The book tax gap is an unfortunate result of the many arcane aspects of the tax code that few ordinary people know much about, but is extremely lucrative for those who do. The basic explanation is that the law allows a system of dual accounting that companies effectively use to practice two different accounting methods, one for reporting taxable income, and another for reporting revenue to investors. This is a questionable idea on the face of it, however, courts have upheld and even strengthened this practice through their rulings.
As companies are clearly interested in maximizing earnings, minimizing taxes paid to the government is perfectly understandable. Companies will choose two different accounting practices to achieve the maximum benefit. This current system of producing differing statements of income to investors and to tax authorities is ripe for exploitation. Corporations are never forced to choose the accounting standard that most accurately reports their income. Investors get the rosiest possible picture, while the government gets a more dubious version.
Despite increasing corporate tax rates and profits, corporate tax revenue has fallen sharply as a percentage of GDP from 1965 to today (Auerbach 8). Some large corporations haven't paid any taxes in years, including GE, Pfizer and the other pharmaceutical giants. The US Treasury’s 1999 white paper listed “lack of economic substance” and “inconsistent financial and [tax] accounting treatment” as the first two “common characteristics” of a corporate shelter (Whitaker 12). Essentially, by taking advantage of "tax preferred" items, many corporations can reliably reduce tax liability to zero.
Most companies use these dual standards without committing any fraud. More worrisome is the ease with which companies can use these standards to obfuscate their accounting, fool auditors, and commit outright fraud. As Wall Street Journal columnist Alan Murray has remarked, “lying to shareholders and lying to the IRS are just opposite sides of the same coin." Pressing the boundaries in one direction makes people think about the boundaries in the other (book and tax accounts). As anyone can see from the accounting scandals of Enron, WorldCom and others, very sophisticated companies can make their financial statements extremely difficult to decipher with creative accounting. The 2003 Joint Committee on Taxation report on the investigation into Enron’s book-and-tax accounting revealed that book-tax differences were critical to Enron’s financial misrepresentations (Whitaker 13).
Tax preferences create tax shelters which contain huge hidden costs. First, "By enabling firms to shelter book income from the IRS, the Code essentially gives corporations interest-free loans financed by the federal government—and ones that they will often never repay" (Whitaker 14). Second, the system is regressive, effectively taxing small and medium businesses at a higher rate. Finally, the cost of complying with the tax code is tax deductible, so the government also subsidizes creative accounting.
One solution is to choose a single accounting standard to apply to both financial and tax accounting. In a survey of hundreds of U.S. tax executives conducted a decade ago, a “significant number” of respondents endorsed book-tax conformity along book-income lines (Whitaker 18). Companies would be forced to report the same income and earnings to both the federal government, and to their investors. This would simplify compliance, and reduce losses from the system dramatically (Whitaker 33). This would also encourage corporations to report the most realistic number. They wouldn't want to overstate income because then they'd have to pay taxes on money they didn't earn, and they would want to understate their income because their stock price would decline. This solution offers more accuracy and transparency, something investors would certainly welcome.
On the other hand, the more radical solution of eliminating corporate income taxes altogether would solve the problem in an extremely simple manner. Since these taxes are only 6-10% of tax revenue, the loss in taxes could be replaced by a small VAT, or a small excise tax on all imports, etc, taxes that are more difficult to evade. This policy has numerous other indirect benefits. Businesses would still be taxed, but at a lower, flat rate, eliminating the subsidy for big business, helping small business compete. In addition, international corporations would be encouraged to headquarter in the US, where they could pay lower taxes, bringing more profits from abroad here. Though big business would now be forced to pay taxes, they would have a hard time lobbying against a flat tax that taxes all corporations equally, increasing the likelihood that this policy could succeed politically.
What do you think? Keep the current system, keep a corporate tax but make it simple, or eliminate it altogether?
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Sources:
Whitaker, Celia "Bridging the Book-Tax Accounting Gap" Yale Law Review, 2005. http://www.yalelawjournal.org/pdf/115-3/Whitaker.pdf
Auerbach, Alan J. "Why Have Corporate Tax Revenues Declined? Another Look" 2006. http://elsa.berkeley.edu/~auerbach/AJA_CESifo_revised.pdf
