brought up with policies that use book numbers to evaluate taxes (e.g., the OECD’s Pillar Two and U.S. CAMT). One of the big benefits that everyone hopes will happen from these types of policies is that tax avoidance will go down. However, these types of policies could substantially lower the quality of information shareholders and debtholders receive,” she says.
Wentland’s warning occurs against a global backdrop in which corporate tax rates are generally declining. The potential inverse relationship between tax rates and book income highlights relevant concerns for the informational environment.
Wentland is careful to offer a caveat with the study’s findings. The analysis primarily focused on European domestic firms, since this setting was the cleanest way to measure the effects of corporate tax rates. While the authors do some later analysis that suggests this may contribute to European multinationals as well, “[t]here could be differences in magnitudes with other settings, such as the U.S., as opportunities for this type of planning may not be the same,” Wentland says.