Academics have studied financial statements from the late 1980s, looking for a shift in corporate earnings due to the 1986 tax overhaul — and many claim they have found it. (AP Photo/Mark Lennihan)
Faced with the administrative complexity and potential for unintended consequences, Congress ultimately included the measure in the 1986 federal tax overhaul, but set it to expire three years later. Many tax and accounting experts say the episode highlights the difficulty of linking financial reporting and the tax code.
"It sounds easy to do, but it's actually extremely complicated to do, because book and tax are so different," said Michelle Hanlon, a professor of accounting at Massachusetts Institute of Technology.
President Joe Biden has yet to provide specific details about his proposal, which was outlined in the Made in America tax plan released by the White House on March 31. The proposed 15% minimum tax on large corporations' book income, according to the plan, would ensure that companies cannot exploit loopholes in the tax code and would backstop the tax plan's other ambitious reforms and apply only to the largest corporations.
Sen. Elizabeth Warren, D-Mass., pushed for a 7% tax on reported corporate profits during a recent Senate hearing, repeating a policy she proposed during her 2020 presidential campaign.
"Corporations will never stop trying to bend the rules. You know, when you plug one loophole, they're going to bring in armies of lawyers, and lobbyists and accountants to try to find another one," Warren said during the March 25 hearing. "A small tax on profits — like the number that CEOs like to brag about: their book profits — would ensure that even the companies that are most skilled at gaming the tax code would have to contribute a fair share."
In recent years, many companies have used deductions and exemptions in the federal code, including those created by the 2017 Tax Cuts and Jobs Act , to achieve low effective tax rates, or in some cases to eliminate tax payments altogether. In that context, a tax that disregards those reductions and looks only to earnings reported to shareholders or investors can seem like a simple, intuitive policy with clear political appeal.
In 1986, the same factors — including a media spotlight on companies' low tax bills — led the Senate to pass legislation that included an alternative minimum tax with an adjustment for "business untaxed reported profits," or book income. But a backlash about administrative difficulty and potential unintended consequences showed that the issue was much more complex than the simple rhetoric.
"The proposal was very controversial, especially with tax lawyers that were upset with the tax law being based on income reported in financial statements," said J. Richard Harvey, a professor at Villanova University Charles Widger School of Law, who helped write regulations at the U.S. Treasury Department on the 1986 alternative minimum tax.
Critics claimed it could unfairly tax companies that aren't involved in avoidance but see a disconnect in financial statement and taxable income due to timing differences in how both systems recognize costs and revenues. Congress would also negate the impact of tax preferences it had previously put into the code, undermining its own policies.
And the tax could lead companies to depress earnings in the hopes of reducing tax payments in the alternative regime, or getting out of it entirely. This result would not only refute the notion that book income is a sturdy backstop to the tax code, but it could also affect information in financial statements. With less reliable data at their disposal, investors would be less certain about choices they are making, inserting a widespread and pernicious distortion into the financial markets, critics claimed.
A version of the tax overhaul passed by the House of Representatives did not include the book income provision. As a compromise, the conference committee tasked with combining the two bills only enacted it for three years, with an expiration set for 1989. After that, it would change into a new calculation based on adjustments to taxable income, which remained in the code until Congress repealed the corporate alternative minimum tax in 2017. The 1986 law also directed Treasury to review the book income provision upon its expiration and make recommendations to Congress about whether to consider extending it.
According to the Joint Committee on Taxation's "General Explanation of the Tax Reform Act of 1986," released in May 1987, Congress wanted to achieve real and apparent fairness by ensuring that "whenever a company publicly reports significant earnings, that company will pay some tax for the year."
"Congress concluded that it was particularly appropriate to base minimum tax liability in part upon book income during the first three years after enactment of the Act, in order to ensure that the Act will succeed in restoring public confidence in the fairness of the tax system," the JCT stated.
In 1989, Congress declined to extend the provision, with most accounting and tax law groups — as well as Treasury — opposed to the policy.
"The book income adjustment may be having a detrimental effect on the quality of financial reporting," acting Assistant Secretary for Tax Policy John Wilkins said during a 1989 House Ways and Means Committee hearing, according to the congressional record. "We would generally be opposed to making the book income adjustment permanent."
In the years since, academics have studied financial statements from the three-year period looking for a shift in earnings due to the tax rules — and many claim they have found it. In a forthcoming paper by Hanlon of MIT, she notes that five studies in the early 1990s found evidence that the 1986 tax law caused companies to reduce their earnings.
Dhammika Dharmapala, a professor at University of Chicago Law School, estimated in a 2020 paper that the minimum tax caused a 17% decline in earnings. Rather than a dependable measuring stick, financial statements may be even more responsive to tax changes than taxable income, because of the subjectivity and leeway in reporting, he argued.
Others claim that these shifts are exaggerated because of the policy's short-term expiration. Companies had little to lose if they could put off profits by a few years.
"It's not unusual for tax provisions to cause timing shifts," said Michael Graetz, a professor of tax law at Columbia Law School. "I really would be surprised if there were major shifts that allowed companies to depress their earnings."
Graetz, who testified in favor of the book income provision in congressional hearings for the 1986 overhaul, also noted that most companies engaging in profit-shifting do so in a way that doesn't hurt earnings.
"If it comes down to a choice between a lower stock price and a little higher payment to the government, I think the managers are going to keep the stock price up," he said. "I think this is a useful tension."
Today, Congress and the White House face many of the same questions that policymakers wrangled over in 1986. Biden often blasts the largest U.S. companies, such as Amazon.com Inc., for allegedly shirking their tax responsibilities. But at the same time, critics worry that intertwining the two spheres could create undo complexity and administrative nightmares. It could also negate provisions helping the U.S. climb out of the recession caused by the coronavirus, such as incentives for research and development and the immediate expensing of new investments.
And aside from concerns about distorted financial reporting, some wonder if linking taxable income and financial reporting will cause Congress to interfere more in accounting rulemaking. This would not only harm reporting, but would work against the policy's goal of protecting the tax code from interference by congressional interests.
Currently, the generally accepted accounting principles used by the U.S. Securities and Exchange Commission are created by the Financial Accounting Standards Board, a nonprofit organization whose members are chosen by accounting, business and government organizations. If its rules are also used to apply taxation, it could become subject to intense lobbying and pressure from Congress over various aspects of the code.
"FASB was set up to be separate from the government for a reason," Hanlon said. "That was to, as much as possible, make sure the earnings numbers are reported to reflect economics, not subject to whatever Congress wants to do with the reporting."
In her forthcoming paper, Hanlon noted that two small provisions in the Coronavirus Aid, Relief and Economic Security Act explicitly allowed some companies to ignore GAAP rules relating to bad debt and losses during early 2020. She wondered if those provisions, while understandable during an economic crisis, were a signal of further congressional meddling in financial accounting in the future.
"Such actions support the argument that Congress would likely exert even more influence over accounting standards in the case of book-tax conformity," she stated. "If Congress is willing to intervene now with portions of GAAP that do not even affect government tax revenues, it seems very likely to be willing to intervene when doing so would affect government revenues."
--Editing by Tim Ruel and Neil Cohen.
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