Write-Off: The Tax Blog

Biden Piles On! Some Thoughts on Taxing Book Income

Thursday December 5, 2019 • Jeff Hoopes, UNC
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Senator Warren has proposed a tax on book income, which I have discussed on this blog previously (and which I found it impossible to find an financial accounting scholar who would support the idea). Recently Democratic presidential candidate Joe Biden proposed several different corporate tax ideas, one of which was, just like Senator Warren, a tax based on book income. Some details are different, but, the general idea is identical–some firms that are profitable for financial accounting purposes pay no taxes, and that feels bad. So apply a tax to financial accounting income for firms above some threshold.

The major arguments against taxing book income are outlined here, in a piece I wrote with Michelle Hanlon about Warren’s plan. The upshot is that book income and taxable income have very different goals. If you think taxable income, what we pay taxes on, is broken, fix it. Don’t tax book income, which will end up breaking it.

As I wrote that piece, I had many other thoughts, and more more details, that were left on the editing room floor. Here they are:

  1. The proposal implies that something is “wrong” with taxable income. For example, one might believe that the current calculation of taxable income does not reflect a desirable tax base. If you believe corporations are not paying enough in tax because, for example, NOL carryforwards allow them to not pay tax after having failed to generate positive taxable income in a prior year (which is what produces MANY of the zero tax liabilities that show up on corporate tax returns), then taxing book income would be a way to indirectly eliminate NOL carryforwards. Or, you could just explicitly eliminate or limit NOL carryforwards. The latter is much more direct, efficient, etc.
  2. There are principled reasons to believe that the calculation of taxable income could be improved upon. For example, many serious and adept people who understand corporate taxation believe that some features of our tax code are more motivated by politics than motivated by the efficient collection of revenue. However, removing these inefficiencies directly seems much more desirable than indirectly by taxing book income because of the potentially negative spillover effects on book income (which I detail later). If the base is broken, fix the base. Don’t break something else.
  3. U.S. capital markets are respected and trusted worldwide. This respect comes from a relatively sound and competent set of securities regulations, excellent financial accounting standards, auditing standards, trust, a sound judicial system, etc. Trying to fix perceived failures in the tax code by taking actions which may have negative spill-over effects on a key element of our robust capital markets – financial accounting standards – seems inadvisable.
  4. A desirable tax has the feature that it is imposed when the taxpayer has cash to be able to remit the tax. For example, of the many reasons we only tax realized capital gains is because taxpayers actually have cash available to remit their tax liability upon realization. This new proposed tax would, at times, impose a tax when firms do not have the cash to remit it. Financial accounting earnings do not necessarily mean positive cash flows, and as a result, the tax may impose a liability on firms without cash to remit.
  5. A corporate alternative minimum tax (AMT) has been a feature of the tax code for some time, but this feature was eliminated with the TCJA. One criticism of the corporate AMT was that it was complex and required firms to keep two (or more) sets of books.  This criticism would not apply to this new proposal, as the new tax base being taxed is already calculated for firms preparing GAAP financial statements. However, there are other features of the recently eliminated AMT that are similar to this tax. In particular, in the recently eliminated version of the AMT, one adjustment that was made to taxable income was for adjusted current earnings (ACE).
  6. The treatment of book losses is extremely important in corporate tax in general, and for this proposal, and so far, no proposal has outlined how to deal with them. If not dealt with in some way (which may well allow many firms with accounting profits to not pay tax), this proposal is tantamount to the partial elimination of net operating tax loss carryforwards, a system that makes economic sense, is near-universally accepted worldwide by other countries, and is accepted in many U.S. states. Many firms that pay no income tax in a year do so because they are carrying forward tax losses. These tax systems could certainly adjust for NOLs, but no detailed plan put forth by Biden or Warren has suggested doing that.
  7. Aside from effectively eliminating the value of NOLs as we know them, one concern is that this tax would be levied on firms with recent NOLs—firms that might be economically challenged, financially constrained, and not in a good position to bear the tax.
  8. The scope of the tax is a challenge, as not all firms prepare GAAP financial statements. There are tax disclosures that are contingent upon filing GAAP financial statements, but I know of no (current) tax that is levied contingent upon having GAAP audited financial statements. Taxing the use of GAAP seem troubling if we believe GAAP financial statements help investors understand the economic reality of the firm better than other systems of accounting.
  9. An explicit tax on book tax differences (the “book income adjustment”) was once a feature of the Corporate AMT under IRC §56. It was eliminated for many reasons, but partly because of the challenge of imposing tax on those that do not prepare GAAP audited financial statements.
  10. The treatment of foreign companies would be challenging, as it was a challenge under the old book income adjustment. Depending on how foreign companies are taxed, this new proposal may provide increased incentives for U.S. firms to expatriate. Regulating U.S. expatriations in response to this increased incentive would add frictions to the M&A market, make foreign acquisitions of U.S. companies more difficult and generally makes the market for corporate control less efficient.  This market does much to discipline corporate behavior and distorting it could have far reaching effects.
  11. This tax imposes an extreme version of worldwide taxation on U.S. firms. This is a system of taxation which the rest of the world has eschewed, and which recently the U.S. (at least partially) moved away from. Based on Biden’s interest in doubling the GILTI rate, this may not concern him, but it is a departure from current norms in international taxation.
  12. This proposal would place much more pressure on independent auditors as they conduct financial statement audits, as not only would the earnings communicated to the market be at stake in the audit, but also the tax liability of the firm, as the financial auditor would be auditing part of the tax base.
  13. The proposal would disproportionately affect public firms over private firms, as capital market pressure would encourage private firms to simply book less GAAP earnings as a way of avoiding the tax. Public companies have very different incentives, abilities, and levels of tax sophistication than private firms. As a result, the proposal would increase the cost of going public. Evidence suggesting that fewer firms are going public coupled with the fact that investment in private firms is much more difficult (if possible) for most Americans, such a proposal would exacerbate the disparity between investment opportunities available to the wealthy versus other Americans.
  14. If applied to private C-corps and not pass-through entities, this may change entity choice considerations.
  15. Prior criticism of conforming book income to tax income to reduce corporate incentives to engage in tax planning was that conforming book income to taxable income would result in information loss to the markets (Hanlon et al. 2005; Hanlon and Shevlin 2005; Hanlon 2005). Taxing book income would have the same result as companies manage their book income for tax purposes and information is lost as a result.
  16. The proposal gives enormous power to the FASB. Historically, the FASB is broadly assumed to be apolitical and unbiased (for a different view, see here). However, I see of no legitimate way one could keep the FASB from becoming a political body, which would degrade the quality of financial reporting, and as a result, could have effects on the efficiency and strength of American capital markets. More than 45 other accounting professors agree we should not politicize the FASB.

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