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CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING
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CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING

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  • 1. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING * LILLIAN F. MILLS Abstract - The tax law provides varying results that proposed Internal Revenue opportunities for tax planning, and Service (IRS) audit adjustments increase firms have competing incentives to as the excess of book income over consider in planning a tax reporting taxable income increases. This is strategy, including financial reporting evidence that firms incur additional effects. I present preliminary results costs for reporting higher financial that Internal Revenue Service audit statement income than taxable income. adjustments increase in the excess of I also investigate how the level of book income over taxable income. This conformity varies as the relative incen- is evidence that firms incur additional tives for book income versus tax savings costs for reporting higher book income change. Tax regimes that require more than taxable income. I also investigate conformity between book and tax the relationship between compliance accounting will likely induce higher tax costs and taxes paid. Existing descriptive payments than those firms whose research emphasizes the social cost incentives to maintain high book burden of such compliance costs. income are the greatest. In addition, Preliminary results indicate that firms government enforcement costs may be that spend more on tax research and higher under a regime where the tax planning report lower tax expense. base is not as strongly related to financial income as is the present corporate income tax system. Second, I investigate the relationship OVERVIEW between compliance costs and taxes paid using data from the Slemrod and The tax law provides varying opportuni- Blumenthal (1996) Compliance Cost ties to firms for tax planning, and firms Study. Prior discussions of these data have competing incentives to consider emphasized the social cost burden of in planning a tax reporting strategy, such compliance costs, focusing on the including financial reporting effects. In high ratio of compliance costs to this paper, I first present preliminary revenue raised. My research examines how firms’ choices of compliance costs differ. Preliminary results indicate that * University of Michigan, Ann Arbor, MI 48109. firms which spend more on tax research 421
  • 2. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 NATIONAL TAX JOURNAL VOL. XLIX NO. 3 and planning report lower tax expense. The U.S. accounting and tax systems Although complexity in the tax law each have enough uncertainty so that creates additional compliance costs, it managers may choose varying degrees may also provide opportunities for of conformity between book and tax planning. Those tax laws which are income. If there were no cost to complex without net tax effect, such as reporting taxable income below book alternative minimum tax depreciation income, then firms would respond to for many firms, generate compliance financial reporting incentives indepen- costs which provide no planning dently from tax savings incentives. In the opportunity for the firm. Such laws are extreme, a firm might report the highest likely to create the most protest from income permitted by independent corporate taxpayers. Tax regimes auditors and report no taxable income. where the compliance costs are related However, the IRS observes the difference to the taxes paid may be less objection- between book and tax income. I able to taxpayers if opportunities exist to hypothesize that proposed tax audit obtain a private benefit from tax adjustments are increasing in the planning. difference between book and tax income. Preliminary findings support this hypothesis. BOOK-TAX DIFFERENCES AND IRS ADJUSTMENTS The tax return and audit data are compiled by the IRS, Office of Special Introduction Studies, Corporate, for the firms in the Coordinated Examination Program from My ongoing research focuses on the 1981 through 1993. The tax and audit relationship between financial reporting data are subject to confidentiality costs, tax savings, and IRS adjustments. requirements, and results are presented The primary finding shown here is that in the aggregate to maintain this proposed IRS adjustments are increas- confidentiality. ing as book income is greater than taxable income. This result may be intuitive to the extent book-tax differ- Background and Hypothesis ences are viewed primarily as discretion- In choosing among alternative tax ary. In contrast, to the extent book- accounting treatments (including tax differences are mechanical, or are evasion), the firm must consider the undisputed by the IRS, no relationship expected costs due to tax enforcement would be found. Given the result that actions by the IRS. One common audit adjustments are related to book- assumption in the tax evasion literature tax differences, firms make different is that the IRS can determine true choices to minimize the joint expected taxable income when it conducts an costs of financial reporting, current audit.1 This assumption is less egregious taxes paid, and tax audit costs. Pre- when the IRS conducts a full-scale liminary evidence suggests that public “taxpayer compliance measurement firms have larger book-tax differences program” audit of individuals or small than private firms, consistent with a corporations (Rice, 1992). However, in hypothesis that public firms face the case of large corporations, the tax stronger incentives for financial report- return and records of the firm can only ing relative to tax savings than do be sampled in the audit. Even if all of private firms. the corporation’s tax positions could be 422
  • 3. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING examined, the concept of true taxable earnings. The only direct requirement in income is elusive. Consequently, it is the tax laws for conformity with rare for the IRS to propose negligence or financial statement accounting is that if criminal penalties in large-case audits. the last-in, first-out method is used for Many proposed penalties are negotiated tax inventory, it must also be used for away during the appeal process. It may financial accounting. still be true, however, that the possibility of penalty prevents the firm from such The accounting literature is inconsistent aggressive tax reporting as would allow in its assumptions about the extent of the IRS to sustain such penalties. In book-tax conformity. Several papers addition, compliance costs increase argue that there is little or no confor- when the firm is audited. Potential mity between book and tax accounting penalties, compliance costs, as well as in the United States.2 In addition, whatever firm preferences exist to avoid research on the book income adjust- disputes with the IRS may be considered ment for alternative minimum tax from costs of audit. 1987 through 1989 is based on the assumption that firms would lower The empirical literature in tax evasion reported book income in ways that did investigates firm characteristics which 2 not reduce taxable income in a con- predict the probability or extent of the forming way.3 In contrast, there is a firm’s evasion (or aggressiveness). sizable body of empirical research However, no empirical papers explore 2 examining tax-induced shifting of book-tax differences as a possible signal income through time or across jurisdic- of aggressiveness. Two survey papers in tions that explicitly or implicitly assumes the accounting literature by Cloyd book-tax conformity by arguing that (1995) and Cloyd, Pratt, and Stock taxable income shifting can be inferred (1994) investigate the extent to which from book income shifting.4 In addi- managers and tax advisors make tion, the earnings management litera- reporting decisions consistent with ture in accounting often includes a beliefs that book-tax differences create measure of tax incentives or tax rate red flags for the IRS. My research under the assumption that there is some provides evidence supporting these conformity of book and tax account- taxpayer perceptions using actual tax ing.5 1 return and IRS audit data. Mills (1996) constructs a simple model There is no requirement in generally of firm and IRS choices which supports accepted accounting principles (GAAP) 1 the hypothesis below, as well as to use tax laws to determine pretax hypotheses regarding the effect of income. Although conservatism (if financial reporting costs on conformity. interpreted as deliberate understate- Based on the beliefs documented by ment of income) is not advocated in the Cloyd (1995), and the assumptions in accounting conceptual framework, the tax accounting literature, I hypoth- residual effects of conservatism remain esize (in alternative form) the following. in accounting practice. Auditor and management risk reduction suggests that firms who wish to manage ac- H1: Tax audit adjustments by the IRS counting earnings downward will face increase as the excess of book income fewer securities litigation costs than over taxable income increases, all else firms who wish to increase accounting equal. 423
  • 4. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 NATIONAL TAX JOURNAL VOL. XLIX NO. 3 Data (which includes private firms), I am limited to IRS data.7 The primary The sample firms comprise all manufac- conformity measure is pretax book turing firms in the Coordinated Exami- income constructed from the tax return nation Program of the IRS. There are Schedule M-1 less taxable income approximately 1500 Coordinated (before net operating loss and other Examination Program firms each year in 3 special deductions). An alternative all industries. Tax revenues from measure of conformity uses tax rather Coordinated Examination Program firms than income amounts. The tax expense represent approximately 50 percent of conformity measure is federal tax all corporate tax revenues collected.6 I expense reported on the tax return use the manufacturing subset of these Schedule M-1 less tax on the return. firms, of which approximately 70 This measure will have less noise from percent are publicly traded, with the undisputed permanent differences and remainder being privately held in the will eliminate noise from varied consoli- United States or subsidiaries of foreign dation reporting choices in the book corporations. Firms are included in the income figure.8 However, the tax Coordinated Examination Program conformity measure will have increased according to a point system that noise due to credits and cannot be used measures the size and complexity of the for firms with tax losses, because no corporate tax return. The IRS coordi- refunds from carryback or carryforward nates the examination between team will be recorded on the current tax members with specialized knowledge in return. the industry, international matters, engineering, economics, and employ- Not all differences between taxable ment and excise taxes. The IRS audits income and financial statement income about 90 percent of the Coordinated are due to aggressive tax or financial Examination Program firms. However, reporting that results in disagreements the audit process is lengthy. For between the firm and the IRS. Many example, only 50 percent of the audits differences in income and deductions of 1982 returns have some agreement are expected due to differences be- seven years later. tween accounting pronouncements and tax laws. An ideal test of the hypothesis The Voluntary Compliance Baseline would remove all book-tax differences Management database contains filing, that were mechanical and nondiscre- audit, appeal, and litigation information tionary. However, the data are not fine for tax return-years from 1981 through enough to remove such differences 1993, as well as certain tax return line directly. Instead, controls are introduced items from Statistics of Income tape for two substantial differences, depre- extracts of filed tax returns, subject to ciation and unrepatriated foreign Internal Revenue Code disclosure earnings. provisions. Using IRS data and public financial statement data from Compustat, I construct the variables to Tests test the hypothesis. Univariate correlations between audit adjustments and book-tax differences I construct several measures of confor- are presented to provide suggestive mity between tax and financial account- evidence on the hypothesis. In addition, ing. For tests using the full sample the hypothesis is tested by regressing 424
  • 5. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING proposed audit adjustments on the of losses, the firm retains the statutory book-tax income difference and other rate for the loss year, consistent with the control and explanatory variables as rate at which revenue protection follows: amounts are imputed by the IRS in the dependent variable. This variable will be refined at a later time. The income conformity measure, BTINC, is pretax book income (from the tax return) less taxable income. I expect that MTR*BTINC will be positively associated with ADTR and that the coefficient α1 will represent the pro- posed adjustment rate by the IRS. PTS equals audit points assigned by the Coordinated Examination Program. PTS The parameter estimates are not represents size and complexity and presented, but results are generally includes a factor for prior audit hours. If described below. the IRS is more successful at detecting avoidance in large, complex firms due to the increased effort expended, then α2 ADTR, which stands for adjusted will be positive. If, however, large, revenue, equals proposed examination complex firms are better able to plan tax deficiencies plus government revenue avoidance which the IRS does not protection amounts.9 ADTR is a variable detect, α2 will be negative. constructed by the IRS, and I refer to this variable throughout the paper as PUBLIC is a dummy variable that equals proposed audit adjustments. one if the firm is publicly held. Since public firms may have higher costs of adjusting financial statement income, BEGASS is beginning book value of total Mills (1996) predicts that public firms assets reported in the balance sheet on will have smaller audit adjustments. the tax return. Therefore, I expect α3 to be negative. NPPE is beginning net depreciable MTR is an estimate of the marginal tax property from the financial statement rate for the firm. First, rates are reported on the tax return. This variable assigned to each calendar year in which is included as a control variable for the firm’s fiscal year begins. Years pre- BTINC, to remove the effect of nondis- 1987 are assigned a rate of 46 percent, cretionary depreciation differences. I 1987 a rate of 40 percent, and post- have no expectation regarding the sign 1987 a rate of 34 percent. This is a of α4. simplification of the Tax Reform Act of 1986 (TRA 86) transition rules. If the ITC is investment tax credit claimed on firm has a loss for the year, it is assigned the tax return (after income limitations the rate of the applicable prior year have been applied). This variable where the loss is fully utilized. If controls for the portion of audit insufficient prior profits permit carryback adjustments that are unrelated to book- 425
  • 6. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 NATIONAL TAX JOURNAL VOL. XLIX NO. 3 tax differences but are due to invest- While firms with financial losses, FLOSS, ment tax credits. The coefficient α5 will comprise more than 20 percent of the equal the average IRS adjustment rate original sample, they comprise only 6 to reverse claimed credits. percent of the sample where adjusted revenue (ADTR) is positive. This is FORINC is included as a control for consistent with the IRS not auditing loss unrepatriated earnings, although it is firms with as great a frequency. also possible that audit adjustments are higher for firms with foreign activities A probit regression determines what (Rice, 1992). characteristics increase the probability of being audited. Parameter estimates are The variable λ is constructed from the not shown here. The probability of Heckman two-stage estimation proce- being audited increases significantly in dure to correct for sample selection audit points, a measure of size, com- bias.10 The results from the first-stage plexity, and prior audit intensity, in probit regression are described generally reported foreign-source taxable income below. and if the firm is publicly held. The probability of being audited decreases significantly if book income is a loss. Results Table 1 presents simple statistics on Table 2 shows correlations of proposed sample variables of interest. All financial (ADTR) and retained (RTNR) audit variables are scaled by beginning total adjustments with both tax return and assets to better protect firm confidenti- Compustat measures of book-tax ality and since the scaled variables are differences. The first three measures are used in tests of hypotheses. The sample income differences of book income less is limited to the 1,545 firm-years taxable income where book income is between 1982 and 1992, where BTINC defined as follows: > 0, ADTR > 0, and BEGASS > 0. (1) pretax income from the tax return Adjusted revenue is 0.88 percent of (BTINC), assets, and retained adjustments, where (2) U.S. pretax income from available, are about one-quarter of that Compustat (USBKTX), or amount. BTINC shows that book (3) consolidated pretax income from income exceeds taxable income by Compustat (WWBKTX). approximately 4.4 percent of assets. Note that the sample is limited to firms The last five measures are tax differ- with BTINC > 0. The lower limit was set ences of federal tax expense less tax on to include only those firms with book the return, where federal tax expense is income in excess of taxable income, defined as follows: where the book-tax difference reflects the traditional direction of tax planning (1) federal tax expense from Schedule and aggressiveness. This limit also M-1 of the tax return (BT), eliminates firms who reported only U.S. (2) U.S. current tax expense from pretax income excluding repatriations of Compustat (USCUR), foreign earnings on Schedule M-1. (3) consolidated current tax expense Approximately 70 percent of the firms in from Compustat (WWCUR), this restricted sample are publicly (4) U.S. total tax expense from traded. Compustat (USTOT), or 426
  • 7. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING TABLE 1 SIMPLE STATISTICS Variable N Mean Standard Deviation Minimum Median Maximum ADTR 1,545 0.0088 0.0200 1.27E–06 0.0032 0.2716 RTNR 993 0.0021 0.0047 0 0.0005 0.0714 BI 1,545 0.1085 0.1024 –0.4237 0.0903 0.9769 TI 1,545 0.0596 0.0901 –0.4791 0.0462 0.8781 BTINC 1,545 0.0443 0.0493 2.23E–09 0.0304 0.4857 BT 1,545 0.0122 0.0206 0.0961 0.0087 0.2029 MTR 1,545 0.4302 0.0476 0.3400 0.4600 0.4600 PUB 1,545 0.7100 0.4539 0 1 1 PTS 1,545 26.8511 19.8665 0 21 174 NPPE 1,545 0.3320 0.2006 0 0.3021 3.8809 ITC 1,545 0.0032 0.0044 0 0.0019 0.0683 FORINC 1,545 0.0127 0.0251 –0.0320 0.0031 0.4003 FLOSS 1,545 0.0642 0.2452 0 0 1 DA 1,545 0.2831 0.2295 0 0.2568 6.0611 ADTR is adjusted revenue, which equals the sum of proposed audit adjustments and revenue protection amounts. RTNR is audit adjustments retained before claims. BI is pretax book income reported on the tax return. TI is taxable income before net operating loss and special deductions. BTINC is BI – TI. BT is federal tax expense less tax declared on the return. MTR is the marginal tax rate. PUB is a dummy variable which equals one if the firm is publicly held. PTS is audit points assigned by the IRS. NPPE is beginning depreciable property net of accumulated depreciation. ITC is investment tax credit claimed on the tax return. FORINC is foreign-source taxable income. FLOSS is a dummy variable which equals one if pretax book income is less than zero. DA is the beginning-of-year ratio of long-term debt to total assets. All financial variables above are scaled by beginning of year book value of total assets. (5) consolidated total tax expense explained by the most aggressive firms from Compustat (WWTOT). recording additional tax expense beyond the tax paid on the current return. All of the above measures are positively Future research will attempt to better and significantly correlated with audit understand the way estimates of tax adjustments. Note that U.S. current tax cushion map into IRS adjustments over expense is the financial statement time. measure which should most closely approximate taxes declared on the U.S. Regressions, not presented here, using corporate tax return. Differences will be either measure of book-tax differences due to estimation errors at the time of (BTINC or BT) indicate that proposed financial statement preparation, audit adjustments increase significantly additional tax planning after year-end in book-tax differences, at a rate of (such as pension funding decisions), approximately 10 to 20 percent. In possible consolidation differences, and either set of regressions, including year tax “cushion.” The tax cushion is the and firm fixed effects increases the provision for tax contingencies accrued standard error, but the results are still by the firm for probable and estimable significant. This is expected, since the liabilities to the tax authority. Thus, the pooled regression erroneously assumes positive association between USCUR that the firm-year observations are and ADTR or RTNR may be partly independent. Annual regressions, not 427
  • 8. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 NATIONAL TAX JOURNAL VOL. XLIX NO. 3 TABLE 2 public firms. Although audit adjust- POOLED CORRELATIONS OF PROPOSED AND ments are positively related to claimed RETAINED AUDIT ADJUSTMENTS WITH BOOK-TAX DIFFERENCES FROM TAX RETURN AND COMPUSTAT investment tax credits, they are nega- ADTR RTNR tively related to depreciable property. BTINC 0.21357 0.06802 0.00010 0.03210 Summary 1545 993 USBKTX 0.17721 0.15018 The results above show that IRS audit 0.00010 0.00010 adjustments increase as conformity 1085 699 between book and tax accounting WWBKTX 0.28931 0.16778 decreases. Work in process investigates 0.00010 0.00010 1085 699 how variation in incentives for book BT 0.27050 0.32525 income reporting versus tax savings is 0.00010 0.00010 related to the level of conformity. 1545 993 Preliminary results suggest that where USCUR 0.13758 0.15490 0.00010 0.00010 tax incentives are high relative to book 1081 695 incentives, book income is closer to WWCUR 0.18306 0.29118 taxable income; these results are 0.00010 0.00010 available on request. 1078 693 USTOT 0.36575 0.22938 0.00010 0.00010 The TRA 86 eliminated many provisions 527 313 which allowed taxable income to WWTOT 0.32340 0.36020 deviate substantially below book 0.00010 0.00010 income, such as rapidly accelerated 1078 693 depreciation, installment sales methods, Each cell has the following three entries: Pearson correlation coefficients and completed contract methods. Prob > |R| under Ho: Rho = 0 Deductions of accruals for tax purposes Number of observations. were restricted as well. Legislative ADTR is adjusted revenue; and RTNR is retained changes which strengthen conformity adjustments before claims. between book and tax accounting are BTINC is pretax income from tax return Schedule M-1 likely to induce higher tax payments less taxable income before Net Operating Loss (NOL). USBKTX (WWBKTX) is U.S. (consolidated) pretax from firms with greater incentives to income from Compustat less taxable income before report high book income. NOL. BT is federal tax expense from the tax return less tax declared on the tax return. USCUR, WWCUR, USTOT, and WWTOT are COMPLIANCE COSTS AND TAX Compustat amounts for U.S.current tax expense, SAVINGS consolidated current tax expense, U.S. total tax expense, and consolidated total tax expense, Introduction respectively, less tax declared on the tax return. This research measures the extent to which corporations reduce income taxes shown here, show a significant main by investing in discretionary tax compli- effect in most years. Public firms have ance costs.11 Recent efforts in measur- lower proposed audit adjustments, ing compliance costs for different tax consistent with the incentive of public regimes around the world have focused firms to report higher book income on the burden of compliance costs. For which lowers overall tax avoidance. In example, compliance costs by the separate tests, both univariate correla- (approximately) 1,500 Coordinated tions and multiple regression indicate Examination Program (large-case audit) that book-tax differences are larger for firms are estimated to total approxi- 428
  • 9. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING mately $2 billion in 1992 (Slemrod and The descriptive research on compliance Blumenthal, 1996). Although the full costs emphasizes the burden of compli- amount of compliance cost is a burden ance costs, with little attention to to society, analytical models and measuring any benefits from tax observation suggest that some costs planning. In contrast, the analytical may be voluntarily incurred by taxpayers research in tax evasion suggests an to generate tax avoidance. This incremental benefit of compliance costs research measures the extent to which in reducing taxes. My research bridges firms avoid taxes with planning and the empirical and analytical work. research costs. Data sources include compliance cost survey data (Slemrod Traditional models of taxpayer compli- and Blumenthal), tax return data, ance deal with evasion under conditions and Compustat financial statement of uncertain detection. The classical data. model of Allingham and Sandmo (1972) assumes that taxpayers maximize expected utility under uncertain Background and Hypothesis detection and known penalties. Cross Interest in compliance costs is relatively and Shaw (1981, 1982) suggest that recent and is reflected in the descriptive this model be expanded to include an nature of much of the existing re- expenditure for legal tax avoidance search.12 These studies compare the measures. Additional expenditures costs of compliance with various scale provide increasing opportunities for factors, such as taxes paid, sales, assets, avoidance, at an increasing marginal and employees. They conclude that cost and decreasing marginal benefit. compliance costs are regressive in that Slemrod (1989) includes the Cross and smaller taxpayers (as measured by any Shaw enhancement in the Allingham of these scale variables) pay higher and Sandmo framework. compliance costs as a percentage of the scale variable. These studies attempt to measure the source of the added In order to determine whether planning compliance costs, in order to provide costs will be effective, I consider the input to tax policymakers who might effect of complexity on tax avoidance. reduce the economic burden of tax Slemrod (1989) discusses the relation- collection. ship between complexity, compliance costs, and tax evasion. As a starting point, he argues that the total cost of Slemrod and Blumenthal (1996) study collection (including taxpayer compli- compliance costs incurred by large U.S. ance costs) is one index of complexity corporations. They seek to better in the tax law. However, in certain cases, understand sources of complexity in the added complexity may decrease tax law, particularly after the TRA 86. In compliance costs. For example, this study, respondent firms report that taxpayers may eliminate compliance compliance costs have increased since costs (in the short run) by not filing 1986 by an average of 77 percent. The returns. However, in the Coordinated firms also note major causes of compli- Examination Program firms considered ance costs: depreciation, alternative in this study, nonfilers generally do not depreciation, uniform capitalization for exist.13 In addition, taxpayers may inventories, and international tax eliminate compliance costs and lower matters. taxes through evasion, by choosing not 429
  • 10. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 NATIONAL TAX JOURNAL VOL. XLIX NO. 3 to report certain types or amounts of in compliance costs may represent income. Similarly, taxpayers may discretionary spending choices where eliminate compliance costs at the cost of the firm believes additional spending increasing taxes by foregoing certain may result in tax avoidance. Therefore, I deductions. The Compliance Cost hypothesize (in alternative form) the Survey reports some firms responding to following. increased complexity in the 1986 law by providing less accurate information to H2: Taxes paid are negatively associated the IRS. It is too soon to tell whether with discretionary compliance costs, all such a response lowers overall compli- else equal. ance costs for such firms or whether compliance costs will increase in the audit process as a result. Data Tax return and audit data are obtained Another aspect of complexity is uncer- from the Office of Special Studies, tainty. Some analytical research shows Corporate, of the IRS Coordinated that increased taxpayer uncertainty Examination Program (CEP). Compli- increases tax compliance (reducing ance cost data are obtained from the avoidance). Scotchmer and Slemrod Slemrod and Blumenthal survey of CEP (1989) model the expected utility firms. Although 365 firms responded to maximization problem where a risk- the confidential compliance cost survey, averse taxpayer is uncertain which of only 308 had sufficient identification to two tax payments is “correct.” The be rematched to IRS data. The IRS does result is that increased uncertainty not have access to the Compliance Cost induces increased compliance. Beck and Survey data nor do the survey firms Jung 1989 draw similar, although have access to IRS tax return and audit somewhat more limited, conclusions for data. All results are presented in the a continuous range of tax assessments. aggregate to protect the confidentiality of these data. Of these 308 matched Neither of the above models take into firms, 186 firms had U.S. sales, U.S. account the uncertainty the IRS has assets, and planning costs reported on regarding the correct tax liability, the the survey plus positive taxes reported infrequency with which penalties are on the tax return. Of these firms, 116 assessed or sustained, or the possibility could be matched to Compustat of lesser degrees of risk aversion at the financial statement information. large-corporation level. These effects suggest that complexity may result in greater tax avoidance. The general Tests argument for a positive association In order to test the hypothesis above, I between complexity and evasion/ regress taxes paid or tax expense on avoidance is that more complex tax law compliance costs. I control for exog- and economic transactions permit enous factors which determine taxes greater opportunities for planning. and nondiscretionary compliance costs. USASS is used as an exogenous variable Thus, although some increases in to explain tax expense and act as a compliance costs are caused by com- control variable for nondiscretionary plexity which does not provide tax compliance costs. The descriptive avoidance opportunities, other increases studies of compliance costs note that 430
  • 11. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING such costs increase with the size of the assets; and INDk are dummy variables firm. Another variable which relates to for IRS industry divisions. the complexity of the firm’s tax affairs is the number of pages in the return. United States assets, research, and PAGES therefore acts as an additional planning costs and pages in the tax control variable for nondiscretionary return are reported by the firm in the compliance costs. Compliance Cost Survey. The natural log of planning and research The regression assumes that firms are cost is added to the regression either each optimizing their choice of research singly or interacted with assets. These and planning costs, and, therefore, the variables capture the effect of tax coefficient on PLAN*USASS represents planning on the amount or the rate (on the firm’s opportunity for planning or sales) of tax paid. The log reflects the idiosyncratic preferences for planning expected decreasing rate of return on and tax aggressiveness. each additional dollar of planning. Finally, industry effects, interacted with Results assets, are added, in order to capture particular effective tax rates experienced There are 186 firms with available tax by separate industries. return data, planning expenses re- ported, and U.S. assets reported. The mean amount of tax planning expenses The hypothesis is tested using the in this sample is approximately following regression: $200,000, and the median is about $100,000. The mean is approximately one-third of one percent of mean taxes USCUR91i = β0 + β1PLANi + β2PLANi paid by such firms. Of this sample, 116 were matched to Compustat with U.S. * USASS + β3PAGEi + β4PLANi * FORi current tax expense available. About half of the firms are manufacturing, + βj INDk,i * USASS + βl P LANi * IND k,i with the next largest groups being * USASS + εi. financial services and public utilities or transportation. USCUR91 is the current portion of 1991 Preliminary results indicate that spend- U.S. tax expense from Compustat. ing on tax research and planning (TXPRR is the taxes declared on the reduces the rate of financial statement return from Statistics of Income data tax expense, or taxes paid, as a percent- and is used in alternate tests.) age of U.S. assets. The magnitude of the effect is greater for the subsample PLAN is the natural log of research and of public firms using financial statement planning costs (plus one) from the tax expense than for the full sample Compliance Cost Survey; USASS is U.S. using taxes paid from the tax return. assets reported by the firm; PAGE is the Preliminary industry effects indicate that number of pages in the tax return; FOR manufacturing firms and public utilities is the ratio of foreign assets to total have greater gains from tax planning. 431
  • 12. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 NATIONAL TAX JOURNAL VOL. XLIX NO. 3 Summary extent that the tax law, or the circum- Firms that spend more on tax research stances of the firm, generates uncer- and planning pay less tax than other tainty through complexity, discretionary firms. This does not suggest that other spending on tax planning and compli- firms would benefit from additional ance appears to benefit the firm. spending on tax planning. Each firm may be at its optimum due to the unique economic conditions and ENDNOTES applicable tax laws that apply to it. This paper is a brief extract of two essays However, it does suggest that not all of comprising my dissertation-in-progress. I the compliance costs incurred by firms appreciate assistance from my committee: Joel are without benefit. While compliance Slemrod, Russell Lundholm, Doug Skinner, and costs constitute an overall burden to the Roger Gordon. I also benefited from comments by workshop participants at the University of Arizona, economy, each firm’s shareholders may University of Chicago, University of Georgia, benefit from retaining additional value University of Iowa, Massachusetts Institute of within the firm rather than transmitting Technology, University of Michigan, Northwestern such value to the government in tax University, and University of Southern California. Internal Revenue Service personnel in the revenue. Future work will investigate Coordinated Examination Program, Office of the relationship of planning, appeal, and Foreign Business Studies, and Office of Special litigation costs to proposed and agreed Studies, Corporate, were especially helpful. I am adjustments by the IRS. grateful for the financial support of the Deloitte and Touche Foundation. 1 A large body of economics literature considers tax evasion by taxpayers. Although the tax Conclusions evasion literature often defines evasion broadly to include tax avoidance, it should be noted that Preliminary analysis suggests that IRS the IRS only refers to evasion in the context of audit adjustments increase as the excess illegal underreporting of net income with criminal of book income over taxable income implications. This literature models taxpayers as maximizing the expected utility of known increases. This finding is important in current taxes and probabilistic additional taxes understanding the friction between and fines. See Allingham and Sandmo (1972) financial reporting and tax incentives. If and Cross and Shaw (1983) for early tax evasion book income were irrelevant in the tax models. Graetz, Reinganum, and Wilde (1986) extend the classic treatment to an interactive audit process, then financial reporting model of IRS and taxpayer behavior. Feinstein need not be considered in tax policy. (1991) develops an econometric specification Tax regimes that require more book-tax using maximum likelihood estimation to conformity may result in firms with encompass both the detection process and the financial reporting constraints being evasion decision. 2 See Cloyd (1995) and Cummins, Harris, and more compliant with revenue-raising Hassett (1994). See also Kasanen, Kinnunen, and features and less responsive to incen- Niskanen (1995), who show significant tax effects tives regarding deductions. on financial income in Sweden where conformity is required by statute. 3 See Boynton, Dobbins, and Plesko (1992), Dhaliwal Second, there is preliminary evidence and Wang (1992), Gramlich (1991), and Manzon that firms that spend more on tax and Plesko (1995). research and planning pay taxes at 4 Most of the intertemporal or cross-jurisdictional lower effective rates. While not denying income shifting research on the TRA 86 assumed that compliance costs are an overall that book income shifting was equivalent to, or at least a necessary condition for, taxable income burden on the economy, it appears that shifting. See Scholes, Wilson, and Wolfson (1992), firms obtain private benefits from such Guenther, (1994), Maydew (1995), Klassen, Lang, costs relative to other firms. To the and Wolfson (1993), Harris (1993), and Harris et al. 432
  • 13. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 CORPORATE TAX COMPLIANCE AND FINANCIAL REPORTING (1993). See Guenther, Maydew, and Nutter (1995) returns. Therefore, tests conducted using RTNR as on cash versus accrual accounting for a context the dependent variable are considered preliminary where the degree of conformity may be better pending more complete data in the future. The predicted. results using RTNR with the tax measure of 5 For example, see Scholes, Wilson, and Wolfson conformity are qualitatively similar to tests with (1990), Beatty, Chamberlain, and Magliolo (1995), ADTR. However, results using RTNR with the and Collins, Shackelford, and Wahlen (1995). income measure of conformity are inconclusive. 6 U.S. Department of Treasury. Internal Revenue See Table 2 for correlations of ADTR and RTNR Service (1995). with book-tax differences. 7 For the public subsample, I can use Compustat 10 Although 90 percent of the firm-years are financial statement information to construct subjected to a full audit, about 10 percent of the conformity equal to U.S taxable income less returns are surveyed, which means they are domestic pretax income (net of current state tax accepted as filed after a preliminary review. In expense). See Table 2. order to remove the sample selection bias in the 8 The corporate tax return instructions are not ordinary least-squares regression, I employ a precise regarding which amount to report as book Heckman two-step estimation procedure. See income on Schedule M-1. A multinational Greene (1993) for further discussion. corporation might report worldwide book income, 11 Compliance costs are the costs of fulfilling the U.S. book income, or a composite amount which requirements of the tax law and include the costs approximates U.S. income plus repatriations, which of bookkeeping, research, planning, filing the tax would resemble the book income which is taxed in return, examination, appeal, and litigation. the United States. Depending on which starting 12 Interest by national governments in understanding income figure was chosen, reconciling items will be the burden of various tax regimes has resulted in included in the book-tax differences in Schedule funded research studies with cooperative access M-1. It is unknown to what extent the choice of to better data, beginning with Sandford’s 1973 book income reporting on Schedule M-1 is study of United Kingdom taxes. Sandford has strategic as opposed to being a function of the been involved in and has influenced a number accounting information system already in place at of compliance cost studies in multiple a firm. There is anecdotal evidence suggesting countries. either case. Since the U.S. federal tax expense is 13 Only 18 returns were not filed out of 13,327 likely to be net of foreign tax credits, the tax returns in 1981–91, a percentage of 0.136. expense figure will likely have less noise from the varied choices of reporting book income. 9 Proposed examination deficiencies only include changes to the current tax due. Some firms have REFERENCES such large net operating losses that proposed increases to taxable income do not result in current Allingham, M. G., and A. Sandmo. “Income increases in tax. 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  • 14. National Tax Journal Vol 49 no. 3 (September 1996) pp. 421-35 NATIONAL TAX JOURNAL VOL. XLIX NO. 3 Cloyd, C. Bryan, Jamie Pratt, and Toby Stock. Harris, David. “The Impact of U.S. Tax Law “The Use of Financial Accounting Choice to Revisions on Multinational Corporations’ Capital Support Aggressive Tax Positions: Public and Location and Income-Shifting Decision.” Journal Private Firms.” University of Texas Working of Accounting Research 31 (Supplement, 1993): Paper. Austin: University of Texas, 1994. 111–40. Collins, Julie, Douglas Shackelford, and Harris, David, Randall Morck, Joel Slemrod, James Wahlen. “Bank Differences in the and Bernard Yeung. “Income Shifting in U.S. Coordination of Regulatory Capital, Earnings and Multinational Corporations.” In Studies in Taxes.” Journal of Accounting Research 33 No. International Taxation, edited by Alberto 2 (Autumn, 1995): 263–91. Giovannini, R. Glenn Hubbard, and Joel Slemrod, 277–302. Chicago: NBER and University of Cross, R., and G. K. Shaw. “The Evasion- Chicago Press, 1993. Avoidance Choice: A Suggested Approach.” National Tax Journal 34 No. 4 (December, 1981): Kasanen, Eero, Juha Kinnunen, and Jyrki 489–91. Niskanen. “Dividend-Based Earnings Manage- ment: Empirical Evidence from Finland.” Cross, R., and G. K. Shaw. “On the Economics Helsinki School of Economics Working Paper. of Tax Aversion.” Public Finance 37 No. 1 Helsinki: Helsinki School of Economics, 1995. (1982): 36–47. Klassen, Kenneth, Mark Lang, and Mark Cummins, Jason G., Trevor S. Harris, and Wolfson. “Geographic Income Shifting by Kevin Hassett. “Accounting Standards, Multinational Corporations in Response to Tax Information Flow and Firm Investment Behavior.” Rate Changes.” Journal of Accounting Research Columbia University Working Paper. New York: 31 (Supplement, 1993): 141–73. Columbia University, 1994. Manzon, Gil, and George A. Plesko. “Self- Dhaliwal, Dan, and Shiing-wu Wang. “The Disclosure and Selection Bias in Studies of AMT- Effect of Book Income Adjustment in the 1986 Motivated Behavior.” Northeastern University Alternative Minimum Tax on Corporate Financial Working Paper. Boston: Northeastern University, Reporting.” Journal of Accounting and 1995. Economics 15 No. 1 (March, 1992): 7–26. Maydew, Edward L. “Tax-Induced Earnings Feinstein, Jonathan. “An Econometric Analysis Management by Firms with Net Operating of Income Tax Evasion and its Detection.” RAND Losses.” University of Chicago Working Paper. Journal of Economics 22 No. 1 (Spring, 1991): Chicago: University of Chicago, 1995. 14–35. Mills, Lillian F. “Two Essays in Corporate Tax Graetz, Michael J., Jennifer F. Reinganum, Compliance: 1) Book-Tax Differences and and Louis L. Wilde. “The Tax Compliance Internal Revenue Service Adjustments, 2) Game: Toward an Interactive Theory of Law Compliance Costs and Tax Savings.” Unpub- Enforcement.” Journal of Law Economics lished Ph.D. diss., University of Michigan, 1996. and Organization 2 No. 1 (Spring, 1986): Rice, Eric M. “The Corporate Tax Gap: 1–32. Evidence on Tax Compliance by Small Corpora- Gramlich, Jeffrey D. “The Effect of the tions.” In Why People Pay Taxes: Tax Compli- Alternative Tax Financial Statement Income ance and Enforcement, edited by Joel Slemrod, Adjustment on Accrual Decisions.” Journal of 125–61. Ann Arbor, MI: The University of the American Taxation Association 13 (Spring, Michigan Press, 1992. 1991): 36–56. Sandford, Cedric. The Hidden Costs of Greene, William. Econometric Analysis. 2d ed. Taxation. London: Institute for Fiscal Studies, New York: Macmillan Publishing, 1993. 1973. Guenther, David A. “Earnings Management in Scholes, Myron, G. Peter Wilson, and Mark Response to Corporate Tax Rate Changes: Wolfson. “Tax Planning, Regulatory Capital Evidence from the 1986 Tax Reform Act.” Planning, and Financial Reporting Strategy for Accounting Review 69 No. 1 (January, 1994): Commercial Banks.” Review of Financial Studies 230–43. 3 No. 4 (1990): 625–50. Guenther, David A, Edward L. Maydew, and Scholes, Myron, G. Peter Wilson, and Mark Sarah E. Nutter. “Tax Planning, Financial Wolfson. “Firms’ Responses to Anticipated Reporting and Book-Tax Conformity.” University Reductions in Tax Rates: The Tax Reform Act of of Chicago Working Paper. Chicago: University 1986.” Journal of Accounting Research 30 of Chicago, December, 1995. (Supplement, 1992): 162–85. 434
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