Kylie Jenner allegedly falsified information in order to appear wealthier than she really is. Joe Biden wants to impose a tax based on the financial accounting earnings of corporations (in addition to their taxable income). What do these two facts have in common? It turns out, a lot.
Jenner allegedly provided fraudulent tax returns to Fortune which made her appear wealthier than she really is. For whatever reason, Fortune has become the arbiter of who the wealthiest people in the world are, and, for people like Jenner, who are mostly famous for being famous, being on that list is a big deal. This is why Donald Trump allegedly lied to Fortune to get on the Fortune 400 list. People who seek attention want Fortune to think they are rich, which results in the Jenners and Trumps of the world allegedly lying to make themselves look richer than they really are.
There are many reasons to prove the extent of our income or our assets, but, interestingly, these different reasons provide different incentives to look either “rich” or “poor.”
Let’s take a concrete example. Imagine a Louisiana fisherman. When he files a tax return every year, he has incentives to minimize his tax bill every year by understating (illegally or not) his income; he wants to look poor. But when the Deepwater Horizon oil spill happens, compensation to injured fisherman is based on how much income he can substantiate, so he wants to show that he made as much money as possible in order to maximize the compensation he receives. (This actually happened. Fisherman who had simply not filed returns struggled to prove they had lost income as a result of the spill).
Likewise, when this fisherman wants a loan to buy a new boat he will want to appear as rich as possible and will provide the bank with documents supporting those riches. That same incentive exists when the fisherman gets lonely and goes out looking for a bride. He will buy the fanciest car and nicest clothes, and court his lady with the nicest meals possible, all to signal his wealth.
But, when she is fed up with him, and he is working through divorce and child support proceedings, he will want to appear as poor as possible, in order to minimize the amount he has to pay out in a settlement. It’s tough being a fisherman — sometimes you have to try to look very rich, and sometimes very poor.
Corporations are no different. Every quarter they want shareholders to perceive them as doing well financially. They want financial accounting earnings (also called book earnings) that are high, that beat analysts’ forecasts, that are increasing, that are smooth and that make the company look successful. But when unions come in and say their members are under-compensated, the corporations will want to appear poorer. If you are looking to the government to provide import relief, you want to look like you are struggling and need the relief.
Different reporting systems have different reporting incentives. Which leads us to Joe Biden’s proposal to use financial accounting earnings as a basis for taxing corporations. Public companies want to appear rich to their shareholders and poor to the IRS. They want to report high earnings per share (EPS) in their quarterly financial reports to shareholders, but low taxable income on their annual tax return sent to the IRS. Like many before him, the former vice president takes this mismatch in reporting incentives and proposes the seemingly ingenious plan to simply levy a tax based on the financial accounting number (the one companies want to be as high as possible).
If the same number is the basis of a tax, and a report to shareholders, then if companies want to report a high number to shareholders, they will have to pay more in tax. Or, if they want to report a low number to the IRS to pay less in tax, they will have to disappoint shareholders. The analog would be to force Kylie Jenner to pay taxes on those fraudulently inflated tax returns she reported to Fortune. Balance (seemingly) achieved!
Using the conflicting incentives of the two reporting systems seems like an ingenious way to force honesty in both systems. It would seem that way, but it is not. Why? Because just as the tax accounting system and the financial accounting system have differing incentives for corporations, they have different motivations. The financial accounting system’s objective is to reflect the actual underlying economics of the firm — how is the company actually doing, and should you buy its stock (or bonds, etc.)? The tax system has a lot of objectives, none of which is to inform shareholders whether they should buy a stock or reflect the economic reality of the firm. The tax system is meant to serve as a basis for collecting revenue and for motivating companies to do things that
Congress thinks they should do (invest in research and development, manufacture domestically, etc.). The two systems have completely different reasons for existing, and using one system in place of the other defies its reason for existing.
Back to the Louisiana fisherman example, it would be like the bank blindly looking at the fisherman’s tax return and noticing that he had no income because the tax system had allowed him a large tax deduction that dramatically reduced his taxable income. If he had purchased a new boat, immediate expensing will make his business look much poorer than if he had prepared GAAP financial statements for the business. GAAP financial statements attempt to look at the actual economic health of the business (a similar thing to what the bank is interested in), whereas the tax code, by allowing for immediate expensing, is trying to incentivize investment and ease record keeping. The two systems have different purposes, and the banker who noted the small taxable income number would be making a mistake by not loaning to the thriving fisherman, just because he had recently bought a new boat and taken advantage of immediate expensing.
There are many other problems with taxing book income, which I have previously highlighted here and here. In short, taxing book income would also distort financial accounting income, as companies manipulate it to lower their tax bill, and you will no longer be able to use earnings as a reliable measure of how a company is doing, eliminating an invaluable signal to the financial markets. Instead, companies will start to report more frequently and depend more heavily on pro-forma earnings numbers, so, they will be governed by no accounting standard. As the financial accounting standards become the basis of tax, Congress may feel obliged to politicize the Financial Accounting Standards Board (the creators of the financial accounting standards), which is a very bad idea.
These proposals to tax book income are trying to co-opt a functional system (the system for creating financial accounting rules) because the system that creates our tax code, Congress, is currently dysfunctional. Rather than write a tax code that achieves desired objectives, proposals like Biden’s sidestep the real problem, that Congress is dysfunctional, by trying to use an existing and functioning system. But by co-opting this system, it would degrade the quality of accounting numbers, numbers our capital market system depends on to efficiently allocate capital.
Given all these issues, it should not come as a surprise, then, that when I surveyed tax accounting professors, every single survey respondent thought that a related plan to tax book income was a bad idea.
Jeff Hoopes is an associate professor of accounting at the University of North Carolina’s Kenan-Flagler Business School.