CONTENTS LIST OF CONTRIBUTORS
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EDITORIAL BOARD
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AD HOC REVIEWERS
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AIT STATEMENT OF PURPOSE
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THE EFFECT OF EXPORT TAX INCENTIVES ON EXPORT VOLUME: THE DISC/FSC EVIDENCE B. Anthony Billings, Gary A. McGill and Mbodja Mougoué
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IMPLICATIONS OF BENCHMARK STATE AND LOCAL TAX RATES FOR MEASURES OF ESTIMATED IMPLICIT TAXES Bradley D. Childs
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TAX ADMINISTRATION PROBLEMS: GAO-IDENTIFIED SHORTCOMINGS AND IMPLICATIONS Philip J. Harmelink, Thomas M. Porcano and William M. VanDenburgh
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IMPLICIT TAXES AND PROGRESSIVITY Harvey J. Iglarsh and Ronald Gage Allan
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THE ASSOCIATION OF CAREER STAGE AND GENDER WITH TAX ACCOUNTANTS’ WORK ATTITUDES AND BEHAVIORS Suzanne Luttman, Linda Mittermaier and James Rebele
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THE DETERMINANTS OF STAFF ACCOUNTANTS’ SATISFACTION WITH SERVICES AT KOREAN DISTRICT TAX OFFICES Tae sup Shim
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TAX POLICY EFFECTIVENESS AS MEASURED BY RESPONSES TO LIMITS PLACED ON THE DEDUCTION OF EXECUTIVE COMPENSATION Toni Smith
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LIST OF CONTRIBUTORS Ronald Gage Allan
Office of Student Financial Services, Georgetown University, USA
B. Anthony Billings
Department of Accounting, Wayne State University, USA
Bradley D. Childs
College of Business Administration, Belmont University, USA
Philip J. Harmelink
Department of Accounting, University of New Orleans, USA
Harvey J. Iglarsh
McDonough School of Business, Georgetown University, USA
Suzanne Luttman
Leavey School of Business, Santa Clara University, USA
Gary A. McGill
Fisher School of Accounting, University of Florida, USA
Linda Mittermaier
Accounting Department, Capital University, USA
Mbodja Mougou´e
Department of Finance and Business Economics, Wayne State University, USA
Thomas M. Porcano
Department of Accountancy, Miami University, USA
James Rebele
Rauch Business Center, Lehigh University, USA
Tae sup Shim
Department of Tax and Accounting, Incheon City College, South Korea vii
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Toni Smith
Department of Accounting and Finance, University of New Hampshire, USA
William M. VanDenburgh
Department of Accounting, Louisiana State University, USA
EDITORIAL BOARD EDITOR Thomas M. Porcano Miami University ASSOCIATE EDITOR Charles E. Price Auburn University
Kenneth Anderson University of Tennessee, USA
Beth B. Kern Indiana University-South Bend, USA
Caroline K. Craig Illinois State University, USA
Suzanne M. Luttman Santa Clara University, USA
Anthony P. Curatola Drexel University, USA
Gary A. McGill University of Florida, USA
Ted D. Englebrecht Louisiana Tech University, USA
Janet A. Meade University of Houston, USA Daniel P. Murphy University of Tennessee, USA
Philip J. Harmelink University of New Orleans, USA
Charles E. Price Auburn University, USA
D. John Hasseldine University of Nottingham, England
William A. Raabe Ohio State University, USA
Peggy A. Hite Indiana University-Bloomington, USA
Michael L. Roberts University of Alabama, USA
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David Ryan Temple University, USA Dan L. Schisler East Carolina University, USA
Toby Stock Ohio University, USA
AD HOC REVIEWERS James R. Hasselback Florida State University, USA
Robert C. Ricketts Texas Tech University, USA
Ernest R. Larkins Georgia State University, USA
Patrick J. Wilkie George Mason University, USA
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STATEMENT OF PURPOSE Advances in Taxation (AIT) is a refereed academic tax journal published annually. Academic articles on any aspect of federal, state, local, or international taxation will be considered. These include, but are not limited to, compliance, computer usage, education, law, planning, and policy. Interdisciplinary research involving, economics, finance, or other areas is also encouraged. Acceptable research methods include any analytical, behavioral, descriptive, legal, quantitative, survey, or theoretical approach appropriate for the project. Manuscripts should be readable, relevant, and reliable. To be readable, manuscripts must be understandable and concise. To be relevant, manuscripts must be directly related to problems inherent in the system of taxation. To be reliable, conclusions must follow logically from the evidence and arguments presented. Sound research design and execution are critical for empirical studies. Reasonable assumptions and logical development are essential for theoretical manuscripts. AIT welcomes comments from readers. Editorial correspondence pertaining to manuscripts should be forwarded to: Professor Thomas M. Porcano Department of Accountancy Richard T. Farmer School of Business Administration Miami University Oxford, Ohio 45056 Phone: 513 529 6221 Fax: 513 529 4740 E-mail:
[email protected] Professor Thomas M. Porcano Series Editor
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THE EFFECT OF EXPORT TAX INCENTIVES ON EXPORT VOLUME: THE DISC/FSC EVIDENCE B. Anthony Billings, Gary A. McGill and Mbodja Mougou´e ABSTRACT This article examines the sensitivity of U.S. exports to the availability of export incentives offered under the Domestic International Sales Corporation (DISC) and the Foreign Sales Corporation (FSC) provisions of U.S. tax law. Evidence on the efficacy of export tax incentives is mixed. The history of the DISC/FSC tax incentives provides a natural experiment to address the question of the effect of tax incentives on export volume. We examine the relation of U.S. export volume to the availability of these export tax incentives from 1967 to 1998, controlling for product class and important macroeconomic variables, and find evidence of a positive association between the level of U.S. exports and the existence of the export incentives offered under the DISC/FSC provisions. However, this association depends on product type. Our findings using actual export data are independent of otherwise available data demonstrating a general growth in the use of DISC/FSC entities and the sales volume of these entities. The latter data suffer from an interpretation problem because changes in the number of special export entities used and their sales volume do not necessarily correlate with changes in actual export levels over time. The approach we use in this study is an attempt to overcome
Advances in Taxation Advances in Taxation, Volume 15, 1–28 © 2003 Published by Elsevier Ltd. ISSN: 1058-7497/doi:10.1016/S1058-7497(03)15001-6
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this limitation. The reported results have implications for both tax policy regarding the design of export tax incentives and the European Union’s claim that U.S. export tax incentives have damaged U.S. competitors in foreign trade.
1. INTRODUCTION Research suggests that national governments can help private industry increase its global market share of products under imperfectly competitive market conditions. The set of available governmental actions includes: (1) imposing tariffs on imports; (2) funding technological innovation; (3) forming export cartels; and (4) offering export incentives.1 This article examines the sensitivity of U.S. exports to the availability of export incentives offered under the Domestic International Sales Corporation (DISC) and the Foreign Sales Corporation (FSC) provisions of U.S. tax law. Evidence on the efficacy of export tax incentives is mixed. U.S. critics argue that such provisions constitute an unwarranted tax benefit to U.S. exporters with little or no real contribution to improving the U.S. balance of trade position. Conversely, the European Union (EU) has long argued that these tax incentives represent an illegal trade subsidy and that their existence has damaged U.S. competitors in world trade. In the midst of this ongoing controversy regarding the influence of export tax incentives, very little research has addressed the relation of these U.S. tax incentives to actual export activity (as opposed to growth in the use of these tax-favored export entities).2 The history of the DISC/FSC tax incentives provides a natural experiment to address the question of the effect of tax incentives on export volume. We examine the relationship of U.S. export volume to the availability of these export tax incentives for the time period 1967–1998, controlling for product class and important macroeconomic variables. The results provide evidence on whether U.S. tax policy has assisted the U.S. private sector in maintaining or increasing its export market share. We find evidence of a positive association between the level of U.S. exports and the existence of the export incentives offered under the DISC/FSC provisions. However, this association depends on product type. The remainder of this article is organized as follows. Section 2 provides an overview of the DISC/FSC provisions and a review of the literature that provides a framework for examining our research question. We define the research variables in Section 3, describe the method of analysis in Section 4, and present the results in Section 5. Section 6 provides sensitivity tests, and Section 7 concludes the paper.
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2. BACKGROUND 2.1. DISC/FSC Provisions In the late 1960s, the United States faced declining productivity for exported staples and a concomitant deteriorating trend in its trade balance with major trading partners. Numerous legislative proposals were introduced in the U.S. Congress to deal with this eroding trade position. The DISC legislation eventually became law in 1971, with the hope that this special tax benefit would stimulate the export of U.S.-produced goods.3 The U.S. trading partners almost immediately reacted negatively. To address the complaints filed by the General Agreement on Tariffs and Trade (GATT), the DISC was essentially abandoned in 1984 and replaced with the FSC regime.4 In 1999, the World Trade Organization (WTO), the successor to the GATT, was successful in requiring that the United States repeal the FSC provisions. In 2001, the U.S. Congress developed a replacement for the FSC (the “extraterritorial income exclusion” regime) only to have this new provision successfully challenged by the EU in 2001. By the end of 2002, the United States faced a call to repeal the extraterritorial income exclusion regime. The DISC was essentially a U.S. “paper” corporation serving as an alter ego of its U.S.-related supplier or principal. The DISC granted tax-deferral privileges to U.S. manufacturers that directly exported U.S.-produced goods. The DISC incentive was intended to aid U.S. exporters competing with foreign exporters that operated under a territorial system of taxation or a value added tax system (VAT). As such, the DISC was structured specifically to address export incentives offered by the U.S. trading partners. Congress intended that the export tax incentive would increase exports of U.S.-produced products. In turn, the increased exports were expected to produce: (1) increased employment in the affected U.S. industries; (2) stabilization of the U.S. dollar against foreign currencies; and (3) increased U.S. workers’ productivity.5 In this regard, the cost of the DISC program in terms of lost tax revenue was considered a small price to pay for the achievement of the aforementioned benefits. Soon after the passage of the DISC legislation, several problems arose with respect to its provisions. First, competing foreign countries argued that the DISC incentives were an illegal export incentive under Article XVI of the GATT. Second, some U.S. businesses and policy makers argued that the DISC provisions favored large companies or specific types of industries and were merely a tax shelter. Third, estimates of additional exports generated by the DISC incentives varied widely.6 Fourth, the DISC legislation was met with disdain by EU members that subsequently launched a formal request to GATT calling for the United States to remedy alleged violations of GATT (Jackson, 1978). According to the
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members, under Article XVI of GATT, a member contracting party such as the United States is precluded from providing a tax incentive for exports without granting a similar incentive to domestic sales (Jackson, 1978).7 In 1976, responding to the aforementioned concerns, the GATT Council formally established a panel to evaluate the DISC with respect to Article XVI of GATT. Although not yet committed to modifying the DISC on a significant basis, in 1976 the United States altered the mechanism by which the tax benefit under the DISC was calculated.8 However, this change appeared cosmetic to the EU member countries and the GAAT Council. Consequently, in December 1981, the GATT panel adopted an understanding, more akin to a compromise plan, stating the following: (1) a country is not obligated to tax economic processes outside its territorial waters; (2) member countries are permitted to adopt measures necessary to avoid double taxation of foreign source income; and (3) an exporting company should use an arms-length pricing method (World Trade Law, 1977). The understanding essentially approved the territorial system used by EU members partly because the territorial system provided only indirect tax incentives rather than the direct export subsidy provided by the DISC provisions. In addition to calling for changes in the DISC provisions, EU members called on the United States to pay between $10 and $12 billion in compensation for lost revenues due to the DISC.9 The United States committed in October 1982 to bring the DISC in conformity with the GATT understanding.10 In March 1983, the Reagan Administration approved the general outline of a proposal to replace the DISC, which died in Committee. The proposal was, as expected, a territorial type of entity involved in exporting U.S. goods. In this regard, the proposed FSC provisions were meant to mirror the territorial tax system used by EU members. The eventual FSC legislation required that the export entity be a foreign corporation organized and registered under the laws of a foreign jurisdiction.11 The new FSC provisions failed to satisfy EU members who believed that the FSC also offered an illegal export subsidy under GATT. Domestic critics continued to argue that, like the DISC, the FSC represented merely a tax shelter for a small number of U.S. companies rather than an export stimulus. The EU’s displeasure with the FSC continued, and eventually the WTO’s Dispute Settlement Body issued a final report in October 1999, finding that the FSC regime violated the WTO’s Agreement on Subsidies and Countervailing Measures. The report recommended that the FSC provisions be withdrawn by October 1, 2000; the United States appealed the WTO’s ruling and lost (World Trade Organization, 2000). In response to the WTO ruling, Congress repealed the FSC provisions and as a replacement for the FSC regime created an exclusion for certain extraterritorial
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income (ETI).12 This Act provided for the exclusion of certain qualifying foreign trade income arising from qualified transactions that are conducted outside the United States after September 30, 2000.13 The EU challenged the ETI Act on the basis that it was substantively a repackaged version of the FSC rules, which were ruled as being in violation of international trade laws. On August 20, 2001, the Dispute Settlement Panel of the World Trade Organization ruled in favor of the EU claim based on two key issues: (1) that the ETI regime constitutes an export-contingent subsidy; and (2) that the ETI provisions do not grant the same tax benefits to U.S. sales as granted to foreign sales. The United States appealed the decision, but the WTO Appellate Body upheld EU claims that the ETI is an illegal export subsidy.
2.2. Research Framework Research has demonstrated that export volume (both product amount and dollar value) and relative market share for exports are sensitive to price changes arising both from fluctuations in exchange rates and real price differences (Collie, 1991; Feenstra, 1986; Ohno, 1990; O’Neill & Ross, 1991). Other work provides evidence that federal tax law changes affecting the cost of capital influence product price and hence export volume (Campbell et al., 1987; Dutton, 1990; Laussel, 1992; Rosson & Ford, 1982). A number of studies have examined trade flows among nations within the purview of the product life cycle model and the Hechscher-Ohlin international trade model (Bilkey, 1982; Karlsson, 1988; Stadler, 1991; U.S. Department of Treasury, 1978). Under the product life cycle model, as a product’s life cycle matures, patents expire and duplication/substitution product production becomes possible in other countries. As a result, competitors in foreign countries may be able to begin production of the product, resulting in stiff price competition for the product (Dollar, 1987; Green & Lutz, 1978; Vernon, 1966). The Hechscher-Ohlin international trade model is broader in scope and identifies economic variables associated with imports and exports for products in individual countries. Economic variables such as: (1) capital to labor ratio; (2) product life cycle; (3) R&D intensity; (4) level of market imperfection; and (5) economies of scale on exports traditionally are used to explain inter-country differences in exports and imports (Schneeweis, 1985). The empirical work based on these models suggests that the existence of market imperfections, technological sophistication, existence of a patent for technology, capital labor ratio, real price differences, and exchange rate fluctuations are significant determinants of trade flows among nations. The primary mechanism
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through which these factors operate is product price. Accordingly, to the extent that the tax incentives offered under the DISC/FSC provisions alter producer prices, we expect to see changes in export volume of U.S. products. Prior research on the economic effects of DISC/FSC provisions has primarily been limited to questionnaire studies administered to users of the DISC/FSC vehicles (Bello & Williamson, 1985; Bilkey, 1982) or analytical analysis of various aspects of the FSC provisions (Jacobs & Larkins, 1998). Several studies have considered the sensitivity of export volume and market share to price changes and to tax law changes (Dutton, 1990; Feenstra, 1986). Other related work has investigated the specific economic factors associated with relative market share of global sales for specific product categories (Brander & Spencer, 1983a; Dutton, 1990; Kim & Lyn, 1987; Laussel, 1992; Lee & Stone, 1994; Nolle, 1991; Rabino, 1989). The studies reviewed here focus primarily on the sensitivity of export and international markets to price differences arising from exchange rate fluctuations and real price differences. These studies are relevant in the examination of the effectiveness of the DISC/FSC incentives because the DISC/FSC incentives theoretically affect the price of exports and thus the volume of exports. Dutton (1990) analytically evaluated the effects of export subsidies under situations where the monopoly power of the exporter is constrained for sales to some countries and not to other countries. Dutton concluded that export subsidies will occur most often where monopoly power is constrained on sales to countries with a low elasticity of import demand and monopoly power is unconstrained to other countries with a high elasticity of import demand. A low elasticity of export supply also is shown to warrant export subsidies. Dutton argues for targeted export subsidies on goods that would not otherwise be exported. Likewise, Itoh and Kiyono (1987) investigated the effects of export subsidies on goods that would not otherwise be exported. They conclude that export subsidies on marginal goods increase the output of such goods and decrease the output of non-marginal goods. More precisely, export subsidies are effective only on goods that are normally exported in small quantities or not at all. Rousslang (1987) investigated the economic impact of the Tax Reform Act of 1986 (TRA, 1986)14 on international trade in disaggregated industries based on the assumption that cost differences resulting from tax law changes were passed on to consumers through price changes. He used a model developed by the U.S. International Trade Commission to assess the economic impact of prior significant tax changes and found that the tax law changes were reflected in the cost of capital and, therefore, affected the ultimate price of the staple.15 Schneeweis (1985) sought to determine the economic determinants of imports and exports in various business units for a number of industries. For this purpose,
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he used the Hechscher-Ohlin International Trade Model to identify the probable economic variables associated with imports and exports of each country. He regressed: (1) capital to labor ratio; (2) product life cycle; (3) R&D intensity; (4) level of market imperfection; and (5) economies of scale on exports and reported that the most significant determinants of exports were the level of market imperfection and R&D intensity. As an alternative to the Hechscher-Ohlin Model, Wells (1969) examined U.S. exports of consumer durables to ascertain if certain economic patterns could be identified within the purview of the Product Life Cycle model. Wells concluded that the income elasticity of the consumers of the product, the ability to achieve economies of scale, and the cost of transportation were significant factors in determining the duration of the cycles and, therefore, global market share of the initial producer of the product. A related conclusion was that the sophistication of the applicable technology also determines the duration of the cycles. In summary, the reviewed studies provide strong evidence that both international market share and export volume are sensitive to price changes. The influence of export subsidies is shown to be most effective on goods that would not otherwise be exported without the export subsidy. The results of prior research suggest that export tax incentives represent a viable way in which U.S. companies can remain competitive in foreign markets as the life-cycle of a particular product matures. The reviewed studies identified the following factors as significant determinants of export volume: (1) size of exporter (Czinkota & Johnston, 1985); (2) R&D intensity (Mansfield et al., 1979; Schneeweis, 1985); (3) capital intensity (Koo & Martin, 1984); (4) export experience (Schneeweis, 1985); (5) perception of long-term profitability (Goldstein & Mohsin, 1987; Rosson & Ford, 1982); (6) export financing (Schneeweis, 1985); (7) stage in product life cycle (Hartzok, 1985; Schneeweis, 1985; Vernon, 1966; Wells, 1969); (8) tax law changes affecting the cost of capital (Rousslang, 1987); (9) the level of market imperfection (Schneeweis, 1985); and (10) value added per employee (Schneeweis, 1985).
3. VARIABLES This study addresses the effect of the DISC/FSC tax regimes on exports by regressing quarterly export volume data (aggregate and separately by product type) on various versions of the DISC/FSC tax regimes while controlling for concurrent variation in important macroeconomic variables. We examine the period beginning with the first quarter of 1967 and ending with the third quarter of 1998. The dependent variable (EXPORT), the volume of export product in U.S. dollars, represents the level of product exported from the United States.16 Export
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volume was restated for each quarter to reflect export volume at 1982 prices to allow examination of the actual changes in exported product independent of price level changes. Quarterly export data were obtained from the U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business.17 The explanatory variables are categorized as macroeconomic and tax regime variables. With respect to the macroeconomic variables, a number of the key variables identified by the reviewed studies are included in the estimation to account for variation in export volume unrelated to changes in the DISC/FSC regimes (Bernard & Jensen, 1998; Chowdhury, 1993; Schneeweis, 1985). Based on earlier studies (Lee & Stone, 1994; Mansfield et al., 1979; Schneeweis, 1985; Vernon, 1966), we expect research and development intensity (R&D) to be positively related to export volume. Firms with greater R&D intensity, ceteris paribus, are expected to be able to better exploit the value of the resulting property created by the R&D in foreign markets because of less competition for their products (duplication or substitution of products are less possible in other countries). R&D intensity is measured as the proportion of sales that is spent on R&D (annual R&D expenditures divided by annual sales). Yearly R&D intensity measures obtained from the National Science Foundation [various issues] were matched with each of the product categories used in the study. Quarterly R&D intensity measures then are generated from these annual R&D intensity measures.18 The reviewed studies also have shown that U.S. exports are affected by exchange rate fluctuations. As products become more costly in U.S. dollars due to exchange rate fluctuations, exports are expected to decline, ceteris paribus. We use the weighted-average exchange value of the U.S. dollar against the currencies of other G-10 Countries (EXCHANGE) to control for variation in exchange rates over the study period (Bernard & Jensen, 1998; Chowdhury, 1993; Schneeweis, 1985). EXCHANGE for each quarter was obtained from the Board of Governors of the Federal Reserve System, Foreign Exchange Rates, G.5 (405). Other macroeconomic variables with the potential to affect export level include: (1) the U.S. consumer price index (CPI); (2) the S&P price index (SPI); (3) the U.S. bond rate (USBOND); and (4) the U.S. industrial production index (INDPROD). Although the export data used in the estimations are measured in constant dollars, changes in CPI could separately affect demand for exports. For example, an increase in CPI could curtail domestic demand and put pressure on firms to increase exports. Quarterly Consumer Price Index-Urban data were obtained from the U.S. Department of Labor, Bureau of Labor Statistics, The Consumer Price Index. The SPI and USBOND variables help control for economy-wide effects that may be associated with firm activity, including export levels. Data for SPI were based on each quarter’s Common Stock Price Index for the S&P 500 and were obtained from
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Standard & Poor’s Corporation, The Outlook. Data for USBOND were obtained from the U.S. Department of the Treasury, Treasury Bulletin. In periods with increased INDPROD, exports are expected to increase because either firms pursue greater export sales because of the increased production or greater export demand helps fuel increased production. Quarterly data for INDPROD were obtained from the Board of Governors of the Federal Reserve System, Industrial Production, Statistical Release G12.3. Table 1 provides a summary of all the variables used in the estimations. The DISC/FSC tax regime variables identify the particular export tax incentive structure in place during the observation quarter. These periods are identified below: (1) Pre-1972. Prior to 1972, no special export tax incentives existed in U.S. tax laws. This period allows examination of the relationship between export volume and the non-tax variables absent the tax incentives. (2) 1972–1976. The initial DISC rules were in place for years after 1971. The 1972–1976 regime is expected to have a positive association with U.S. export level if the DISC provisions were effective in increasing exports. (3) 1977–1984. The Tax Reform Act of 1976 placed a limit on DISC benefits for entities with adjusted taxable income exceeding $100,000. Only taxable income attributable to export gross receipts exceeding 67% of a four-year base period average was subject to deferral treatment. This 1977–1984 regime is expected to have a negative association with U.S. export level relative to the previous period because the DISC benefits were restricted. (4) Post-1984. The DISC provisions were repealed generally and replaced with the FSC provisions in 1984. This post-1984 regime is expected to have a positive association with U.S. export level. To examine the effects of the DISC/FSC programs on exports on an overall basis, we use aggregated export data. See Fig. 1 for a summary of exports over the sample period. However, disaggregation of exports into various commodity classes enables us to ascertain whether the functional relations between export volume and the various explanatory variables differ by product type. Eleven product groupings were selected for analysis based on data availability.19 The selected product groupings, listed in Table 2, cover a large number of sectors, ranging from nondurable goods to capital goods. Seven of the product classes are unique, with two of the classes (consumer goods and industrial supplies and materials) further subdivided into two subcategories each. Quarterly export data for the various product categories were obtained from the U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business (U.S. Department of Commerce, various).
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Table 1. Model Variables. Variable
Description
Sourcea
EXPORT
Log of quarterly export level in constant 1982 dollars (millions)
R&D
Log of ratio of annual R&D outlays to annual sales aggregated by industry
EXCHANGE
Log of weighted-average exchange value of U.S. dollar against currencies of other G-10 countries Log of Consumer Price Index for all Urban Consumers
U.S. Department of Commerce, Bureau of Economic Analysis: Survey of Current Business Research and Development in Industry, Surveys of Science Resources Series, National Science Foundation (various years) Board of Governors of the Federal Reserve System: Foreign Exchange Rates, G.5 (405) U.S. Department of Labor, Bureau of Labor Statistics: The Consumer Price Index Standard & Poor’s Corporation: The Outlook U.S. Department of the Treasury: Treasury Bulletin Board of Governors of the Federal Reserve System: Industrial Production, Statistical Release G12.3 Created
CPI
SPI USBOND INDPROD
TREND
D1L
D1S
D2L
D2S
D3L
D3S
a
Log of common stock price index (Composite – S&P’s 500) Log of yield on 10-year U.S. Government bonds Log of industrial production index (All markets) Dummy variable counter for time period 1 to N (1–127 quarters); measures slope of export series prior to DISC introduction Dichotomous dummy variable scored 0 before DISC rules effective and 1 afterward (January 1971); captures change in the level of exports Dummy variable counter scored 0 before DISC rules effective and 1 to N for periods afterward (January 1971); captures change in slope Dichotomous dummy variable scored 0 before Tax Reform Act of 1976 change to DISC rules and 1 afterward (January 1977); captures change in the level of exports Dummy variable counter scored 0 before TRA 1976 changes and 1 to N for periods afterward (January 1977); captures change in slope Dichotomous dummy variable scored 0 before change to FSC and 1 afterward (January 1985); captures change in level Dummy variable counter scored 0 before change to FSC and 1 to N for periods afterward (January 1985); captures change in slope
Created
Created
Created
Created
Created
Created
Machine readable versions of the noted series obtained from CITIBASE (1978), as updated.
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Fig. 1. Level of U.S. Exports.
Table 2. Product Groupings Used in Analysis.a Model
Product Groupings
1 2 3 4 5 6 7 8 9 10 11
Automotive vehicles, engines, and parts Capital goods, except automotive Civilian aircraft, engines, and parts Computers, peripherals, and parts Consumer Goods, except automotive (aggregate of product classes 6 and 7) Durable goods (sub-class under consumer goods, except automotive) Nondurable goods (sub-class under consumer goods, except automotive) Industrial supplies and materials (aggregate of product classes 9 and 10) Durable Goods (sub-class under industrial supplies and materials) Nondurable Goods (sub-class under industrial supplies and materials) Foods, Feeds, and Beverages
a Product
categories were obtained from the U.S. Department of Commerce, Bureau of Economic Analysis, Survey of Current Business.
4. METHOD The relationship between exports and the explanatory variables is estimated for the aggregate data and for each of the product class groupings using the following model in which exports and all of the macroeconomic control variables are expressed in logarithmic form:20 EXPORTt = 0 + 1 TREND + 2 D1L + 3 D1S + 4 D2L + 5 D2S + 6 D3L + 7 D3S + 8 R&Dt + 9 EXCHANGEt + 10 INDPRODt + 11 CPIt + 12 SPIt + 13 USBONDt +
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where = − ␣1 t−1 − · · · − ␣p t−p ; is normally and independently distributed with a mean of 0 and a variance of s2 ; and p is the order of the autoregressive process to be fit.21 TREND is a simple time trend (1–127) used to capture the slope of the export series. The Di Ls and Di Ss are indicator variables used to capture the impact of each tax regime on exports. That is, D1L is a dummy variable scored 0 before the 1971 DISC rules became effective and 1 afterward; D1L captures the change in the level of exports due to the initial adoption of the DISC. D1S is a dummy variable counter scored 0 before DISC rules became effective and 1, 2, 3, . . ., N for periods afterward; D1S captures change in the slope or growth rate of exports after introduction of the DISC. D2L is a dummy variable scored 0 before Tax Reform Act (TRA) of 1976 change to the DISC rules and 1 afterward; D2L captures the incremental change in the level of exports caused by the 1976 TRA. D2S is a dummy variable counter scored 0 before TRA 1976 changes and 1, 2, 3, . . ., N for periods afterward; D2S captures the change in the slope or the growth rate of exports attributable to the 1976 TRA. D3L is a dummy variable scored 0 before the 1984 change to FSC and 1 afterward; D3L captures the change in the level of exports brought about by the 1984 change to the FSC regime. D3S is a dummy variable counter scored 0 before the change to FSC and 1, 2, 3, . . ., N for periods afterward. D3S captures the change in the slope or the growth rate of exports attributable to the 1984 change. The estimation model is Lewis-Beck’s (1986) “interrupted” time series model. The model’s most appealing feature is that it allows for the assessment of each regime’s effect on both the level and growth rate of exports. With the introduction of each new regime, the dummy variables related to that regime capture any changes in the intercept (DL) or slope (DS). Significant parameter estimates for the tax regime variables provide evidence of an incremental tax effect after controlling for other macroeconomic variables. This approach is equivalent to fitting separate regression models for each of the tax regime periods and then comparing the resulting intercept and slope parameters (Lewis-Beck, 1986). Because the dependent variable is the logarithm of export level, the estimated parameters (×100) of the dummy variables can be interpreted as percentage changes in export level. Econometric analysis of time series data must include unit root testing because the validity of the empirical relation between variables is predicated on the requirement that the classical stationarity assumptions are satisfied. Granger and Newbold (1974) and Phillips (1986) point out the dangers of spurious results if the time series involved are nonstationary.22 Consequently, before any attempt to measure the impact of export-related tax incentives on export volume is made we first examined the dependent and independent variables to determine whether they satisfied stationarity conditions. Two stationarity testing procedures were used.
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The Phillips-Perron (1988) (PP) test for unit roots involves estimating the following regression equation: Y t = ␣ + ∃(t − N/2) + Y t−1 + t ,
t = 1, 2, . . . , N
where Yt denotes the series being tested for a unit root, (t − N/2) is a time trend, and N is the sample size. The PP equation is employed to test three null hypotheses: (1) H10 : = 1, the series Yt contains a unit root with a drift and a time trend. (2) H20 : ␣ = 0, = 1, the series Yt contains a unit root with a time trend and without a drift. (3) H30 : ␣ = 0,  = 0, = 1, the series Yt contains a unit root without a time trend and without a drift. The 5 and 1% critical values for testing these three hypotheses are taken from Fuller (1976) and Dickey and Fuller (1981). The results for the PP tests are presented in Panel A of Table 3. All the reported statistics are significant at the 1% level, indicating that all the series are stationary and, therefore, need not be differenced in empirical investigation. The PP test has come under attack on the grounds that its failure to reject the unit root hypothesis may be attributable to its low power against weakly stationary alternatives. Kwiatkowski, Phillips, Schmidt and Shin (1992) (KPSS) recommend a test of the null hypothesis of stationarity against the alternative of a unit root.23 The KPSS test statistics are given by 2 ∗2 S S t t ˆ u = N −2 and ˆ t = N −2 s 2 (L) s ∗2 (L) where St =
t
ei ,
t = 1, 2, 3, . . . N;
S ∗t =
i=1
s 2 (L) = N −1
t
e ∗i ,
t = 1, 2, 3, . . . N;
and
i=1 N t=1
e 2t + 2N −1
N L 1−s s=1
L+1
e t e t−s
t=s+1
The ei s and e ∗i s are the residuals obtained by regressing the series being tested on a constant without a trend and on a constant and a time trend, respectively. If the test statistic exceeds the critical values, the null hypothesis of stationarity is rejected in favor of the unit root alternative.
14
B. ANTHONY BILLINGS, GARY A. McGILL AND MBODJA MOUGOUE´
Table 3. Unit Root Results for the Log of Aggregated Data. Panel A: Phillips-Perron Testa (Null Hypothesis)
Variable
EXPORT R&D EXCHANGE INDPROD CPI SPI USBOND
Panel B: KPSS Testb (Null Hypothesis)
H10 : = 1
H20 : ␣ = 0, = 1
H30 : ␣ = 0,  = 0, = 1
H10 : Series is Level-Stationary
H20 : Series is Trend-Stationary
−25.763∗ −17.553∗ −22.645∗ −31.004∗ −16.634∗ −26.548∗ −13.581∗
62.109∗ 56.070∗ 43.007∗ 21.037∗ 49.943∗ 39.672∗ 42.592∗
49.534∗ 40.764∗ 39.985∗ 17.963∗ 37.136∗ 36.115∗ 39.154∗
0.275 0.333 0.234 0.291 0.197 0.310 0.267
0.034 0.107 0.067 0.113 0.047 0.099 0.023
a See Phillips and Perron (1988) for a complete description of the method. The 5 and 1% critical values are taken from Fuller (1976) and Dickey and Fuller (1981) and are, respectively: H10 : − 3.43 and −3.99; H20 : 4.75 and 6.22; H30 : 6.34 and 8.43. The truncation lag is twelve for the reported results, but the conclusions are the same for other truncation lag values. An asterisk (∗ ) indicates significance at the 1% level. b The test statistics for the null hypotheses of level-stationary series ˆ u and trend-stationary series ˆ t are given as follows, S 2t S ∗2 t −2 ˆ u = N−2 and ˆ = N t s 2 (L) s ∗2 (L)
where St =
t
ei ,
t = 1, 2, 3, . . . N;
S ∗t =
i=1
s 2 (L) = N −1
t
e ∗i ,
t = 1, 2, 3, . . . N;
and
i=1 N t=1
e 2t + 2N −1
N L 1−s s=1
L+1
e t e t−s
t=s+1
The ei s and e ∗i s are the residuals obtained by regressing the series being tested on a constant without a trend and on a constant and a time trend, respectively. The 5 and 1% critical values are 0.463 and 0.739 and 0.216 and 0.146 for ˆ u and ˆ t , respectively (Kwiatkowski et al., 1992, p. 166, Table 1). The reported test statistics are computed using lag length L that equals 12.
The results of the KPSS test are given in Panel B of Table 3. The ˆ u statistic tests the null hypothesis of level stationary series, whereas the ˆ t statistic tests the null of trend-stationary series. Both test statistics fail to achieve statistical significance at any conventionally accepted level for the dependent variable and all the macroeconomic control variables. This finding indicates a rejection of the unit root hypothesis and is in agreement with the PP test in supporting the stationarity of all the macroeconomic variables over the 1967–1998 period.
The Effect of Export Tax Incentives on Export Volume
15
5. RESULTS Table 4 contains the parameter estimates for each of the tax regime dummy variables, controlling for macroeconomic variables, for models using aggregate U.S. product exports and separately for each of the eleven separate product categories. In the model for all product exports (ALL), four of the six macroeconomic control variables are significant in the theoretically expected direction. The R&D coefficient (0.1671) is positive and statistically significant ( p = 0.0035). This finding suggests that R&D does exert a strong influence on export level and is consistent with earlier studies (e.g. Schneeweis, 1985). As expected, the relation between the level of export and exchange rate (EXCHANGE) is negative and statistically significant ( p = 0.0000). This finding is consistent with prior research (Bernard & Jensen, 1998; Chowdhury, 1993; Schneeweis, 1985). The EXCHANGE result implies that as the weighted-average exchange rate increases (i.e. as the U.S. dollar appreciates) the export levels decline. Both increased industrial production (INDPROD) and CPI are positively related to export level. The positive association between INDPROD and exports can be viewed as evidence that, all else constant, an increase in industrial production tends to put pressure on U.S. firms to pursue foreign markets or that foreign market demand fuels increased production. An increase in CPI could potentially curtail domestic demand. Any decrease in domestic demand for U.S. goods puts pressure on firms to export. Finally, neither the SPI nor the USBOND variable achieves statistical significance.24 The results for each of the eleven product class models are mixed, but many of the same relations exist. R&D was significant and positive in five models and negative and significant in two models. EXCHANGE was significant and negative in nine models. INDPROD was positive and at least marginally significant in nine models. CPI was positive and at least marginally significant in eight models. SPI was significant in only three models but with mixed signs. USBOND was positive and at least marginally significant in only two models. Overall, these macroeconomic control variable results are consistent with relations identified in prior research (e.g. Bernard & Jensen, 1998; Nolle, 1991; Yang, 1996). In order to interpret the tax regime parameter estimates, recall that the estimates 0 and 1 , for example, indicate the overall level and trend of exports, respectively. We evaluate D1L and D1S to ascertain whether the level and trend changed as a result of the adoption of the DISC provisions. If the coefficient on D1L is statistically different from zero, the implication is that the 1971 DISC legislation had an influence on the level of exports. Similarly, if D1S is statistically significant, we infer that the adoption of the 1971 legislation altered the growth rate of exports.25
d
R-Square Constant TREND D1L (+) D1S (+) D2L (−) D2S (−) D3L (+) D3S (+) R&D EXCHANGE INDPROD CPI SPI USBOND
R-Square Constant TREND D1L (+) D1S (+) D2L (−) D2S (−) D3L (+) D3S (+) R&D EXCHANGE
Coefficient (p-Value in Parentheses) by Export Modelc All
Product 1
Product 2
Product 3
Product 4
0.9939 1.4762 (0.0000) −0.0687 (0.0024) 0.0486 (0.4505) 0.0429 (0.0557) −0.0710 (0.0096) −0.0204 (0.0000) 0.0158 (0.0000) 0.0389 (0.0000) 0.1671 (0.0035) −0.1920 (0.0000) 1.4168 (0.0000) 2.2552 (0.0000) 0.0445 (0.3980) 0.0294 (0.5122)
0.9835 4.9091 (0.1269) 0.0244 (0.0004) 0.0015 × 10−2 (0.0000) 0.0068 × 10−2 (0.0000) 0.0011 × 10−2 (0.0000) 0.0005 × 10−3 (0.0000) 0.0084 × 10−2 (0.0000) 0.0008 × 10−2 (0.0000) 0.2518 (0.0379) 0.0836 (0.1761) 1.1203 (0.0029) −0.2641 (0.6229) −0.4407 (0.0000) −0.0920 (0.2196)
0.9967 −1.5918 (0.0000) −0.0392 (0.0074) −0.0333 (0.4733) 0.0264 (0.0669) −0.1784 (0.0000) −0.0340 (0.0000) −0.0103 (0.0000) 0.0491 (0.0000) 0.1053 (0.0007) −0.1701 (0.0045) 1.3232 (0.0000) 2.4636 (0.0000) 0.0725 (0.2240) 0.1081 (0.0529)
0.7074 1.3865 (0.5013) 0.0070 (0.8793) 0.0039 × 10−2 (0.0000) 0.0017 × 10−2 (0.0000) 0.0070 × 10−3 (0.0000) 0.0056 × 10−2 (0.0000) 0.0031 × 10−2 (0.0000) 0.0088 × 10−3 (0.0000) 0.0842 (0.8928) −1.2371 (0.0000) −4.4618 (0.0456) 1.1996 (0.7137) 0.6577 (0.1424) 0.5354 (0.1177)
0.9979 1.5872 (0.0002) −0.0446 (0.0000) −0.2865 (0.0016) 0.0613 (0.0000) 0.0093 (0.9375) 0.0162 (0.1042) 0.0213 (0.0002) −0.0058 (0.4828) 0.6018 (0.0000) −0.4056 (0.0004) 1.3656 (0.0060) 2.0815 (0.0096) −0.0105 (0.9360) 0.0972 (0.5095)
Product 5
Product 6
Product 7
Product 8
Product 9
0.9846 1.4965 (0.0000) −0.0440 (0.1586) 0.1279 (0.1578) 0.0048 (0.8755) 0.0639 (0.1381) −0.0168 (0.0014) −0.0163 (0.0032) 0.0538 (0.0000) 0.1135 (0.1241) −0.3943 (0.0003)
0.9747 2.1255 (0.0000) −0.0290 (0.1894) 0.1487 (0.0233) −0.0385 (0.0642) 0.1154 (0.0379) −0.0208 (0.0007) −0.0247 (0.0000) 0.0823 (0.0000) 0.3884 (0.0000) −0.4672 (0.0002)
0.9929 1.2481 (0.0000) −0.0565 (0.2011) 0.1424 (0.2455) 0.0356 (0.4189) −0.0359 (0.3405) −0.0103 (0.0274) −0.0166 (0.0000) 0.0273 (0.0000) −0.4463 (0.0000) −0.1303 (0.00411)
0.9750 1.2398 (0.0000) −0.0902 (0.0030) 0.1475 (0.1030) 0.0544 (0.0725) −0.0635 (0.1350) −0.0055 (0.3291) −0.0595 (0.0223) 0.0236 (0.0000) 0.0041 (0.9612) −0.2108 (0.0001)
0.9760 1.2767 (0.0014) −0.0896 (0.0000) −0.0332 (0.4421) 0.0909 (0.0000) −1.2049 (0.0000) −0.0334 (0.0091) 0.0121 (0.0029) 0.0113 (0.0282) 0.1752 (0.0488) −0.4281 (0.0000)
B. ANTHONY BILLINGS, GARY A. McGILL AND MBODJA MOUGOUE´
Variableb (Expected Sign)
16
Table 4. Time Series Regression Models Explaining Export Volume: Aggregate Exports and Separate Product Categories.a
R-Square Constant TREND D1L (+) D1S (+) D2L (−) D2S (−) D3L (+) D3S (+) R&D EXCHANGE INDPROD CPI SPI USBOND
1.1193 (0.0005) 2.9873 (0.0000) −0.1027 (0.1872) 0.0269 (0.7677)
1.8798 (0.0000) 4.1185 (0.0000) −0.3199 (0.0020) −0.0844 (0.5377)
Product 10
Product 11
0.9822 −4.2377 (0.0957) 0.0132 (0.6975) 0.0047 × 10−2 (0.0000) 0.0051 × 10−2 (0.0000) −0.0429 (0.9236) −0.0262 (0.4293) 0.0344 (0.2031) 0.0177 (0.0001) 0.0694 (0.1569) −0.0820 (0.0488) −0.2209 (0.3962) 0.8437 (0.0811) 0.0147 (0.7842) 0.0681 (0.2791)
0.9549 1.1501 (0.0538) −0.0327 (0.1351) 0.0997 (0.2447) 0.0176 (0.3946) 0.1956 (0.5012) −0.0157 (0.3525) −0.0185 (0.0063) 0.0177 (0.0017) −0.2096 (0.0325) −0.0757 (0.3480) 0.9269 (0.0837) 1.4894 (0.2192) 0.1566 (0.2328) 0.0371 (0.7806)
0.7070 (0.0021) 2.5269 (0.0000) 0.0384 (0.4520) −0.0086 (0.8972)
1.1193 (0.0000) 2.2196 (0.0000) 0.0925 (0.1468) −0.0264 (0.6725)
0.9813 (0.0395) 2.3243 (0.0036) 0.3392 (0.0339) 0.2607 (0.0183)
17
a The parameter estimates and related significance tests were generated using a maximum likelihood estimation procedure to control for any autocorrelation among the model residuals. b EXPORT is log of quarterly export level in constant 1982 dollars (millions); R&D is the log of ratio of annual R&D outlays to annual sales aggregated by industry and converted to quarterly data; EXCHANGE is the log of the weighted average exchange value of U.S. dollar against the currencies of other G-10 countries; INDPROD is the log of Industrial Production Index (All markets); CPI is the log of Consumer Price Index for all Urban Consumers; SPI is the log of the value of the S&P500 index; USBOND is the log of the Yield on 10-year U.S. Government bonds. See Table 1 for tax regime indicator variable definitions. c The eleven product groupings are described as follows: (1) Automotive vehicles, engines, and parts; (2) Capital goods, except automotive; (3) Civilian aircraft, engines, and parts; (4) Computers, peripherals, and parts; (5) Consumer Goods, except automotive (aggregate of product classes 6 and 7); (6) Durable goods (sub-class under consumer goods, except automotive); (7) Nondurable goods (sub-class under consumer goods, except automotive); (8) Industrial supplies and materials (aggregate of product classes 9 and 10); (9) Durable Goods (sub-class under industrial supplies and materials); (10) Nondurable Goods (sub-class under industrial supplies and materials); (11) Foods, Feeds, and Beverages. d The R2 relates to the structural model after transformation for any autocorrelation but does not include the variance explained related to the inclusion of the models’ past residuals.
The Effect of Export Tax Incentives on Export Volume
INDPROD CPI SPI USBOND
18
B. ANTHONY BILLINGS, GARY A. McGILL AND MBODJA MOUGOUE´
Examination of the ALL model in Table 4 suggests that on an aggregate product basis, the 1971 introduction of DISC affected exports only marginally. The coefficient on D1L (0.0486) is insignificant ( p = 0.4505) but the coefficient on D1S (0.0429) is marginally significant ( p = 0.0557). These findings indicate that although the adoption of the DISC legislation did not meaningfully alter the level of exports, it did lead to a marginal increase in the growth rate of exports, measured in the aggregate. The restriction of DISC benefits in 1977, however, appears to have significantly affected both the level and growth rate of exports on an overall basis. Table 4 reports that both D2L and D2S have significant and negative coefficients, as predicted. These results indicate that the limitation of the DISC tax benefits beginning in 1977 dampened both the level of exports (a 7.10% decrease) and the export growth rate (a 2.04% decrease). Prior to the 1977 tax regime, the model intercept term is estimated at 1.5248 (1.4762 + 0.0486) and the model slope (growth rate over time) is estimated at −0.0258 (−0.0687 + 0.0429). Thus, prior to the change in the DISC benefits, the real growth rate of exports was a negative 2.58% per year. After the change to DISC benefits in 1977, the intercept is estimated at 1.4538 (1.5248 − 0.0710) and the slope becomes more negative at −0.0462 (−0.0258 − 0.0204). Consequently, the 1977 DISC change appears to have lowered both the level of exports and the export growth rate measured on an aggregate basis. This negative effect is predicted because the 1977 changes reduced potential DISC tax benefits. Finally, the introduction of the FSC in 1985 seems to have exerted a significant impact on both the level and growth rate of exports. As indicated in Table 4, both D3L and D3S have significant positive parameter estimates in the ALL model, suggesting that the imposition of the FSC rules in 1985 improved the level of exports by 1.58% (D3L = 1.58%) and the export growth rate by 3.89% (D3S = 3.89%). Thus, the FSC rules appeared to have reversed the negative trend in exports generated by the restricted DISC rules introduced in 1977. Examination of the eleven product class models produces somewhat mixed evidence, suggesting that the export incentives effect varies across product category. With regard to the imposition of the 1971 DISC rules, four product categories (1, 3, 6, and 10) produce positive and significant level effects and one product category (4) has a significant negative level effect. The remaining six product groupings (2, 5, 7, 8, 9, and 11) exhibit no significant relationship between export level and the introduction of the DISC regime. As for the growth (slope) effect (D1S), Table 4 shows that five product categories (1, 3, 4, 9, and 10) are significant at the 1% level and two product groups (2 and 8) achieve statistical significance at the 10% level, all with the expected positive sign. Only one product grouping (6) shows a negative slope effect that approaches significance ( p = 0.0642).
The Effect of Export Tax Incentives on Export Volume
19
The effect of the 1977 DISC change on exports is captured by the estimates of the D2L and D2S coefficients. Two of the eleven product groups (2 and 9) have the expected significant negative level effects (D2L). Three of the product groups (1, 3, and 6) have significant positive level coefficients. The findings for the 1977 change slope effect are more consistent across product classes. Five of the eleven product categories (2, 5, 6, 7, and 9) have the expected significant negative slope effects (D2S). Two of the remaining product groups have significant positive slope effects (1 and 3). The effect of the FSC regime introduction on export level is captured by D3L. Table 4 reports that four of the product groups (1, 3, 4, and 9) have the predicted significant positive sign on the D3L coefficient. Six of the remaining product categories (2, 5, 6, 7, 8, and 11) have significant negative level effects. In contract to these mixed results on the level coefficients, the introduction of the FSC regime is consistently positively associated with the growth rate of exports as predicted. With the single exception of the insignificant coefficient for product group 4, the D3S coefficients are all significant and positive, implying a strong export growth effect. Overall, it appears that the adoption of the FSC regime had the intended effect of increasing growth in U.S. export levels relative to the dampening effect triggered by the 1976 legislation placing limits on DISC benefits. The predicted level effects are mixed, with product categories 1 (automotive vehicles, engines, and parts) and 3 (civilian aircraft, engines, and parts) demonstrating the most consistency with the expected effect from introduction of the DISC or FSC regimes. Product categories 2 (capital goods), 5 (consumer goods, except automotive), 7 (nondurable goods, subclass of category 5), 8 (industrial supplies and materials), and 11 (foods, feeds, and beverages) do not conform to the predicted level effects from the DISC or FSC regimes. Predicted growth effects are more consistent across product categories. The structure of these separate product category results are explored in more detail in the discussion section below.
6. SENSITIVITY TESTS In this section, we conduct additional tests to determine the robustness of our empirical findings with respect to: (1) the measurement of the export dependent variable; and (2) two international agreements thought to have affected U.S. exports through significant changes in the relative value of the U.S. dollar. In order to determine the sensitivity of our results with respect to the measurement of the export variable, we redefine U.S. exports as a percentage of gross domestic product (GDP). See Fig. 2 for a summary of exports relative to GDP. An increase in export level could come from two sources: a shift from domestic sales
20
B. ANTHONY BILLINGS, GARY A. McGILL AND MBODJA MOUGOUE´
Fig. 2. U.S. Exports Relative to GDP: 1967Q1–1998Q3.
to export sales or an increase in domestic production, with some portion of this increase accruing to export sales. Defining exports as a percentage of GDP allows us to avoid this interpretation problem. We re-estimate our model for the aggregate data and for each of the eleven product categories using the new export definition. The empirical results are qualitatively similar to those reported in Table 4. We also evaluate the sensitivity of our empirical findings with respect to two major international agreements: The Plaza Accord (September 1985) at which the G-7 nations agreed to co-ordinate policy so as to substantially reduce the value of the U.S. dollar in foreign exchange markets, and the Louvre Accord (February 1987), where the G-7, having decided that the dollar had fallen enough, reversed course and sought to stabilize the U.S. dollar within a relatively narrow target vis-`a-vis the German mark and the Japanese yen. Using indicator variables to control for these events (similar to the method employed to capture the tax regime effects), we re-estimate the models to determine whether these international agreements affected U.S. export levels by affecting the relative value of the U.S. dollar in foreign exchange markets. The empirical results are qualitatively similar to those in Table 4 for both the aggregated data and for the eleven product categories.26 The last sensitivity test we conduct examines the impact of lagged independent variables on our overall results. More specifically, we re-estimate our model using: (a) the levels and the lagged values of the independent variables jointly; and (b) lagged independent variables only. Overall, these additional tests reveal
The Effect of Export Tax Incentives on Export Volume
21
that lagged values of the independent variables are not significantly related to either the level or the growth of U.S. exports during the 1967–1998 period.
7. DISCUSSION Our research objective is to determine whether export tax incentives demonstrate any significant association with export level after controlling for other macroeconomic factors. The aggregate analysis suggests that the DISC/FSC incentives are significantly related to changes in the level and/or growth rate of exports over the period studied. The model estimation results seem particularly credible because the tax regime variables demonstrate a positive association with exports when the tax regime change increases tax benefits and a negative association with exports when the tax regime change reduces tax benefits. However, these aggregate results do not hold consistently for each of the eleven product groupings examined. This result suggests that although there is some detectible relationship of export level to tax incentives, substantial variability exists among product groups. The observed variability of the effects of the DISC/FSC regimes among the product classes is in accord with prior research that suggests export subsidies influence only certain products and exports to certain countries (Dutton, 1990; Itoh & Kiyono, 1987). More precisely, Itoh and Kiyono (1987) suggest that export subsidies influence exports primarily on products sold to countries with a high elasticity of import demand. Likewise, Dutton (1990) argues that export subsidies are most effective on goods that would not otherwise be exported or on goods that are exported in small quantities. The U.S. Treasury previously estimated the effect of FSC benefits on different products based on supply and demand elasticities (U.S. Treasury, 1993).27 The product categories used in the current study are rather broad compared with the Treasury data; however, some high-level comparisons are possible. In the Treasury study, machinery (electrical and non-electrical) and transportation equipment are expected to be the most sensitive sectors to the availability of FSC benefits (U.S. Treasury, 1993, Table 4-1). In the current study, product classes 1 (automotive vehicles, engines, and parts) and 3 (civilian aircraft, engines, and parts) can be mapped into the Treasury’s transportation category. Product classes 2 (capital goods, except automotive) and 9 (durable goods) are related to the Treasury’s machinery category. Consistent with the Treasury findings, product classes 1, 2, 3, and 9 exhibit the greatest number of significant parameter estimates consistent with the hypothesis that DISC/FSC benefits influence export volume in the expected direction. With 24 possible DISC/FSC effects (4 product categories with 6 level or growth parameters), 67% (16 of 24) were significant in the predicted
22
B. ANTHONY BILLINGS, GARY A. McGILL AND MBODJA MOUGOUE´
direction. Compare these results with categories 4, 5, 6, 7, 8, 10, and 11 where only 33% (14 of 42) of the possible DISC/FSC effects were significant in the predicted direction. At the other extreme, the Treasury found that food products were expected to have little sensitivity to FSC benefits. Product class 11 (foods, feeds, and beverages) can be mapped into the Treasury’s food category. Consistent with the Treasury results, the findings for class 11 suggest that this product class is less sensitive to DISC/FSC benefits. Only one of the six DISC/FSC regime variables (17%) is statistically associated with export level in this category in the expected direction. In summary, the cross-product variation in sensitivity to export incentives observed in this study is consistent with the Treasury’s results obtained using a different method.28 Lastly, the macroeconomic control variables used in our study produce findings consistent with their use in prior research (e.g. Kim & Lyn, 1987; Laussel, 1992; Ohno, 1990; O’Neill & Ross, 1991; Schneeweis, 1985). For example, R&D intensity, exchange rates, industrial production level, and CPI are significant in the predicted direction for the aggregate model and across many of the separate product class models. Product group 11 is a notable exception, with none of the control variables significant in the expected direction. This result is not surprising because this category represents food products and export levels in this category are expected to have low supply and demand elasticities (U.S. Treasury, 1993). The results of this study must be considered in light of several limitations. Questions addressing broad macroeconomic relationships are difficult at best, and made only more so with the introduction of multinational effects. More specifically, the effects of the DISC/FSC tax incentives captured in this study might be explained in alternative ways. Other events during the period of study may coincide with the tax regime periods and our robustness tests did not capture all possible events. Furthermore, the measures used in this study are at a fairly broad level of aggregation and a finer partition may produce different results. Notwithstanding these limitations, the results of this study provide evidence that export tax incentives influence export levels in the theoretically-predicted manner. We examine the relation of U.S. export volume to the availability of these export tax incentives over the period 1967–1998, controlling for product class and important macroeconomic variables, and find evidence of a positive association between the level of U.S. exports and the existence of the export incentives offered under the DISC/FSC provisions. However, this association is dependent on product type. Our findings using actual export data are independent of otherwise available data demonstrating a general growth in the use of DISC/FSC entities and the sales volume of these entities (e.g. U.S. Treasury, 1993). The latter data suffer from an interpretation problem because changes in the number of special export entities used and their sales volume do not necessarily correlate with changes in
The Effect of Export Tax Incentives on Export Volume
23
actual export levels over time. The approach we use in this paper is an attempt to overcome this limitation. The reported results have implications for both tax policy regarding the design of export tax incentives and the European Union’s claim that U.S. export tax incentives have damaged U.S. competitors in foreign trade.
NOTES 1. See, for example, Auquier and Caves (1979), Bello and Williamson (1985), Brander and Spencer (1983a, b), Gravelle, Hughes and Farb (1976), Green and Lutz (1978), Nolle (1991), Goldstein and Mohsin (1987), Schneeweis (1985), U.S. Department of Treasury (1978), and Vernon (1966). 2. Data are available from the U.S. Treasury regarding the growth in the number of DISCs or FSCs over time and the export volume reported by these entities (see, for example, U.S. Treasury, 1993). However, data on changes in the number of special export entities and their sales volume do not necessarily correlate with changes in actual export levels over time. For example, firms may begin using FSCs for export sales that already were being made outside the FSC entities. Consequently, an increase in reported FSC sales may not correspond with an actual increase in export sales. The approach we use in this study is an attempt to overcome this limitation. 3. Revenue Act of 1971, P.L. 92–178. 4. A restricted version of the DISC remained after 1984 (the so-called Interest-Charge DISC). In response to the criticism that tax deferral on DISC profits resulted in a permanent reduction in the tax liability of DISC shareholders, IRC Section 995(f)(1) was added to impose an interest charge on the deferral of DISC income earned after January 1, 1985 to the extent deferral reduces the tax liability of affected shareholders. The taxpayer cost of the interest charge provision is partially mitigated because the interest charge is a deductible expense. 5. Hearings Before the House Ways and Means Committee, 91st Cong., 2d Sess., pt. 2 at 500 (1970) and H.R. Rep. 658, 94th Cong., 2d Sess. 264 (November 12, 1975). 6. The U.S. Treasury, as part of its 1981 annual report, reported that DISC tax incentives induced additional exports between $7.2 and $11 billion annually (U.S. Department of Treasury, 1983). According to the Treasury report, U.S. exporters deferred up to $751 million in taxes under the DISC program. As of 1975, DISCs also were credited with providing roughly 230,000 U.S. jobs annually. But the Treasury Department’s estimates also reported a $1.65 billion cost of the DISC program. In rebuttal to the Treasury report, domestic critics argued that the DISC provisions created no more than $1–3 billion in additional exports at a revenue cost of approximately $1.2 billion (World Trade Law, 1977). 7. Indeed, the DISC had several provisions that were allegedly in violation of Article XVI of GATT. The most blatant of these were: (1) the lack of required foreign presence; (2) the failure to charge interest on deferred tax liabilities; and (3) the failure to impose arm’s length pricing between the DISC and its related supplier/principal. 8. Tax Reform Act of 1976, P.L. 94–455. 9. This request may have been made in part because of negative sentiment against FSC proposed changes. The formal request was made on July 16, 1984. The United States
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responded to the GATT panel by pointing out the following: (1) DISCs, in substance, complied with the policy objectives and intent of GATT; (2) DISCs actually provided a smaller tax benefit to U.S. exporters than that allowed under the territorial system of taxation sanctioned by the GATT council understanding; and (3) the understanding adopted by GATT did not optimally promote GATT policies. 10. S. Report. 2708, 97th Cong., 2d Sess., 128 Cong. Rec. S7895 (1982); the bill died in Committee. 11. Tax Reform Act of 1984, P.L. 98–369. See Larkins (1991) for a detailed discussion of the FSC provisions. 12. Foreign Sales Corporation Repeal and Extraterritorial Income Exclusion Act of 2001, P.L. 106–519. 13. The ETI Act created three new Code Sections, 941, 942, and 943, under Subpart E of the Internal Revenue Code. Section 941 defines qualifying foreign trade income with respect to any transaction as the amount of gross income which, if excluded, will result in a reduction of the taxable income of the taxpayer from such transaction equal to the greater of: (1) 30% of the foreign sale and leasing income derived by the taxpayer from the transaction, or (2) 1.2% of the foreign trading gross receipts derived by the taxpayer from the transaction, or (3) 15% of the foreign trade income derived by the taxpayer from the transaction. The ETI Act also created Code Section 114, providing for an exclusion from gross income of qualifying income. 14. Tax Reform Act of 1986, P.L. 99–514. 15. The specific tax law changes considered include: (1) the changes in depreciation tax rules; (2) the repeal of the investment tax credit; and (3) the reduction in the corporate statutory income tax rate. 16. The Census export data are compiled from U.S. Custom’s documents that reflect all shipments from U.S. ports using the “free alongside ship” value of merchandise without regard to the profitability of the exporter. See, for example, Bureau of the Census (2002a) for a discussion of trade data sources. Because the exporting firms change somewhat from quarter to quarter, we do not attempt to specify specific firm types for each quarter. In 2002, the Census Bureau identified 246,452 exporting companies with 219,390 small companies (less than 100 employees), 19,139 medium companies, and 7,923 large companies (more than 500 employees). Although smaller in number, large companies represented 71% of export value (Bureau of the Census, 2002b). 17. Machine readable versions of these data and the other macroeconomic variables were obtained from CITIBASE (1978) as amended. 18. The quarterly R&D amounts are the result of linear interpolation of the annual series, subject to the condition that their sum for each year should add up to the corresponding annual value. This is accomplished following methods used in Diz (1966) and El-Sharif (1979). 19. From an initial list of 20 product classes with varying levels of missing data over the 1967–1998 period, we eliminated service-related product classes (not generally eligible for the DISC/FSC benefit) and other classes deemed to be too broadly defined. 20. The model is estimated using a Gauss-Marquardt maximum likelihood method to simultaneously solve for both the model’s parameter estimates and its autoregressive relationship (Harvey, 1981; Judge et al., 1985). That is, the relationship between the currentand prior-period error terms are modeled concurrently with the structural parameters. This approach provides more accurate standard error estimates than an ordinary least squares estimation.
The Effect of Export Tax Incentives on Export Volume
25
21. An autoregressive process of up to five periods was modeled for each regression. Nonsignificant lags were removed from any model; most models were accurately specified with a single period lag, AR(1). 22. Such regressions produce high R2 values, low Durbin-Watson statistics, and low standard errors. In addition, the t- and F-statistics are invalid because the error terms are nonnormally distributed and may be autocorrelated. Furthermore, if the time series analyzed are cointegrated, ordinary regression estimates can be biased in small samples. As shown by Stock (1987), least square estimators of cointegrating parameters in static level regressions are superconsistent, theoretically converging to their probability limits at faster rates than conventional values. 23. See Kwiatkowski et al. (1992) for a complete description of this testing procedure. 24. Using the yields on the 20- and the 30-year U.S. Government bonds does not alter the results with respect to the statistical significance of the parameter estimates. 25. The intercept and slope parameter estimates at any given point in time are determined by taking the base year estimates (0 and 1 ) and adjusting them for cumulative changes up to that point. For example, for the post-1977 period, the intercept and the slope estimates are (0 + 2 + 4 ) and (1 + 3 + 5 ), respectively. For the post-1984 period, the intercept and the slope estimates are, respectively (0 + 2 + 4 + 6 ) and (1 + 3 + 5 + 7 ). 26. The results of these robustness tests are available on request from the authors. 27. See also World Trade Organization (2002, Annex A) for alternative calculations of the export subsidy provided to certain product categories in 2000. 28. The European-American Business Council (2001) produced a more recent study that examines potential products that might be targeted in the EU FSC/ETI trade retaliation. Although their estimates are not necessarily based on product elasticities, the report indicates that products such as aircraft parts, machinery, vehicles, and electrical equipment account for a substantial amount of U.S. exports to Europe. These products are consistent with product classes 1, 2, 3, and 9 in the current study and these classes demonstrated the most consistent sensitivity to the changes in export tax incentives.
ACKNOWLEDGMENTS The authors gratefully acknowledge the financial support of the Ernst & Young Foundation through its Tax Research Grant Program. The authors thank Jongsub Kim for able research assistance, Wei Li for his comments on the econometrics, and the two referees and editor for their helpful comments.
REFERENCES Auquier, A., & Caves, R. (1979). Monopolistic export industries, trade taxes and optimal competition policy. Economic Journal, 89, 559–581. Bello, C., & Williamson, N. C. (1985). The American export trading company: Designing a new international marketing institution. Journal of Marketing, 49, 60–69.
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Bernard, A. B., & Jensen, J. B. (1998). Understanding the U.S. export boom. Working Paper 6438. National Bureau of Economic Research. Bilkey, W. (1982). Variables associated with export profitability. Journal of International Business Studies, 13, 39–55. Brander, J., & Spencer, B. (1983a). Strategic commitment with R&D: The symmetric case. Bell Journal of Economics, 14, 225–235. Brander, J., & Spencer, B. (1983b). Tariffs and the extraction of foreign monopoly rents under potential entry. Canadian Journal of Economics, 14, 371–389. Bureau of the Census, Foreign Trade Division (2002a). U.S. international trade in goods and services, Report FT900 (CB-02-132) (August). Bureau of the Census, Economics and Statistics Administration (2002b). Advance report: A profile of U.S. exporting companies, 2000 (CB-01-136) (October 18). Campbell, J. C., Ito, K., Pucik, V., & Yu, C. M. (1987). The Japanese and the U.S. tax systems: Implications for Japanese auto exports. MIR, 2, 32–45. Chowdhury, A. R. (1993). Does exchange rate volatility depress trade flows? Evidence from error correction models. Review of Economics and Statistics, 75, 700–706. CITIBASE (1978). Citibank Economic Database (machine-readable magnetic data file), 1946. New York: Citibank, N. A. Collie, D. (1991). Export subsidies and countervailing tariffs. Journal of International Economics, 31, 309–324. Czinkota, M. R., & Johnston, W. J. (1985). Exporting: Does sales volume make a difference? Reply. Journal of International Business Studies, 16, 157–162. Dickey, D. A., & Fuller, W. A. (1981). Likelihood ratio statistics for autoregressive time series with a unit root. Econometrica, 49, 1057–1072. Diz, A. C. (1966). Money and Prices in Argentina, 1935–1962. Unpublished doctoral dissertation, University of Chicago, Chicago. Dollar, D. (1987). Import quotas and the product cycle. Quarterly Journal of Economics, 102, 615–632. Dutton, J. (1990). Targeted export subsidies as an exercise of monopoly power. Canadian Journal of Economics, 23, 705–710. El-Sharif, A. S. (1979). A structural model of the monetary sector of Libya. Unpublished doctoral dissertation, Indiana University, Bloomington. European-American Business Council (2001). Scenarios for Possible EU Retaliation in the FSC Dispute. Policy Paper, http://www.eabc.org/publications.htm. Washington, DC. Also reported in Worldwide Tax Daily, 2002 WTD 14–27. Feenstra, R. (1986). Trade policy with several goods and market linkages. Journal of International Economics, 20, 249–267. Fuller, W. A. (1976). Introduction to statistical time series. New York: Wiley. Goldstein, M., & Mohsin, K. (1987). The supply and demand for exports: A simultaneous approach. Review of Economics and Statistics, 60, 275–285. Granger, C. W. J., & Newbold, P. (1974). Spurious regressions in econometrics. Journal of Econometrics, 26, 1045–1066. Gravelle, J., Hughes, K., & Farb, W. E. (1976). The domestic international sales corporation and its effects on U.S. foreign trade and unemployment. Congressional Research Service. Washington, DC. Green, R. T., & Lutz, J. M. (1978). The role of technology in export trade. The United States and World Trade, 131–147. Hartzok, J. (1985). Domestic international sales corporation returns, 1980. Compendium of Studies of International Income and Taxes. Statistics of Income, Internal Revenue Service, pp. 289–309.
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Harvey, A. C. (1981). The econometric analysis of time series. New York: Wiley. Itoh, M., & Kiyono, K. (1987). Welfare-enhancing export subsidies. Journal of Political Economy, 95, 115–137. Jackson, J. H. (1978). The jurisprudence of international trade: The DISC case in GATT. American Journal of International Law, 72, 747–757. Jacobs, F. A., & Larkins, E. R. (1998). Export tax incentives for establishing foreign markets: An analysis of marginal costing techniques. Accounting Horizons, 12, 374–396. Judge, G. G., Griffiths, W. E., Hill, R. C., & Lee, T. C. (1985). The theory and practice of econometrics. New York: Wiley. Karlsson, C. (1988). Innovation adoption and the product life cycle. Umea Economic Studies Series No. 185. Kim, S. W., & Lyn, E. O. (1987). Foreign direct investment theories, entry barriers, and reverse investments in U.S. manufacturing industries. Journal of International Business Studies, 18, 53–66. Koo, A. Y. C., & Martin, S. (1984). Market structure and U.S. trade flows. International Journal of Industrial Organization, 2, 173–198. Kwiatkowski, D., Phillips, P. C. B., Schmidt, P., & Shin, Y. (1992). Testing the null hypothesis of stationarity against the alternative of a unit root. Journal of Econometrics, 54, 159–178. Larkins, E. R. (1991). Alternative tax vehicles for exportation (Part II). The Tax Adviser, 22, 247–257. Laussel, D. (1992). Strategic commercial policy revisited: A supply function equilibrium model. American Economic Review, 82, 84–99. Lee, H., & Stone, J. A. (1994). Product and process innovation in the product life cycle: Estimates for U.S. manufacturing industries. Southern Economic Journal, 60, 754–763. Lewis-Beck, M. (1986). Interrupted time series. In: W. D. Berry & M. S. Lewis-Beck (Eds), New Tools for Social Sciences: Advances and Applications in Research Methods (pp. 209–240). Beverly Hills: Sage. Mansfield, E., Romeo, A., & Wagner, S. (1979). Foreign trade and U.S. research and development. Review of Economics and Statistics, 61, 49–57. National Science Foundation (various). Research and development in industry. Surveys of Science Resources Series. Nolle, D. (1991). An empirical analysis of market structure and import and export performance for U.S. manufacturing industries. Quarterly Review of Economics and Business, 31, 59–78. Ohno, K. (1990). Exchange rate fluctuations, pass-through, and market share. International Monetary Fund Staff Papers, 37, 294–310. O’Neill, H. M., & Ross, W. (1991). Exchange rate and income effects on South Korean exports: The U.S. case. Journal of Economic Development, 16, 87–111. Phillips, P. C. B. (1986). Understanding spurious regressions in econometrics. Journal of Econometrics, 33, 311–340. Phillips, P. C. B., & Perron, P. (1988). Testing for a unit root in time series regression. Biometrika, 75, 335–346. Rabino, S. (1989). High technology firms and factors influencing transfer of R&D facilities. Journal of Business Research, 18, 195–205. Rosson, P. J., & Ford, D. L. (1982). Manufacturers overseas distributor relations and export performance. Journal of International Business Studies, 13, 57–72. Rousslang, D. J. (1987). The effects of recent corporate tax changes on international trade. National Tax Journal, 40, 603–615. Schneeweis, T. (1985). A note on international trade and market structure. Journal of International Business Studies, 16, 139–152.
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Stadler, M. (1991). R&D dynamics in the product life cycle. Journal of Evolutionary Economics, 1, 293–305. Stock, J. H. (1987). Asymptotic properties of least squares estimators of cointegrating vectors. Econometrica, 55, 1035–1056. U.S. Department of Commerce (various, 1967–1998). Survey of Current Business 47–78. Bureau of Economic Analysis, U.S. Department of Commerce, Washington, DC. U.S. Department of Treasury (1978). The Operation and Effect of the Domestic International Sales Corporation Legislation: 1976 Annual Report (April). U.S. Department of Treasury (1983). The operation and effect of the DISC: 1981 Annual Report. U.S. Department of Treasury (1993). The operation and effect of the foreign sales corporation legislation (January). Vernon, R. (1966). International investment and international trade in the product cycle. Quarterly Journal of Economics, 80, 190–207. Wells, L. T. (1969). Test of a product cycle model of international trade: U.S. exports of consumer durables. Quarterly Journal of Economics, 83, 152–162. World Trade Law (1977). GATT: DISC and other discriminating income taxes. Journal of World Trade Law, 564–566. World Trade Organization (2000). United States – Tax treatment for “foreign sales corporations”, Report of the Appellate Body; AB-1999-9 (February 24). World Trade Organization (2002). United States – Tax treatment for “foreign sales corporations”, recourse to arbitration by the United States under article 22.6 of the DSU and article 4.11 of the SCM agreement (August 30). Yang, J. (1996). Exchange rate changes and pricing behavior of U.S. exporters. Review of International Economics, 4, 339–354.
IMPLICATIONS OF BENCHMARK STATE AND LOCAL TAX RATES FOR MEASURES OF ESTIMATED IMPLICIT TAXES Bradley D. Childs ABSTRACT The results of this study indicate that a likely reason why a negative relation between estimated implicit taxes and pretax returns is empirically observed is the researcher’s election to choose a zero tax rate as the benchmark state and local tax rate. Normally, an observed negative relation between estimated implicit taxes and pretax returns supports the hypothesis generated by implicit tax theory. This conclusion regarding the implicit tax hypothesis may be premature whenever the incidence of state and local income taxes contributes to this empirical finding. First, state income taxes, treated as a negative subsidy when the benchmark state and local tax rate is set at zero, will likely cause implicit taxes to be underestimated. Second, the observed relationship between estimated implicit taxes and pretax returns appears to be reversible depending upon the researcher’s election of a statutory tax rate that incorporates the selected benchmark state and local tax rate. The present study uses a sample of 848 firms covering the years from 1989 through 1998 to show how the relation between estimated implicit taxes and pretax returns can be manipulated by the selection of the benchmark
Advances in Taxation Advances in Taxation, Volume 15, 29–42 Copyright © 2003 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(03)15002-8
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state and local tax rate. Since choosing an accurate benchmark state and local tax rate can be problematic, the present study suggests adjusting both estimated implicit taxes and pretax income by the amount of state and local income taxes incurred. The results, using the regression model making this adjustment, appear to nullify the negative bias of a zero tax rate as the benchmark state and local tax rate.
INTRODUCTION The Scholes et al. (2002, p. 93) approach to implicit taxes emphasizes the notion of a benchmark asset that can be used to compare pretax returns. This approach does not emphasize a benchmark ordinary income tax rate for the calculation of implicit taxes, presumably because it should not matter. In theory, firms located in high-tax (low-tax) jurisdictions should have higher (lower) pretax profitability, which should render meaningless the selection of a tax rate benchmark. Perhaps for this reason, prior researchers (Callihan & White, 1999; Wilkie, 1992) have implicitly assumed benchmark state and local tax rates to be zero.1 One rationale for a zero benchmark rate is the idea that if a firm creates nexus with a state that has a corporate income tax, then operations in that state will produce enough additional benefits (i.e. implicit tax benefits) to offset the incurrence of state income taxes. In the real world, these offsetting benefits may not arise, and even if they do, measurement issues surrounding implicit taxes in the corporate sector may provide no evidence in support of the implicit tax hypothesis.2 The current study presents evidence that indicates that the choice of a benchmark state and local tax rate is an important decision to be made by empirical researchers. In the imperfect world of empirical analysis of financial statement data, a low benchmark state and local tax rate may lead to a negative bias in the relationship between pretax profitability and estimated implicit taxes. This potential bias can lead researchers and their audience to prematurely conclude that there is evidence of implicit taxes in the corporate sector.3 One way to control for this potential bias is to select the proper benchmark, but this is a daunting task given the lack of multijurisdictional data in the financial statements of public companies. Accordingly, the current study controls for this potential bias by subtracting current state and local income tax expenses from computations of pretax income and estimated implicit taxes. After removing the potential negative bias associated with a low benchmark rate for state and local income taxes, the results do not support implicit tax theory. While these results suggest non-trivial market frictions, there are several other factors (e.g. risk differences, accounting method differences and industry differences) that
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may account for these results. It is beyond the scope of this article to tackle these difficult empirical issues, but future research will need to control for some of these differences if the expected relation between pretax profitability and implicit taxes estimated from tax subsidies is to be observed. The remainder of this article is organized as follows. First, implicit tax theory is reviewed and the effects of omitting state and local tax rates is developed. Second, the empirical procedures are discussed. Finally, the descriptive statistics and results are analyzed and conclusions are made.
IMPLICIT TAX THEORY Using notation from Scholes et al. (2002, pp. 98–99), let Rb be the risk-adjusted before-tax return on the benchmark investment. Let Ra be the risk-adjusted before-tax return on a particular investment, and let r∗ be the common after-tax return that would occur in a perfectly competitive equilibrium. Scholes et al. (2002, p. 99) define an alternative investment’s implicit tax as: R b − R a = Implicit tax for the alternative investment.
(1)
Using the preceding definitions and Eq. (1), the following equation can be derived: r ∗ = R b (1 − t) = R a (1 − t) +
TSa Ia
(2)
where, t: the statutory tax rate, TSa : the tax subsidy or savings generated by the alternative investment, and Ia : the alternative investment. With further substitution, Eq. (2) becomes r∗ =
PTIb PTIa TSa (1 − t) = (1 − t) + Ib Ia Ia
(3)
where, PTIa,b : the pretax income generated from the respective investments, and Ib : the benchmark investment. The definition of TSa , the tax subsidy of an alternative investment is as follows: TSa = (PTIa )t − CTEa
(4)
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where, CTEa :
current tax expense of the alternative investment.
Equation (4) defines a tax subsidy as the difference between what the tax should have been given pretax income vs. the actual tax liability. Using Eqs (3) and (4), an estimated implicit tax for a firm can be calculated as follows: IMPLICITi =
((PTIi )t − CTEi )/(1 − t) Ii
(5)
where IMPLICITi : PTIi : CTEi : Ii :
the estimated implicit tax for firm i, pretax income for firm i, all current income taxes for firm i, and the investment for firm i.
The estimation of implicit taxes as presented in Eq. (5) is the method that has been used by Wilkie (1992) and Callihan and White (1999) in their exploration of implicit taxes in the corporate sector. Both studies found a negative relation between estimated implicit taxes and pretax returns, although Callihan and White (1999) only found this relation after inserting market structure variables that were significantly associated with estimated implicit taxes.4 Their interpretation of reduced implicit taxes for firms benefiting from market structure has been criticized on methodological grounds by Wright (2001). In the prior research, the benchmark tax rate was limited to the federal tax rate only, but most domestic firms are subject to state and local income taxes or their equivalents.5 A benchmark tax rate that excludes state and local income tax rates will lead to underestimating tax subsidies as follow: UnderTSa = [(PTIa )d − CTEa ] − [(PTIa )f − CTEa ]
(6)
where, UnderTSa : the underestimated tax subsidy for the alternative investment, d: the domestic statutory rate or [f + s(1 − f)], s: the state and local statutory rate, and f: the federal statutory rate. In Eq. (6), the domestic rate is the federal rate plus the state and local rate, net of the federal tax benefit of the deductibility of state and local income taxes.
Implications of Benchmark State and Local Tax Rates
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Substituting and rearranging terms in Eq. (6) results in the following: UnderTSa = (PTIb )s(1 − f).
(7)
An example illustrates the understatement of the tax subsidy in Eq. (7). Assume a state and local tax rate of 10%, a federal rate of 40%, and pretax income of $1,000 from the benchmark investment. CTEb is $460 (state and local tax is $100 and the federal tax is $360, net of the state tax benefit at the federal level), and the tax subsidy computed using the federal rate only is −$60 ($1,000 × 0.40 − $460). However, the true tax subsidy is zero. The tax subsidy is underestimated by $60 [$1,000 × 0.10 × (1 − 0.40)], as shown in Eq. (7). If tax subsidies are understated, as in Eqs (6) and (7), then estimated implicit taxes will be understated as follows: (PTIa )d − CTEa (PTIa )f − CTEa UnderIMPLICITa = − (8) 1−d 1−f where, UnderIMPLICITa : the underestimation of implicit taxes for the alternative investment. Equation (8) simplifies as follows: UnderIMPLICITa =
s(PTIa − CTE) 1−d
(9)
and,6 UnderIMPLICITa = s(PTIb ).
(10)
Using Eq. (10) makes it easy to calculate the understatement of implicit taxes. This can be illustrated by modifying the prior example. Assume an equivalent alternative investment has qualified for a $100 federal tax credit. The implicit tax associated with this tax subsidy is $185.19 ($100/0.54), as the implicit tax per theory is the tax subsidy divided by 1 minus the tax rate. As implicit taxes reduce pretax income, the PTI from this example is reduced to $814.81 ($1,000 − $185.19). The estimated tax subsidy using the federal rate only is $51.11 [$814.81 × 0.40 − ($814.81 × 0.46 − $100)], and the estimated implicit tax is $85.19 ($51.11/0.60). The understatement of implicit taxes equals $100 ($185.19 − $85.19, or 0.10 × $1,000). As Eq. (10) shows, the understatement of implicit taxes, which will occur when state and local tax rates are higher than assumed, is unaffected by the level of tax subsidy. If after-tax returns are common across firms or investments, then the mismeasurement of estimated implicit taxes will not introduce a negative bias in the
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relation between estimated implicit taxes and pretax returns. On the other hand, if after-tax returns are not common, then the underestimation of implicit taxes does introduce a negative bias, which the following illustrates. Assume firms i and j make $1,000 investments that are fully taxable in a jurisdiction with a 10% state and local tax rate and a 40% federal rate. Assume firm i’s pretax income is $100 and firm j’s pretax income is $120. Since both firms made fully taxable investments, there is no relation between pretax returns and implicit taxes as the latter is zero for both investments. But if the federal tax rate is used to estimate implicit taxes, then firm i’s estimated implicit tax will be −$10, and firm j’s estimated implicit tax will be −$12. The two pairs of estimated implicit taxes and pretax income exhibit a negative relation – firm i {−$10, $100} and firm j {−$12, $120}. Conversely, although it is not shown here, if the statutory tax rate used incorporates a state and local tax rate that is higher than the one in existence, then a positive bias would be introduced when after-returns are not common across firms or investments. Evidence consistent with these assertions is presented in the next section.
EMPIRICAL PROCEDURES Sample The primary sample is drawn from the 1998 Compustat CD-ROM and firms were excluded by the following screens: (1) (2) (3) (4) (5) (6) (7)
firms missing state income tax data for any year from 1989 through 1998; firms missing other tax data (income tax expense and deferred tax expense); firms missing financial statement data (stockholders’ equity); firms with cumulative small or negative stockholders’ equity; firms that are subsidiaries, firms with cumulative negative pretax income, and; firms with net operating loss carryforwards.
The first exclusion allows for control of estimated implicit taxes associated with state and local income taxes. The second exclusion permits the calculation of current tax expense, which is a necessary component of the estimated implicit tax calculation.7 The next two exclusions permit the calculation of pretax returns. The fifth exclusion prevents double counting a firm. The sixth and seventh exclusions are screens to omit firms that may not be in the high marginal tax clientele.8 Table 1 outlines the sample selection process. Due to these eliminations, a total of 848 firms were used in the study.
Implications of Benchmark State and Local Tax Rates
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Table 1. Effect of Sample Selection Procedures on Sample Size. Procedure
Sample
1. All active firms on 1998 Compustat CD-ROM 2. Delete firms with missing state income tax data for 1998 3. Delete firms without state income tax data available for 10 calendar years 4. Delete firms with other missing tax data 5. Delete firms with missing financial data 6. Delete firms with negative stockholders’ equity 7. Delete firms with small stockholders’ equity 8. Delete firms that are subsidiaries 9. Delete firms with negative pre-tax income 10. Delete firms with NOL carryforwards 11. Sample size
10,188 6,224 2,779 74 31 4 5 29 63 131 848
Variable Deflation Measures of estimated implicit taxes and pretax returns are deflated by a measure of stockholders’ equity. One measure sums the current year’s common equity, preferred stock, deferred tax liability and investments in unconsolidated investees.9 The measure used in this study combines the prior year’s balance of common equity, preferred stock and deferred tax liability. (All results also were computed using the prior measure, but there were no qualitative differences in results using either equity measure.)
Regression Models All of the data variables in the regression models are cumulative from 1989 through 1998.10 The pretax return variable for a given firm is its cumulative pretax income divided by its cumulative stockholders’ equity. The use of ten-year averaging smoothes out some of the variability in pretax returns and estimated implicit taxes.11 The results of two simple regression models are reported in this study. The initial regression model explores the relation between pretax returns and estimated implicit taxes as follows: PTROEi = 0 + 1 IMPLICITij + ij where:
(11)
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PTROEi : firm i’s cumulative pretax return IMPLICITij : firm i’s cumulative estimated implicit taxes given state tax rate j, and, ij : error term. The model in Eq. (11) is estimated for three different benchmark state and local tax rates −0, 5 and 10%. As there is no telling which benchmark state and local tax rate is correct, the next model ignores state and local income taxes by subtracting these taxes in the calculation of the variables. This model follows: ADJPTROEi = 0 + 1 NATIMPLi + i
(12)
where: ADJPTROEi : firm i’s cumulative adjusted pretax return; NATIMPLi : firm i’s cumulative estimated implicit taxes at a national level; and, i : error term. In the model in Eq. (12), adjusted pretax return is adjusted pretax income divided by stockholders’ equity. Adjusted pretax income is income after deducting state and local income taxes, but before deducting foreign and federal income taxes. Estimated implicit taxes at a national level are those estimated implicit taxes that are attributable to federal and foreign tax subsidies. The only difference between regular estimated implicit taxes and estimated implicit taxes on a national level are the estimated implicit taxes associated with state and local income taxes given a benchmark state and local tax rate of 0%.
RESULTS General The descriptive statistics for the sample are displayed in Table 2. For the time span between 1989 and 1998, the mean and median estimated implicit taxes are negative when the benchmark state and local tax rate is set at zero. These same statistics are positive when the benchmark state and local tax rate is set at 10%. When the benchmark state and local tax rate is set at 5%, the mean and median estimated implicit taxes are nearly zero. Table 3 contains the correlations between estimated implicit taxes and pretax returns are similar to the examples outlined previously. When the benchmark state
Implications of Benchmark State and Local Tax Rates
37
Table 2. Descriptive Statistics.
All firms, n = 848 PTI SE DTI CTE IMPLICITS=0 IMPLICITS=5 IMPLICITS=10 PTROE TOTTX TXFED TXFOR TXS STIMPLS=0 STIMPLS=5 STIMPLS=10 NATIMPL ADJPTROE
Mean
Std. Dev.
Median
Minimum
Maximum
242.6 926.7 0.280 87.075 −0.011 −0.001 0.011 0.211 87.355 51.917 25.280 9.266 −0.012 −0.002 0.010
743.1 2523 42.92 264.8 0.030 0.032 0.034 0.119 266.7 139.6 144.9 24.52 0.009 0.007 0.010
37.60 192.8 −0.059 14.22 −0.001 0.000 0.012 0.194 14.32 9.867 0.000 2.015 −0.010 −0.001 0.010
0.069 1.562 −776.9 −6.267 −0.292 −0.296 −0.300 0.004 −6.270 −45.86 −0.804 −0.086 −0.094 −0.054 −0.033
9,176 36,361 350 3,048 0.154 0.175 0.189 0.955 3,398 1,613 2,141 373.1 0.000 0.025 0.061
0.001 0.199
0.027 0.113
0.000 0.183
−0.282 −0.006
0.170 0.897
Definition of Variables: PTI = Compustat data code for pretax income – cumulative from 1989 to 1998 SE = Compustat data codes for common stockholders’ equity, preferred stock and deferred tax liabilities – cumulative from 1989 to 1998 DTI = Compustat data code for deferred tax expense – cumulative from 1989 to 1998 TOTTX = Compustat data code for total income tax – cumulative from 1989 to 1998 CTE = current tax expense: TOTTX – DTI IMPLICITS=x = estimated implicit tax: [(PTI × t − CTE)/(1 − t)]/SE : (t = F + ((1 − F) × S; F = 0.34 from 1989 to 1992 and 0.35 from 1993 to 1998; S is the benchmark state and local tax rate) PTROE = pretax return: PTI/SE TXFED = Compustat data code for current federal income taxes – cumulative from 1989 to 1998 TXFOR = Compustat data code for current foreign income taxes – cumulative from 1989 to 1998 TXS = Compustat data code for current state and local income taxes – cumulative from 1989 to 1998 STIMPLS=x = estimated implicit tax associated with state and local income taxes: [((PTI × S − TXS) × (1 − F))/(1 − t)]/SE NATIMPL = estimated implicit tax associated with national income taxes: [((PTI − TXS) × t − CTE)/(1 − t)]/SE ADJPTROE = adjusted pretax return: (PTI − TXS)/SE
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Table 3. Correlations. PTROE
ADJPTROE
IMPLICITS=0 IMPLICITS=5 IMPLICITS=10
−0.151*
STIMPLS=0 STIMPLS=5 STIMPLS=10
−0.682* −0.037 0.651*
NATIMPL
NATIMPL
0.080**
0.044 0.234*
0.058
n = 848. Definition of Variables: PTROE = pretax return: PTI/SE IMPLICITS=x = estimated implicit tax: [(PTI × t − CTE)/(1 − t)]/SE STIMPLS=x = estimated implicit tax associated with state and local income taxes: [((PTI × S − TXS) × (1 − F))/(1 − t)]/SE NATIMPL = estimated implicit tax associated with national income taxes: [((PTI − TXS) × t − CTE)/(1 − t)]/SE ADJPTROE = adjusted pretax return: (PTI − TXS)/SE ∗ Significant
at the 0.01 level. at the 0.05 level.
∗∗ Significant
and local tax rate is set at 0%, there is a significant negative correlation between estimated implicit taxes and pretax returns. When the benchmark state and local tax rate is set at 10%, there is a significant positive correlation between estimated implicit taxes and pretax returns.
Regressions Results of estimating the regression models are shown in Table 4.12 Panel A of Table 4 estimates the model in Eq. (11) for the three selected benchmark state and local tax rates, and Panel B estimates the model in Eq. (12), which controls for state and local income tax effects. The simple regression results mirror the results of the correlations. When the state and local income tax effects are controlled, as they are in Panel B, there is no significant negative relation between estimated implicit taxes and pretax returns. In fact, the relation is significantly positive (t = 2.33, p = 0.02, two-tailed test). This positive relation may not be robust given the insignificant correlation between PTROE and NATIMPL, which is reported in Table 3.
Implications of Benchmark State and Local Tax Rates
39
Table 4. Regression Analysis. Independent Variables and Statistics (n = 848)
S = 0%
Panel A: PTROEi = 0 + 1 IMPLICITS=x,i + F statistic 19.86* Adjusted R2 0.273 Intercept 0.204* (47.4) −0.590* (−4.46) IMPLICITS=x
S = 5%
S = 10%
1.62 0.023 0.211* (51.8) 0.164 (1.28)
49.12* 0.653 0.201* (48.6) 0.808* (7.01)
Panel B: ADJPTROEi = 0 + 1 NATIMPLi + 5.45* 0.069 0.198* (51.4) 0.334** (2.33)
F statistic Adjusted R2 Intercept NATIMPL Definition of Variables:
PTROE = pretax return: PTI/SE IMPLICITS=x = estimated implicit tax: [(PTI × t − CTE)/(1 − t)]/SE NATIMPL = estimated implicit tax associated with national income taxes: [((PTI − TXS) × t − CTE)/(1 − t)]/SE ADJPTROE = adjusted pretax return: (PTI − TXS)/SE ∗ Significant
at 0.01 level two-tailed. at 0.05 level two-tailed.
∗∗ Significant
Other Sample Size Results The requirement of state and local income tax data for all ten years may be too restrictive. Relaxing this requirement increases the sample size to 1,422. Thousands of observations are still lost, because the computation of estimated implicit taxes requires complete data for total income tax expense, deferred income tax expense and stockholders’ equity. The results using the increased sample, though unreported in a table, are qualitatively similar to the results reported in Table 4. Foreign tax rates can lead to the similar biases that are inherent in state tax rates. Ideally, it would be desirable to control for the foreign tax rate effect in a similar manner to the state and local tax rate effect. Unfortunately, this is not practicable. Foreign income taxes, unlike state income taxes, are a tax credit for federal purposes. In addition, while pretax income and estimated implicit taxes can be partitioned between foreign and domestic sources, the same cannot be said for the partitioning of stockholders’ equity into foreign and domestic uses. Therefore, a domestic-only sample is tested to determine if the results of the primary sample are driven by foreign income tax effects. The domestic-only
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sample has 623 firms and the results, also unreported, are qualitatively similar to those of the primary sample. All of the tests are conducted using ten-year averages. It is possible that the reported results are driven by a sub-period. All tests were rerun using five-year averages (1989–1993 and 1994–1998). These results (not reported) are qualitatively similar to the results reported in this study.
CONCLUSIONS When the benchmark state and local tax rate is set at 0%, estimated implicit taxes are negatively related to pretax returns. When the benchmark state and local tax rate is set at 10%, estimated implicit taxes are positively related to pretax returns. In theory, the selection of a benchmark state and local tax rate should not matter because after-tax returns are in common, but in practice these after-tax returns vary and the handling of state and local income taxes can become an important issue. The results of this research suggest that future researchers should take care in their treatment of state and local income taxes in their research designs. This caution, along with the reservations outlined by Wright (2001), may make it more difficult to report upon the presence or absence of implicit taxes in the corporate sector, but the presence or absence of implicit taxes is central to the question of whether taxes really matter in corporate investment decisions. The importance of this question should continue to motivate investigations of implicit taxes in the corporate sector regardless of the difficulties in doing this research.
NOTES 1. Both studies set the tax rate to equal the maximum statutory federal tax rate for corporations. 2. Wilkie (1992) contains an excellent discussion of these measurement issues. 3. Scholes et al. (2002) report the conclusions of both Wilkie (1992) and Callihan and White (1999). In addition, Scholes et al. (2002) present a summary literature review of empirical evidence regarding implicit taxes. 4. In Callihan and White (1999), pretax returns and estimated implicit taxes are positively correlated at a significance level of 0.01. 5. Hellerstein and Hellerstein (2001) report that corporate income taxes in the 1990s accounted for approximately 7% of state tax collections. Only Nevada, Texas, Washington and Wyoming do not have corporate income taxes. In addition, South Dakota only taxes financial institution corporations. Not all states that tax corporations do it in the form of an income tax. Some of the taxes are franchise and/or excise taxes. The formulas for these taxes often include measures of income, receipts and net assets.
Implications of Benchmark State and Local Tax Rates
41
6. The derivation to Eq. (9) is as follows: PTIa × f − CTEa PTIa × d − CTEa − 1−d 1−f =
s(1 − f)(PTIa − CTEa ) s(PTIa − CTEa ) (d − f)(PTIa − CTEa ) = = (1 − d)(1 − f) (1 − d)(1 − f) 1−d
The derivation to Eq. (10) recognizes that PTIb = (PTIa − CTEa )/(1 − d) because after-tax incomes are equal for a given investment amount in implicit tax theory. 7. Timing differences became temporary differences after adoption of Statement of Financial Accounting Standard No. 109. Not all timing differences are temporary or vice-versa, but the overlap is very substantial. 8. Graham (1996) considers high marginal tax firms to be those firms that meet the following two tests: firms with positive pretax income and firms without net operating loss carryforwards. 9. Investments in unconsolidated investees is dropped for the denominator and equity income is dropped for the numerator for two reasons: (1) both numbers have negligible effects on the ratios and both numbers are often combined figures with other income or other assets; and (2) equity income can be thought of as similar to tax-exempt interest, both items reflect after-tax income and they may be ideal candidates for finding an inverse relationship between estimated implicit taxes and pre-tax income. 10. Whenever a variable is computed using the statutory tax rate, two cumulative figures are used. For example, IMPLICIT is computed for 1989–1992 separate from 1993–1998, because the statutory federal rate was increased from 0.34 to 0.35. The overall IMPLICIT variable for a firm combines the 1989–1992 figure and the 1993–1998 figure. 11. A lot happened in the USA in the ten years from 1989 through 1998, but the same could probably be said for any ten year period in the modern economy of the United States. Nevertheless, it is possible that in a different time period a negative relation between pretax income and estimated implicit taxes could be found while controlling for state and local taxes. The purpose of this study is not an attempt to discredit implicit tax theory. Instead, the purpose is to improve the method of testing for implicit taxes in the corporate sector. 12. As some of the variables are not distributed normally, monotonic regressions were estimated for all models. Monotonic regressions are a nonparametric procedure that ranks all variables on percentile ranks. If the regular regressions have similar results to the monotonic regressions, as is the present case, Conover (1980) recommends reporting the regular regression results.
ACKNOWLEDGMENTS The author appreciates the comments and suggestions of participants in workshops at Iowa State University, University of Dayton and the 2000 AAA Annual Meeting. The author would also like to thank the anonymous reviewers for their helpful comments.
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REFERENCES Callihan, D., & White, R. (1999). An application of the Scholes and Wolfson model to examine the relation between implicit and explicit taxes and firm market structure. The Journal of the American Taxation Association, 21(Spring), 1–19. Conover, W. (1980). Practical nonparametric statistics (2nd ed.). New York, NY: Wiley. Graham, J. (1996). Proxies for the corporate marginal tax rate. Journal of Financial Economics, 42, 187–221. Hellerstein, J., & Hellerstein, W. (2001). State and local taxation: Cases and materials (7th ed.). St. Paul, MN: West Publishing Co. Scholes, M., Wolfson, M., Shevlin, T., Erickson, M., & Maydew, E. (2002). Taxes and business strategy: A planning approach. Englewood Cliffs, NJ: Prentice-Hall. Wilkie, P. (1992). Empirical evidence of implicit taxes in the corporate sector. The Journal of the American Taxation Association, 14(Spring), 97–116. Wright, B. (2001). An application of the Scholes and Wolfson model to examine the relation between implicit and explicit taxes and firm market structure: An analysis. The Journal of The American Taxation Association, 23(Fall), 59–67.
TAX ADMINISTRATION PROBLEMS: GAO-IDENTIFIED SHORTCOMINGS AND IMPLICATIONS Philip J. Harmelink, Thomas M. Porcano and William M. VanDenburgh ABSTRACT An assimilation and a synthesis of the major General Accounting Office (GAO) reports released on the Internal Revenue Service (IRS) for calendar year 2002 reveal a variety of tax administration problems. An analysis of the GAO reports also suggests that the IRS might be a contributor to the non-compliance problem. Additionally, Congresses and Administrations have not facilitated meaningful improvements. While the GAO reports generally attempt to portray the ongoing modernization efforts within the IRS favorably, the weaknesses identified suggest that significant tax administration problems exist. This article presents a detailed analysis of the GAO overall report on the 2002-filing season and assesses GAO reports and testimonies that contain IRS in their titles.
INTRODUCTION The Internal Revenue Service (IRS) is the predominant collection agency for the United States (U.S.) Government.1 Congress exerts primary oversight relative
Advances in Taxation Advances in Taxation, Volume 15, 43–91 Copyright © 2003 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(03)15003-X
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P. J. HARMELINK, T. M. PORCANO AND W. M. VANDENBURGH
to IRS functions through Congressional hearings, budgetary allocations and the General Accounting Office (GAO) audits/reports. In 2002, the GAO issued over 25 reports on the IRS directly (see Table 1) and hundreds indirectly.2 The sheer volume and scope of these reports make it a difficult task to assess them in totality. The specific purpose of this article is to assimilate and synthesize the critical overriding attributes of these audit reports. The IRS has not adequately addressed some of the material issues raised in these reports. (Congress also makes annual tax law changes, adding significantly to the IRS’s administrative burden. Thus, Congress has substantial responsibility for these problems, but ultimately it still is the IRS’s responsibility to effectively administer the tax system.) This has a material direct cost, as well as a negative effect in terms of the overall public perception of the government. Research suggests that complexity and procedural justice (or lack thereof) contribute to the taxpayer non-compliance (Porcano, 1988). If the IRS appears to act in an anti-taxpayer manner, then taxpayers will believe that procedural justice is lacking and will react by reducing compliance. As shown in Table 2, the U.S. government collected nearly $1.9 trillion in fiscal year 2002. However, the lost tax revenue resulting from non-compliance, omissions, and errors is estimated at 10% of revenues collected; i.e. more than $200 billion (Grenshaw, 2003). A clear example of the non-compliance and excessive complexity is the ever-expanding Earned Income Tax Credit (EITC) Program. In a general GAO analysis on the overall “government’s improper payments problems,” it noted (GAO-02-749, 8/09/02, p. 6): In March 2001 we reported that, during fiscal year 2000, the Internal Revenue Service (IRS), relying on past experience, screened tax returns claiming Earned Income Tax Credits (EITC) to identify (for detailed examination) those considered most likely to be invalid. IRS examiners performed detailed reviews of about 257,000 tax returns claiming approximately $587 million in EITC and found that about 173,000 of those tax returns claiming $395 million in credits (67%) were invalid.
The EITC continues to be plagued with improper payments of material amounts – estimated at $10 billion annually (McKinnon, 2003). This is a specific example of a difficult-to-administer area for which repeated Congressional changes have only added to its complexity. This contributes to increased taxpayer non-compliance and tax administration problems. This article presents an examination of major GAO reports on the IRS from 2002 for central themes and issues within the current environment. It also extends the work of Harmelink and VanDenburgh (2002), which presented an opposing view to the Hite (2002) study. The present article, in direct contrast, is a broad-based
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Table 1. Search of GAO Site for 2002 for the Title Terms: Internal Revenue Service or IRS. Reference No.
Date
Title
GAO-03-314
12/20/02
GAO-03-243
11/15/02
GAO-03-143
11/22/02
GAO-03-50R GAO-02-848
10/21/02 7/30/02
GAO-02-804
7/12/02
GAO-02-746R
7/30/02
GAO-02-733
5/22/02
GAO-02-715T
5/14/02
GAO-02-711R GAO-02-704
7/8/02 6/28/02
GAO-02-619T
4/15/02
GAO-02-618T
4/11/02
GAO-02-580T
4/9/02
GAO-02-558
4/24/02
GAO-02-526
4/30/02
GAO-02-509
3/29/02
GAO-02-444
7/17/02
GAO-02-414 GAO-02-356
2/27/02 2/28/02
GAO-02-353
4/12/02
GAO-02-336 GAO-02-311
1/31/02 3/15/02
GAO-02-234R GAO-02-92
5/9/02 2/20/02
IRS’s 2002 Tax Filing Season: Returns and Refunds Processed Smoothly; Quality of Assistance Improved Highlights Financial Audit: IRS’s Fiscal Years 2002 and 2001 Financial Statements Tax Administration: IRS Needs to Further Refine Its Tax Filing Season Performance Measures IRS and Terrorist-Related Information Sharing Internal Revenue Service Status of Recommendations From Financial Audits And Related Financial Management Reports Performance Management Systems: IRS’s Systems for Frontline Employees and Managers Align with Strategic Goals but Improvements Can be Made Management Report: Improvements Needed in IRS’s Accounting Procedures and Internal Controls Internal Revenue Service: Efforts to Identify and Combat Abusive Tax Schemes Have Increased, but Challenges Remain Tax Administration: Continued Progress Modernizing IRS Depends on Managing Risks IRS’s Budget Justification: Options for Structure and Content Internal Revenue Service: Improving Adequacy of Information Systems Budget Justification Tax Administration: IRS Continues to Face Management Challenges in its Business Practices and Modernization Internal Revenue Service: Enhanced Efforts to Combat Abusive Tax Schemes Challenges Remain Internal Revenue Service: Assessment of budget Request for Fiscal Year 2003 and Interim Results of 2002 Tax Filing Season Tax Administration: IRS’s Innocent Spouse Program Performance Improved; Balanced Performance Measures Needed Tax-Exempt Organizations: Improvements Possible in Public, IRS, and State Oversight of Charities Tax Deductions: Further Estimates Of Taxpayers Who May Have Overpaid Federal Taxes By Not Itemizing Political Organizations: Data Disclosure and IRS’s Oversight of Organizations Should be Improved Financial Audit: IRS’s Fiscal Years 2001 and 2000 Financial Statements Business Systems Modernization: IRS Needs to Better Management Capacity with Systems Acquisition Workload Private Pensions: IRS Can Improve the Quality and Usefulness of Compliance Studies Tax Abatements: Better IRS Data Could benefit Small Businesses and IRS Tax Administration: IRS Should Evaluate the Changes to its Offer in Compromise Program IRS Guidance on Economic Analyses in Investment Business Cases Tax Administration: IRS’s Efforts to Improve Compliance with Employment Tax Requirements Should be Evaluated
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Table 2. Final Monthly Treasury Statement September 30, 2002 (Fiscal Year 2002).a,b Individual Income Taxes Corporate Income Taxes Social Insurance and Retirement Receipt Excise Taxes Estate and Gift Taxes Custom Duties Miscellaneous Total Receipts Total Outlays Deficit a Dollar
$858,347 148,042 700,762 66,989 26,507 18,602 34,040 $1,853,288 $2,011,808 $158,520
46.31% 7.99% 37.81% 3.61% 1.43% 1.00% 1.84% 100.00%
amounts in 000,000.
b http://fms.treas.gov/mts/mts0902.pdf,
p. 5.
assessment of ongoing management problems that are repeatedly identified by the GAO. It takes a global perspective of the current tax administration problems. As opposed to examining a specific issue, this article is not limited to analyzing a piece of the problem but focuses on the overall situation. First, the current situation of the tax system and the role of the GAO are described. The article then examines key reports from the GAO on the IRS to identify and summarize major concerns. Finally, recommendations are made to fully realize the benefits inherent in adequately addressing the GAO examinations.
MOUNTING COMPLIANCE CRISIS Congress has enacted approximately 25 major Tax Act changes since the Tax Reform Act of 1986 (TRA86). TRA86 attempted to achieve some measure of simplification. The Act basically attempted to broaden the base and lower rates by eliminating deductions, while at the same time increasing the personal exemption and standard deductions. Nevertheless, complexity has grown with the increased use of phase-outs, credits and deductions. A salient illustration of this is the multitude of education provisions, which now include deductions for adjusted gross income (AGI), credits, and Educational-Individual Retirement Accounts, many of which are subject to various phase-outs. Provisions are added annually to the IRC for social and political reasons, while the primary goal of revenue collection is suffering. A significant decrease in noncompliance could eliminate the current deficit of $159 billion – “the first deficit since fiscal year 1997” (Financial Management Service, 2002). An examination of the GAO’s reports in their entirety suggests that the IRS has a role
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in, and is a contributor to, this noncompliance (see Table 1 for a list of 2002 GAO reports). The titles by themselves convey the enormity of the problems and the issues confronting effective tax administration. In a 2002 Congressional hearing and article for the 30th Anniversary of Tax Notes, Michael J. Graetz (former Deputy Assistant of the Treasury for Tax Policy) noted the following (Graetz, 2002 and Subcommittee, 2002): The current income tax is a horrible mess. The tax system should be transparent and simple. Graetz advocates a consumption tax as a system that the IRS could administer. The President and Congress use the current system as a magic solution. Tax credits are employed for education, child care affordability, health insurance coverage, financing of long-term care, etc. Tax legislation in the 1990s unraveled TRA86, which was based on the concept of a broad base, low rate, and simplified system. In 1940, instructions for the 1040 were four pages. Currently, instructions total 117 pages with 11 schedules and 20 additional worksheets. (In 2002, the 1040 instructions now total 126 pages.) While he is a fan of former IRS commissioner Charles Rossotti, Graetz is wary of a concept of a customer-friendly IRS. Graetz proposes a value added tax (VAT) of approximately 12% combined with a tax of 25% on incomes over $100,000. This would eliminate 85% of taxpayers who currently file from filing. The VAT is utilized in 120 countries on five continents. The Economic Growth and Tax Relief Act of 2001, with a decade of phase-ins and phase-outs, makes re-examination of the tax structure inevitable. We have no stable status quo. The EITC supplies indispensable wage subsidies to low-income workers and their children, but it is not working well. During the past 25 years, the income tax has fallen into disrepute. Congress creates the complexities in the tax law, often providing convoluted or inadequate statutory guidance, then blames the IRS for being unable to cope. The fundamental problem is that the IRS is asked to do too much; it cannot accomplish all that Congress requires of it. Graetz’s primary purpose in the above statements was to advocate that the VAT replace much of the current tax system. However, the supporting conditions he cited are highly relevant to the current tax environment. In particular, with 1040 tax instructions totaling over 100 pages, the practical reality is that few taxpayers or the IRS fully understand the basic provisions of the current system. Additionally,
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Graetz observes the reality that Congress directs the IRS to administer an almost unworkable system. Adding credence to the growing consensus of a crisis are the following points highlighted by Grenshaw (2002), whereby he quotes extensively from former IRS Commissioner Charles O. Rossotti: Confidence in the U.S. tax system is being undermined in part due to high income tax avoidance schemes; former IRS Commissioner Charles O. Rossotti stated that a “quite significant revamping of our priorities” is needed. As Rossotti noted, revenue loss is significant, “There are some very amazing examples [involving] tens of millions of dollars in additional tax. There’s a lot of money out there. . . . You have individuals who are almost like corporations, with sophisticated advisers and the ability to move income around among different entities.” In 1997, the IRS was sharply criticized by the Senate Finance Committee for allegations of taxpayer abuse. The chance of being audited subsequently dropped to 1 in 200 overall at one point in time with a concentration on low-income individuals. Previous budgetary surpluses made Congress less concerned over revenue lost due to non-compliance. More than 60% of the individual income tax comes from taxpayers with more than $100,000 in income. These individuals have “more potential to manipulate” income through partnerships, trusts and corporations. There are over 150 ongoing investigations into tax shelters. These probes are leading to additional inquiries. While experts commend the current efforts, they cautioned that the IRS has a long way to go in enforcing tax laws. Former IRS Commissioner Donald Alexander observed that “what the IRS needs is considerably more in the way of resources, and they need to use those resources carefully and well.” In general, low audit rates encourage tax advisers and payers to be “aggressive and take chances.” Rossotti acknowledged that the IRS is struggling with its workload. “We are trying to use the resources we have as well as we can. We still have major problems in terms of sheer capacity. We don’t have the resources to deal with all the cases we should deal with.” The IRS budget is $9.9 billion (up from $8.8 billion) last year. For 2003, the IRS is requesting $10.4 billion. The IRS workforce is below its 1992 level of 116,000 workers. In 1995, there were 18,000 auditors and agents. Of the 100,000 IRS employees, 13,000 are revenue agents.
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The IRS has recently hired 700 new personnel for enforcement activity. However, they lacked the experience and training and many are just replacements for retiring personnel. The above observations indicate that the tax system has some fundamental problems. An examination of the details contained in audits and reports by the GAO (Congress’s own investigative arm) can help identify underlying conditions needing reform. The results portray an agency that has difficulty performing some of the functions and duties that Congress and the Administration have assigned. Additionally, they strongly imply that Congress consciously overlooks these problems (the GAO reports often cast a positive tone but the details convey basic problems with the tax system). Quite the opposite of addressing these chronic problems, Congress has added to the problem. It continues to add more intricate provisions to the already overburdened IRC and IRS. Congress requires the IRS to do too much through its continuous code changes, thereby requiring the IRS to direct its attention away from underlying tax administration areas (e.g. the 2002 advance tax rate reduction credit).
GAO The GAO serves the Congressional branch of the U.S. government. It is geared toward evaluations for performance enhancement. Its mission statement reads: The General Accounting Office is the investigative arm of Congress. GAO exists to support the Congress in meeting its Constitutional responsibilities and to help improve the performance and ensure the accountability of the federal government for the American people. GAO examines the use of public funds, evaluates federal programs and activities, and provides analyses, options, recommendations, and other assistance to help the Congress make effective oversight, policy, and funding decisions. In this context, GAO works to continuously improve the economy, efficiency, and effectiveness of the federal government through financial audits, program reviews and evaluations, analyses, legal opinions, investigations, and other services. GAO’s activities are designed to ensure the executive branch’s accountability to the Congress under the Constitution and the government’s accountability to the American people. GAO is dedicated to good government through its commitment to the core values of accountability, integrity, and reliability.
In general, the GAO has moved away from “gotcha” studies to more of a “reform agenda” (Burman, 1999). Burman, a former administrator of the Office of Federal Procurement Policy, noted the following: The GAO was established in 1921 as an oversight body to oversee all executive financial branch financial transactions. The staff, which was originally comprised mostly of auditors, is now made up of public administrators and economics graduates.
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It now has a reform agenda that emphasizes improving government management. Agency failures are not the focus of GAO reports; it has taken a more positive approach since 1976. However, the GAO continues to conduct specific reviews mandated by Congress. Much of the fraud, waste, and abuse studies are now conducted by an agency’s independent inspector general. Executive branch officers are known to debate the merits of the reports. No matter the tenor of GAO’s report, Congress will have the last word. The above observations from an inside party of the GAO audit process are highly relevant to the analysis of GAO reports on the IRS. In general, GAO reports of overall studies can be expected to offer praise for efforts undertaken, but the details of the reports often communicate fundamental problems. Further, specific review audits often are more directly critical, possibly due to greater GAO staff freedom. These points are present in 2002 GAO reports on the IRS.
THE 2002 FILING SEASON In December 2002, the GAO released its annual assessment of the IRS’s previous filing season.3 The report summary had a generally favorable tone and was even titled “IRS 2002 Tax Filing Season: Returns and Refunds Processed Smoothly; Quality of Assistance Improved” (GAO-03-314, 12/20/02).4 It centered on five major IRS facets: processing returns, refunds and remittances; electronic filing; telephone assistance; face to face assistance; and web services for the IRS’s Wage and Investment (W&I) Operating Division (mainly individuals).5 Information was obtained from the IRS, outside parties (e.g. return preparers), Congressional testimony, Treasury Inspector General for Tax Administration (TIGTA) reports, and observations of IRS activities. It relied on IRS-provided data that were “not independently verified.” Importantly, it noted that the IRS is required to provide “top quality service to all taxpayers” as part of the IRS Restructuring and Reform Act of 1998. Table 3 contains IRS information regarding returns processed and taxpayer assistance. In the conclusion, the GAO noted that the IRS should be commended for the various efforts it took to prepare for and improve performance during the filing season. The IRS successfully confronted a “new rate reduction credit” that caused taxpayer errors (in the GAO’s view), relief notices resulting from terrorist attacks, and a reorganization which caused computer files “shifts.” The report also highlighted areas of sub-performance on the part of the IRS administration. For instance, it observed (GAO-03-314, 12/20/02, p. 3):
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Table 3. IRS Tax Facts. Returns processed Total returns Paper returns Electronic returns Paper processing centers Electronic processing centers Refunds
131 million 84 million 47 million 8 3 99 million
Taxpayer assistance Calls to IRS IRS assistor Automated and hang up (including disconnected) Call in sites (including automated) Contacts at walk-in sites Walk-in sites Internet down loads
104 Million 30 Million 74 million 26 5 million 477 379 million
Source: GAO 2002 Reports. Walk-in Assistance – Despite data limitations, there was enough evidence to suggest that the accuracy of tax law assistance provided by IRS’s walk-in sites improved in 2002 compared with 2001, although the level of accuracy (about 50%) was still low. Some of that improvement might be attributed to better training of field assistance employees. Although field assistance has made and anticipates making more workload and staffing changes at its walk-in sites, it has no comprehensive plans for doing so. When we discussed this with field assistance officials, they told us that they put the changes on hold until they are able to do more comprehensive planning.
A 50% accuracy rating is not consistent with the IRS’s mission statement of providing “America’s taxpayers top quality service.” In 2001, TIGTA reported (2001-40-077, May 1, 2001) a 50% accuracy rating based on random on-site visits. However, the actual rate in this critical area has been documented in an IRS internal review to be as low as 19% (Harmelink & VanDenburgh, 2002). Thus, when taxpayers seek personal assistance from an IRS walk-in site, they, at best, have a 50% chance of correct answers. Even though walk-in assistance was not a “primary focus” of this GAO report, the above quote from the GAO report stated that “comprehensive planning” still has not occurred in this critical area. Walk-in sites are the focal point of contact for most taxpayers when dealing with the IRS “face to face.” As such, the IRS should strive to increase its performance. In conclusion, the GAO observes (GAO-03-314, 12/20/02, p. 44): IRS’s decision to use existing data to measure return-preparation accuracy in lieu of having staff visit walk-in sites to observe return preparation could free up the resources needed to expand
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P. J. HARMELINK, T. M. PORCANO AND W. M. VANDENBURGH the reviews of account accuracy. IRS also needs to ensure that changes to walk-in sites and staffing are thoroughly analyzed and planned.
Overall, the December 2002 GAO assessment is somewhat misleading, as evidenced from a USA Today news headline about the release of the report: “IRS Gets High Grade for Service in 2002” (USA Today, 2002). An actual examination of the details of the report makes this assessment questionable at best. For example, while the GAO casts the IRS’s handling of the “new rate reduction credit” positively, it is possible that the IRS’s forms and instructions were deficient, and this deficiency caused compliance problems (which the GAO even asserted in an earlier 2002 testimony). Details from each of the five reviewed areas in the report follow. Processing Returns As Table 3 shows, the IRS processed 131 million returns in 2002. Eighty-four million were paper filed and it issued 99 million in refunds. The IRS had eight return processing sites. The GAO observed that tax preparation firms thought the season went “relatively smoothly” and that TIGTA also had given a positive assessment. It did note that since the “IRS revised its letter error rate and notice error rate performance measures since last filing season, we could not compare its performance in 2002 with its performance in 2001 or against its goals for 2002” (GAO-03-314, 12/20/02). Early preparation was cited as the key factor in this perceived success, and that process started in early February 2001. The GAO observed that “advance tax refunds and the rate reduction credit led to many errors on filed returns.” As late as March of 2002, the IRS was still making “programming changes” due to the sheer number of returns that had made this one error. In total, eight million returns contained this single error and practitioner-prepared returns made up over three million of these returns. Table 4 shows the number of returns and breakdown of errors. Table 4. Rate Reduction Errors 2002 Tax Filing Season. Returns Prepared by
Number of Returns Processed
Number of Returns with Errors
Number of Returns with Rate Reduction Credit Errors
Rate Reduction Credit Errors as a Percentage of Returns with Errors
Taxpayers Tax return practitioners
49,939,318 73,013,833
8,369,035 5,691,483
4,208,991 3,816,860
50.3% 67.1%
Total
122,953,151
14,060,518
8,025,851
57.1%
Source: Derived from GAO-03-314 table, p. 46.
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The rate reduction credit errors made were grouped into three categories (GAO-03-314, 12/20/02, p. 51): Taxpayers and practitioners filed over 5 million returns in which they failed to claim a credit even though the taxpayers were entitled to one; About 2 million returns were filed in which a credit was claimed even though the taxpayers had received the maximum advance tax refund in 2001 and thus were not entitled to a credit; And almost 1 million returns were filed in which a credit was appropriately claimed, but the credit amount was incorrectly computed. In December 2002, the GAO suggested that the IRS had successfully dealt with the problem of the “new rate reduction credit” by correcting the errors. However, in April 2002, in a write up for Congressional testimony, the GAO observed (GAO-02-580T, 4/9/02, p. 23): Although the IRS took several steps after the filing season began in response to the large number of rate reduction credit errors, the GAO believes, in retrospect, that some of those errors might have been prevented if the instructions for Forms 1040, 1040A, and 1040EZ had been clearer. For example, the IRS did not highlight the rate reduction credit on the new line on the tax form related to the rate reduction credit on the cover page of the instructions, where the IRS alerts taxpayers to changes from the prior year. Instead, the IRS highlighted the fact that tax rates were reduced. Only if taxpayers read the paragraph under the highlighted caption “Tax Rates Reduced” would they see mention of the credit . . . In retrospect, including the same explanation of “before any offset” in the instructions would have made the instructions clearer.
This directly contradicts its December 2002 assessment. Other problems with this credit also occurred. A computer programming error resulted in “erroneous credits.” The IRS chose not to “attempt to recover any erroneous payments resulting from this problem because recovery would not be cost-effective.” While a relatively minor issue, it shows the degree to which non-compliance is tolerated. In another instance, 1.6 million taxpayers who under-claimed the credit were not notified of this until TIGTA observed (GAO-03-314, 12/20/02) that this was “inequitable.” This problem was not included in the total returns with an error count of eight million (thus, the number of total errors is greater than stated). Also, the GAO failed to observe that the IRS initially sent out 500,000 notices that overstated the amount of the credit a taxpayer would receive (Hamilton, 2001).
Electronic Filing The IRS Restructuring and Reform Act of 1998 established an electronic filing goal of 80% by 2007. As shown in Table 5, only 36% of individual returns were
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Table 5. Electronic and Paper Filing Statistics.a 2000
2001
2002
92,322
89,834
83,816
Traditional On-line Tele-File
25,211 5,022 5,161
28,988 6,838 4,419
33,286 9,428 4,176
Total Electronic
35,394
40,245
46,891
127,716 27.7
130,079 30.9
130,708 35.9
Paper Electronicb
Total Returns Percentage filed electronically
Source: Derived from GAO-03-314 Table 1 page 16 (see for greater details). a Number of returns are in 000. Numbers are from the filing period January to October of the year. b Traditional electronic filing involves the transmission of returns over communication lines through a third party, such as a tax return practitioner, to an IRS processing center. On-line returns are prepared and transmitted by taxpayers through on-line intermediaries using personal computers and commercial software. Under Tele-File, certain taxpayers who are eligible to file a Form 1040EZ are allowed to file using a toll-free number on touch-tone telephones.
filed electronically (47 million returns) in 2002. In addition to the potential to reduce the number of filing errors, electronic filing also eliminates the reliance on the U.S. postal system. Unfortunately, an IRS, Congressional and Administrative commitment to electronic filing appears to be lacking. Only $15 million was spent in marketing this critical program in 2002. The GAO noted (GAO-03-314, 12/20/02) that the Electronic Tax Administration Advisory Committee (ETAAC) considers the current growth rates as unsustainable and therefore infers that reaching the 80% goal appears unattainable without changes. The ETAAC observed that early/easy adopters already are part of the program, and that there are still “various barriers” to electronic filing. Practitioner satisfaction with electronic filing has dropped from 93% in 2000, to 90% in 2001 and to 85% in 2002. The IRS has identified many “impediments to electronic filing,” such as privacy and security, cost, awareness, interest, and the fact that certain information cannot be transmitted electronically. In 2002, the IRS announced an agreement with a “consortium” of private companies to allow for potentially 78 million returns to be filed for free. The program was based on the current “on-line intermediary” approach whereby taxpayers cannot directly file with the IRS. Taxpayers must go to an internet site (software is not given to taxpayers). This indirect approach is problematic. Such an approach increases taxpayer compliance costs and creates additional security and privacy concerns. A better alternative would be a direct
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Table 6. EFTPS Facts. Enrollments (as of May 12, 2001) Number of payments since 1996 Dollars transmitted electronically
3,454,923 197 million $5 trillion
Source: http://www.eftps.gov/
filing system, where the IRS mails each taxpayer a basic tax disk or provides on-line access to a program that allows for electronic filing without any fees. Taxpayers wanting enhanced services could purchase commercially-available software. Since 1996, the IRS has had a related program that allows for direct electronic payments (recently expanded to include individuals). Electronic Federal Tax Payment System (EFTPS) was developed by the U.S. Department of the Treasury’s Internal Revenue Service (IRS) and Financial Management Service (FMS) to enable taxpayers to pay their federal taxes electronically. The system allows taxpayers to use the phone, personal computer (PC) software (for businesses only), or the Internet to initiate tax payment reports to EFTPS directly. It is convenient, secure, and timesaving. As the GAO noted (GAO-03-314, 12/20/02), security and privacy concerns make adoption of electronic filing unappealing to many. Table 6 contains data about the EFTPS. From 1996 to May 2001, there were less than 3.5 million enrollments. The EFTPS is an underutilized program. A direct electronic filing approach, similar in format to EFTPS, would eliminate many of the above concerns. The IRS is considering another initiative to encourage electronic filing (GAO03-314, 12/20/02). It would provide larger-scale practitioners offering electronic services access to “valuable tools to improve their service to customers and reduce costs . . . such as taxpayer identification matching and account resolution.” Unfortunately, as currently structured, this would not be available to small- and mid-size practitioners. The GAO states (GAO-03-314, 12/20/02) that the IRS has taken steps to “address most of the identified impediments,” but only 36 million returns were filed electronically. Mailing postcards to taxpayers encouraging electronic filing has not been sufficient to convert “40 million computer-prepared” returns to electronically-filed returns. A direct approach as noted above is needed if electronic filing is to approach 80% of all returns. Telephone Service The GAO stated that “telephone service improved compared with last year” and that it “was more accessible and accurate.” Additionally, it observed that the “IRS
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met most of its performance goals.” The calling season annually runs from January 1 to July 15 each year. After April 15, the IRS receives calls inquiring about refund statuses and notices. Despite the positive GAO section lead-in, the report states (GAO-03-314, 12/20/02, p. 21): (only) 21.2 million of the 30.4 million callers attempting to reach an assistor actually reached one; 42.9 million calls resulted in the caller receiving an automated service; and 40 million calls resulted in the caller hanging up or being disconnected without receiving service, including callers who received a busy signal. The above numbers indicate that, at best, only 70% of callers needing assistor aid actually received it. As a footnote to the report suggests, the IRS can only estimate the number of callers who get a “busy signal,” and it does not attempt to estimate those “callers who did not get a busy signal but hung up before completing the menu responses.” The report notes that customer telephone assistance improves after a “January slump,” with a “classic learning curve” effect occurring. However, the overall commitment to better telephone taxpayer service is questionable. As seen in Table 7, the IRS has set many goals in the 70% range. Even in the area of “accounts correct response rate,” it achieved a 91% rate when its goal was only 93%. Table 7. Caller Assistance Numbers.a 2001
2002
2002 Goal
68% 39% 5.62 minutes
71% 51% 4.47 minutes
72% 44% 4.82 minutes
75% 69% 79% 88%
82% 76% 85% 91%
78% 72% 85% 93%
Customer satisfaction (average of the 2 periods) Wage and investment 3.46 Small business/self-employed 3.46
3.47 3.50
3.49 3.58
Accessibility measures CSR level of service Assistor response level Average speed of answer Accuracy measures Tax law quality rate Accounts quality rate Tax law correct response rate Accounts correct response rate
Source: Derived from GAO-03-314, Table 2, page 24 (see for greater details). a Again, numbers are cast in favorable fashion. Instead of minutes, seconds are reported in the GAO report. Additionally, customer survey results are broken down into periods. Customer satisfaction is based on callers that got through to an assistor (which likely biases upward the reported numbers).
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The IRS received a 3.47 out of 4.00 customer quality rating for its W&I and Small Business divisions. However, these numbers are positively skewed because callers who received a busy signal or hung up (as approximately 40 million callers did) were not included in this assessment. Additionally, despite the “January Effect,” closer scrutiny of a relevant GAO data reveals that customer satisfaction decreased after April.
Walk-In Assistance In many instances, taxpayers receive less than adequate service at the over 400 IRS walk-in sites. This is the only point of direct one-on-one contact that most taxpayers have with the IRS. Whether an error (or bad service) occurs when an IRS employee refers a taxpayer to a publication (as opposed to answering the question) is debatable. However, the GAO even stated (GAO-03-314, 12/20/02, p. 29): In commenting on a draft of this report, the Acting Commissioner of Internal Revenue said that our use of TIGTA’s accuracy rates is inappropriate because TIGTA included referrals to IRS publications as errors. While noting that the IRS does not want employees to improperly refer questions, the Acting Commissioner said that those referrals should not be counted as incorrect answers. According to the Acting Commissioner, the true cumulative accuracy rate” through June 2002 was 66% instead of 50%. We disagree. As TIGTA explained in its report, referrals were counted as incorrect when the IRS employee merely provided the publication, without walking the customer through it to identify the answer, as required by established field assistance procedures. In our view, the complexity of tax laws and varying education levels among taxpayers seeking assistance suggest that requiring field assistance employees to walk the taxpayer through a publication to identify the correct response is a necessary procedure that should be followed in practice for the response to be considered correct.
As TIGTA observed (2001-40-077, May 1, 2001) in actual 2001 site visits, the referrals to publications are an easy way to avoid dealing with taxpayer problems and are done at times in a totally inappropriate manner. TIGTA also noted that: At another TAC, a reviewer (who waited 1.5 hours) was told to read a stack of publications and “do her homework” to figure the answer out. The IRS employee, in less than 5 minutes, told the reviewer that it would take 8 hours to answer all of her questions and he did not have the time. At yet another TAC, a reviewer was told that she would have to come back the next day to ask her questions because they were not issuing any more numbers after lunch. The assistor handed her some publications related to her scenario and told her that she would also need the Form 1040 publication, but they were out of them. (The authors note that there is a Form 1040 but no 1040 publication.)
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The Chairman on the Subcommittee on Treasury and General Government stated in September 2001 that taxpayer service had to improve. He also noted that the problem is so severe that “if we don’t put service back into the IRS,” tax compliance of the American people would erode (Mohr, 2001). Problems in taxpayer service and compliance are inevitable if the IRS continues to disregard IRS walk-in sites. The symbolic value of this is highly significant. The GAO report (GAO-03-314, 12/20/02) also observed the following (mostly troubling facts and issues): Quality of walk-in assistance improved and wait-time was about as good
as last year, based on available information, although fewer taxpayers were assisted. From January through April 2002, TIGTA reviewers made 157 anonymous visits to 77 walk-in sites, asking two tax law questions on each visit. TIGTA found that only about 50% of its questions were answered correctly. Reported accuracy was about double the 24% accuracy TIGTA reported for 2001. (The authors observe once again that the actual accuracy rating varies from 19 to 50% depending upon the report.) IRS reduced the number of sites for which wait-time data was tracked. Accuracy of tax law assistance by walk-in sites improved since last year but remains low. Most taxpayers waited 30 minutes or less for walk-in assistance in 2002, but many others waited much longer. IRS also refined the process for referring complex tax law questions that are beyond the scope of normal walk-in staff training to expert field assistance, toll-free telephone, or compliance staff. IRS has been reducing the income ceiling for return preparation assistance, thus limiting the number of taxpayers eligible to receive that kind of assistance. For the 2001 filing season, IRS had a ceiling of $41,000. For the 2002 filing season, IRS reduced that ceiling to $33,000 – a level that approximated the $32,121 income ceiling on taxpayer eligibility for the earned income credit. Number of taxpayers assisted declined, but field assistance staffing has increased. Field assistance has no comprehensive workload and staffing plans. Field assistance does not have clear, comprehensive plans and timetables for making the workload changes just discussed, as well as other changes.
The use of TACs declined from 6.1 million to 4.9 million between 1999 and 2002. IRS officials cite the decline to increased reliance of volunteers (Volunteer Income Tax Assistance and Tax Counseling for the Elderly), the web and telephone, and reduction in eligibility for income tax preparation assistance. Other plausible reasons, such as a 50% accuracy rating, also might be a contributor to the decline.
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Table 8. TAC Numbers. TAC sites (varies) Alternative sites (seasonal – libraries and shopping mails) Mobile units (Van, etc.) Self-service stations (i.e. Kiosks) Returns preparation assistance One-person Sites Time spent on return preparation Field assistor satisfaction in 2001 Field assistor satisfaction in 2002 Return preparation assistant limit EITC phase-out
420 50 7 15 10% 83 25% 37% 49% $33,000 $32,121
Source: TIGTA and GAO Reports.
(Although utilization has declined and field assistance staff has increased 31% in this period, accuracy ratings still are at best 50%.) The IRS had approximately 50 outreach sites in 2002. Going to customers to hand out forms, instructions and publications along with needed assistance could be excellent marketing tools for the IRS. Utilizing secure stand-alone stations to allow for free electronic filing of simple returns at these outreach sites could be a highly meaningful and visible method to reach the 80% electronic filing goal. Table 8 contains data regarding TAC sites. There is only one assistor at approximately 20% of the sites. Staff satisfaction ratings of 50% also are discouraging. The GAO made the following basic management advice (GAO-03-314, 12/20/02, p. 3): We are making recommendations to the Commissioner of Internal Revenue to improve certain performance measures and to ensure that changes to walk-in sites and staffing are thoroughly analyzed and planned.
Web-Based Assistance Another vital area of IRS taxpayer service occurs through its internet site (irs.gov). The IRS web site could be a critical tool in helping taxpayers; however, it is not user friendly. The GAO stated the site was (GAO-03-314, 12/20/02): more user friendly, although there are certain aspects of the site that need attention; generally used more often, although IRS’s primary measure of usage – number of hits – is flawed.
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The GAO noted that a taxpayer seeking information/assistance on the EITC would be confronted with over a thousand hits when a search of the IRS sites is conducted. It observed (GAO-03-314, 12/20/02, p. 35): The most significant problem in navigating the site is a search engine that often generates a very large number of items relating to the subject of the search, which makes it extremely difficult to locate the most useful/appropriate item. For example, when we entered “earned income credit” into the general search engine, we were provided a list of over 1,500 items. The publication that would provide someone interested in the earned income credit with the most thorough information (Publication 596 – “Earned Income Credit”) was the 64th item on the list. This would require users to scroll through 6 pages of items before finding the basic publication dealing with the subject of the search.
The GAO footnoted (GAO-03-314, 12/20/02) the following regarding a problem with page formats with broken links (links to other web pages): According to a cognizant IRS official, a tool that helps eliminate broken links was not added to the site in 2002 as IRS had originally intended; implementation is now planned for 2003.
This indicates that a total acceptance of the use of the web for taxpayer service is absent. Additionally, the GAO report contained the following additional concerns: According to IRS officials responsible for the web site, the E-mail feature was not made easier to locate because the IRS is still considering whether it is best to answer taxpayer questions via the Web site or the telephone. The IRS received fewer e-mail questions via its Web site and did a worse job responding to the questions. This is an area where the IRS could improve its response accuracy. Written answers should help avoid the poor accuracy rating of IRS walk-in sites. The ability to email IRS questions is an area that should be improving. However, the quality of a question directly affects the quality of the answer. Thus, the ability of average taxpayers to utilize this tool is limited. Overall, the IRS should better utilize this taxpayer service tool, even if only to direct a taxpayer to an IRS source for the needed assistance. E-mail response time actually increased from two business days to 2.4 business days in 2002 despite a decrease in the number of requests from 160,000 to 109,000 (the IRS apparently concealed this feature). The IRS attributes this increase in response time to consolidation of its email process. The GAO noted (GAO-03-314, 12/20/02): To obtain local numbers, we had to scroll through 11 other topics, including information on where to file a return, TeleTax, Braille materials, and volunteer and education programs.
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We continued to find some incorrect and inconsistent data, outdated material, and missing information, but not as much as last year. For example, during our review of the Web site in 2002, we found that the site had incorrect office hours and addresses for walk-in assistance sites and obsolete data that pertained to 2001. Although these steps appear to have reduced the volume of inaccurate and inconsistent data, a cognizant IRS official opined that it would take about two years before all data on the Web site are made current and consistent. Brown University’s Center for Public Policy evaluated how well 50 federal government Web sites would aid an average citizen logging onto a public sector Web site. IRS’s site received a score of 76 out of 100, making it the eighth highest rated Web site in the study. As we have reported before, the number of hits is a flawed measure of use because: (1) every time a user accesses IRS’s home page it counts for about 16 hits; and (2) a hit is counted every time the user moves to another page of the site. Even the IRS in its audit response stated (GAO-03-314, 12/20/02): The IRS website, www.irs.gov, is one of the most used government sites. During the tax season we had 3.1 billion hits, a 15% increase from last year. In addition, the number of files downloaded last year topped 437 million, an increase from 317 million the year before. Clearly, many taxpayers prefer to deal with the IRS electronically. Usage of the IRS web site is widespread. From basic areas, such as searching capabilities and adequate e-mail response, the GAO report showed that problems exist in the tax administration system’s utilization of the internet.
EITC The ongoing problems within the administration of the IRC are highlighted in the continual noncompliance within the EITC program. As the GAO observed in April 2002, the following conditions exist (GAO-02-580T, p. 9): The most recent IRS information shows that the rate of EITC noncompliance is still very high. According to the IRS’s report on its analysis of EITC compliance rates on tax year 1999 returns filed in 2000: (1) about one-half of the 18.8 million returns on which taxpayers claimed the EITC involved overclaims; and (2) of the estimated $31.3 billion in EITC claims made by taxpayers who filed returns in 2000, between $8.5 billion and $9.9 billion should not have been paid.
In another report (GAO-02-449, 4/25/02), the GAO noted that the EITC was initiated in 1975 and that since 1995, GAO has identified this area as “high-risk.” As the GAO noted, non-compliance in this area has resulted in billions of dollars
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of claims that the IRS has paid inappropriately. Since 1999, the GAO and TIGTA have expressed concerns over the EITC recertification (eligibility determination) program. The GAO observed that EITC eligibility is difficult to administer. One problem is that Form 8862 is of questionable value. Approximately 86% of recertification examiners did not find the form useful. This has important implications for those taxpayers who are expected to complete the form correctly. Additionally, the GAO maintains that Form 886-R is confusing and provides incomplete information. The form “easily confuses” taxpayers. Of the ten examiners interviewed by the GAO, eight believed that the IRS’s taxpayer’s support in this area is insufficient. Also, this form does not satisfy the substantiation relationship requirements. Examiners were noted to be inconsistent in their treatment of taxpayers. Case study scenarios indicated wide variance in the recertification decisions. The EITC Program is specifically geared to assist low-income taxpayers. However, compliance for them is complicated. The GAO (GAO-02-449, 4/25/02, p. 19) noted that many low-income taxpayers: Move from location to location for job reasons, Have children who receive their medical care at hospital emergency rooms and have no medical insurance, and Rely on relatives for free child-care service instead of taking their child to a child-care center. The IRS’s National Taxpayer Advocate has determined that the difficulty of the EITC is the fifth worst issue facing taxpayers. It is estimated that nearly $2 billion of $30 billion in EITC claimed is paid to return preparers, refund loan facilitators, etc. On an individual basis, about $200 of the average $1,700 credit for “low-income” workers went to someone other than the taxpayer (tax.org 2003). This tax filing cost is incurred by members of society with the least means to afford professional tax help and is the direct result of complexity inherent in the program structure. The IRS clearly is not fully responsible for EITC administration problems. Congress has made this an extremely complex area to administer. McCubbin (2000) showed that the EITC error rate among attorneys, CPAs, or enrolled agents was 14.8%. This was significantly less than the individually prepared return error rate of 26.1%. Thus, there appears to be an 11% difference when a trained professional determines the EITC vs. when less-prepared individuals calculate it. The above-mentioned research indicates the positive compliance effect that meaningful training can have. Clearly, however, all parties involved with the EITC have difficulty with it. Because of the enormous complexity, the GAO commented that certain taxpayers are in essence manipulating the system, but the complexity of the program makes the determination of these individuals problematic.
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The above strongly shows that the EITC, as currently structured by Congress, is bound to lead to continual fraud year after year. Even worse, many taxpayers needing the assistance and who are eligible will not receive the assistance to which they are entitled. The GAO in Congressional correspondence (GAO-02-290R, 12/14/01) observed that more than 4.3 million eligible households did not claim the credit. About 28% of these households contain three or more qualifying children. Relevant additional GAO assessments of the EITC are below (GAO-02-414, 2/27/02, pp. 94, 98): The IRS follows-up on only a portion of the suspicious EITC claims it identifies, although the EITC has historically been subject to high rates of invalid claims. The amount of improper payments included in the almost $26 billion IRS disbursed for EITC in fiscal year 2001 is unknown. In September 2000, the IRS estimated that of about $30 billion in EITC claims filed by taxpayers in tax year 1997, about $9.3 billion (31%) were invalid. Of this amount, only $1.5 billion (16%) was either recovered or expected to be recovered through compliance efforts. The dollar amount of improper refunds disbursed related to these invalid EITCs is unknown. However, based on the tax year 1997 refund rate, which was about 78%, the IRS may have disbursed about $7.3 billion in EITC-related improper refunds in tax year 1997, of which about $6.1 billion (84%) may never be recovered. The full magnitude of improper refunds disbursed annually due to invalid EITCs is unknown. The IRS is currently in the final year of a five-year initiative started in fiscal year 1998 to address noncompliance problems with EITCs. The above shows the continuing inability to address this chronic administrative problem issue. As noted in the above bullet, the five-year compliance program has just ended. The current Administration’s answer to the problem is another $100 million initiative.
SYNOPSES OF MAJOR 2002 GAO CONCERNS In addition to the GAO’s overall review of the 2002 filing season, and reports concerning the EITC, the GAO issued other reports and testimony concerning IRS administration and management. Testimonial reports are highly relevant because they typically summarize numerous individual GAO Reports. Appendix 1 contains a synopsis of four GAO Testimonials that address additional concerns about the IRS. The tone of these reports focuses more on the inherent problems and conditions.
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Although the GAO attempts to present a positive view of the IRS, a review of the testimonies suggests a tax administration system that is laden with problems. The GAO Testimonials, in part, portray the tax collection system as: (1) overburdened and understaffed; (2) dysfunctional; (3) not making sufficient progress to modernize and to correct continuing problems; (4) becoming less efficient and less productive; (5) not adequately addressing the noncompliance problem (and perhaps exacerbating the problem); and (6) mismanaged.
GAO REPORTS An analysis of other GAO Reports on the IRS raises additional issues, as well as clarifies previously cited concerns. These reports are more specific in nature than the previous testimonials. Appendix 2 contains summaries of 20 GAO Reports. These reports provide the background for information (IRS and tax system problems) presented in Table 1. Like the Testimonials, they portray a tax system with problems that are extensive in nature (and some of these problems continually fail to be addressed). They identify more problems and suggest that the IRS contributes to taxpayer non-compliance and to tax revenue loss. Some specific problem areas identified were: inadequate accounting and reporting systems; inadequate information system; inadequate performance measures and budgeting practices; and problems with control over enforcement in the following areas: innocent spouse, tax-exempt organizations, tax return preparer errors, pension compliance, offers in compromise (OIC), EITC, and employment taxes. The GAO notes that certain issues have been raised repeatedly to no avail. The “cascading” effects of these problems are indicative of a tax system that has numerous difficulties in achieving efficient administration and enforcement.
Conclusion The IRS has an enormous job. Indeed, administering and enforcing tax laws are very complex endeavors. The intricate nature of tax law, combined with complex individual and business transactions, makes administration difficult. The voluntary compliance aspect of tax law also increases the administrative burden. Finally, constant tax law changes and administrative requests by Congress add to the IRS’s considerable responsibilities. As such, the IRS’s job is challenging, and it is not directly responsible for some of the tax administration problems. Also, in some instances it does a good job (e.g. see Hite, 2002). However, there are
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problems and the purpose of this article is to identify the major areas of concern as identified repeatedly by other governmental agencies – in this case, focusing on the GAO’s 2002 reports. Since government reports were used, one limitation of this study is the bias and different performance measurement techniques that are present in the reports. Additionally, defining performance objectives and obtaining accurate measures of tax administration performance would improve the analysis (but also are difficult to obtain). Finally, a long-term performance study would improve the analysis as well as provide for a natural extension of this study. As support for the long-term nature of the underlying problems, the GAO observed in its annual financial statement review, “the IRS continues to face many of the pervasive internal control weaknesses that the GAO has reported each year since it began auditing its financial statements in fiscal year 1992.” This would indeed strongly imply that a long-term performance data analysis would support the underlying nature of these problems. Additionally, the Administration’s 2004 proposed budget for the IRS specifically earmarked the following additional spending: $100 million to address the EITC’s improper payment problems; $133 million to combat abusive tax shelters and schemes; $429 million for its multi-year problem-plagued computer upgrades. Thus, while the analysis and conclusions presented in this article are subject to the limitations just noted, the overall purpose of this study is to identify problems in the system at an in-depth level as opposed to identifying both areas where the system is working well and where it is not working well. This research design is inductive in nature, building from individual GAO-raised concerns to broader patterns. This approach allows for an analysis of the overall interactions and processes. IRS tax administrative problems are fundamental in nature and likely are interconnected and linked. An assimilation and a synthesis of the details contained in the GAO 2002 Testimonials and Reports on the IRS reveal a tax system with some problems that are not adequately addressed by IRS management, Congress or the Administration. Even though the Congressionally-controlled GAO has attempted to portray the current crisis positively, a detailed analysis of its publications suggests otherwise. The current Administration, however, appears to be cognizant of the situation to a degree. The President’s nomination of a new IRS commissioner, in the view of some, would address the IRS’s poor performance and ineffective restructuring efforts. Additionally (as noted above), the Administration’s proposed 2004 budget specifically targets declining audit rates, tax shelters and EITC fraud. However,
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the 2001 Administration-inspired tax changes added significant and growing complexity to an already overburdened system. Lost tax revenue from noncompliance is significant. The non-compliance problem is exacerbated by tax administration/system problems. The IRS’s budget is approximately $10 billion (even with the proposed 2004 budget increase). One has to question if this is adequate, based on the demands placed on it by Congress. The GAO Reports show that the current tax system lacks resources in terms of needed management, employee motivation, and training and other fundamental attributes. Electronic filing is a clear example. Congress has mandated a goal that 80% of returns be electronically filed. Despite the imperative nature of this initiative, heightened due to terrorism, only $15 million was spent on marketing in 2002, even though its cost savings potential is enormous. The EITC is another example where fraud and noncompliance occur due to a basic design failure. The Administration, Congress and IRS urgently need to address the tax administration problems. Improving the tax system and the administration of it will result in increased taxpayer compliance and increased tax revenues.
NOTES 1. The IRS collects 95% of the U.S. government revenue (GAO-03-243, 11/15/02). 2. Search of the term “Internal Revenue Service,” for the year 2002, on the GAO web site resulted in over 300 hits. For purposes of this article, we classify a report as “directly” related to the IRS when “Internal Revenue Service” or “IRS” was contained in the title. 3. The IRS filing season for this report is considered from January 1 to April 15, 2002. This is generally when most taxpayers deal with the IRS. 4. The general source for this section and next five subsections has the reference number GAO-03-314 and was dated 12/20/02. Other GAO reports and sources are noted when relevant. 5. As part of the October 2000 restructuring, the IRS has four sections serving taxpayers. They are: Wages and Investment, Small Business and Self-Employed, Large-Mid Size Business, and Tax-Exempt and Government Entities.
ACKNOWLEDGMENTS The authors gratefully acknowledge the helpful comments of three reviewers and Charles E. Price, the Associate Editor, who not only provided excellent comments but also made the final accept/reject decision on the paper. The authors are responsible for all errors of commission and/or omission.
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REFERENCES Burman, A. (1999). GAO: Watchdog or reformer. Government Executive (June), p. 76. EFTPS Facts, http://www.eftps.gov/ Financial Management Service, Final Monthly Treasury Statement, September 30, 2002, http://fms.treas.gov/mts/mts0902.pdf General Accounting Office (2002). Tax abatements: Better IRS data could benefit small businesses and IRS (January 31). Reference GAO-02-336. General Accounting Office (2002). Tax administration: IRS’s efforts to improve compliance with employment tax requirements should be evaluated (February 20). Reference GAO-02-92. General Accounting Office (2002). Financial audit: IRS’s fiscal years 2001 and 2000 financial statements (February 27). Reference GAO-02-414. General Accounting Office (2002). Business systems modernization: IRS needs to better management capacity with systems acquisition workload (February 28). Reference GAO-02-356. General Accounting Office (2002). Tax administration: IRS should evaluate the changes to its offer in compromise program (March 15). Reference GAO-02-311. General Accounting Office (2002). Tax deductions: Further estimates of taxpayers who may have overpaid federal taxes by not itemizing (March 29). Reference GAO-02-509. General Accounting Office (2002). Internal Revenue Service: Assessment of budget request for fiscal year 2003 and interim results of 2002 tax filing season (April 9). Reference GAO-02-580T. General Accounting Office (2002). Internal Revenue Service: Enhanced efforts to combat abusive tax schemes challenges remain (April 11). Reference GAO-02-618T. General Accounting Office (2002). Private pensions: IRS can improve the quality and usefulness of compliance studies (April 12). Reference GAO-02-353. General Accounting Office (2002). Tax administration: IRS continues to face management challenges in its business practices and modernization (April 15). Reference GAO-02-619T. General Accounting Office (2002). Tax administration: IRS’s innocent spouse program performance improved; balanced performance measures needed (April 24). Reference GAO-02-558. General Accounting Office (2002). Earned income credit, opportunities to make recertification program less confusing and more consistent (April 25). Reference GAO-02-449. General Accounting Office (2002). Tax-exempt organizations: Improvements possible in public, IRS, and state oversight of charities (April 30). Reference GAO-02-526. General Accounting Office (2002). IRS guidance on economic analyses in investment business cases (May 9). Reference GAO-02-234R. General Accounting Office (2002). Tax administration: Continued progress modernizing IRS depends on managing risks (May 14). Reference GAO-02-715T. General Accounting Office (2002). Internal Revenue Service: Efforts to identify and combat abusive tax schemes have increased, but challenges remain (May 22). Reference GAO-02-733. General Accounting Office (2002). Internal Revenue Service: Improving adequacy of information systems budget justification (June 28). Reference GAO-02-704. General Accounting Office (2002). IRS’s budget justification: Options for structure and content (July 8). Reference GAO-02-711R. General Accounting Office (2002). Performance management systems: IRS’s systems for frontline employees and managers align with strategic goals but improvements can be made (July 12). Reference GAO-02-804. General Accounting Office (2002). Political organizations: Data disclosure and IRS’s oversight of organizations should be improved (July 17). Reference GAO-02-444.
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General Accounting Office (2002). Management report: Improvements needed in IRS’s accounting procedures and internal controls (July 30). Reference GAO-02-746R. General Accounting Office (2002). Internal Revenue Service status of recommendations from financial audits and related financial management reports (July 30). Reference GAO-02-848. General Accounting Office (2002). Financial management: Coordinated approach needed to address the government’s improper payments problems (August 9). Reference GAO-02-749. General Accounting Office (2002). IRS and terrorist-related information sharing (October 21). Reference GAO-03-50R. General Accounting Office (2002). Highlights financial audit: IRS’s fiscal years 2002 and 2001 financial statements (November 15). Reference GAO-03-243. General Accounting Office (2002). Tax administration: IRS needs to further refine its tax filing season performance measures (November 22). Reference GAO-03-143. General Accounting Office (2002). New markets tax credit: Status of implementation and issues related to GAO’s mandated reports (December 6). Reference GAO-03-223R. General Accounting Office (2002). IRS’s 2002 tax filing season: Returns and refunds processed smoothly; quality of assistance improved (December 20). Reference GAO-03-314. General Accounting Office, Mission Statement, http://www.gao.gov/ Graetz, M. (2002). 100 million unnecessary returns: A fresh start for the U.S. tax system. Tax Notes (30th Anniversary ed.). Grenshaw, A. (2002). IRS shifts focus to pursuit of rich scofflaws. washingtonpost.com (September 13). Grenshaw, A. (2003). IRS narrows scope of audits. washingtonpost.com (January 2). Harmelink, P., & VanDenburgh, W. (2002). The failure of the IRS to provide top quality service. Advances in Taxation, 14, 137–158. Hite, P. A. (2002). The preparer effect on IRS customer satisfaction. Advances in Taxation, 14, 159–183. McCubbin, J. (2000). Noncompliance: The determinants of the misreporting of children. National Tax Journal, 53(4), Part 2, 1135–1164. McKinnon, J. D. (2003). IRS to use private agencies in push to collect back taxes. wsj.com (February 3). Mohr, P. (2001). Senate clears $9.45 billion budget for IRS. Tax Notes (September 24), p. 1648. Porcano, T. M. (1988). Correlates of tax evasion. Journal of Economic Psychology, 9, 47–67. Subcommittee on Select Revenue Measures of The Committee on Ways and Means House of Representative (2002). Second in series of the extraterritorial income regime (portion containing Michael J. Graetz statement) (May 9). Treasury Inspector General for Tax Administration (2001). Letter Report: The Internal Revenue Service Continues to Give Incorrect Tax Law Information in Taxpayer Assistance Centers (May 1). http://www.ustreas.gov/tigta/2001reports/200140077fr.html. Reference Number 2001-40-077. Tax preparers took $212 million from working poor in 1999, tax.org 1/13/03. USA Today (2002). IRS gets high grade for service in 2002 (December 24).
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APPENDIX 1 GAO Testimonials Identifying Potential IRS Problems Presented under each GAO Report is a synopsis of the critical issues relevant to this article (paraphrasing and direct quoting).
GAO-02-715T Tax Administration: Continued Progress Modernizing IRS Depends on Managing Risks – 5/14/02 Overall, since the mid-1990s, the IRS has seen increased workload, decreased staffing, and significant changes in the allocation of resources between taxpayer assistance programs and its compliance and collection programs. Between 1995 and the end of 2001, the IRS’s workload, measured by returns filed, increased by about 10%, while aggregate staffing declined by about 14%. Electronic filing of returns increased but not enough to reduce paper returns sufficiently to free significant processing resources for use elsewhere. The compliance and collection programs have seen large and pervasive declines in performance indicators such as audit rates, collection cases closed, enforcement actions such as liens and levies, and raw productivity. Compliance and collection programs have declined, sometimes dramatically, since 1996. Relative to modernization efforts, the foundation is not complete. The IRS must successfully manage some significant risks that threaten progress. Areas of risk include the IRS’s compliance and collection programs that have seen large declines, systems modernization where several large systems are moving into deployment and performance management where new measures and systems are being implemented. The IRS is not where it committed to be in acquiring infrastructure and business application systems despite $1 billion for investments in this area. The IRS’s financial management approach takes months to complete and does not produce timely information for managing the agency. The IRS faces risks in several areas that if not successfully managed could threaten the agency’s ability to continue making progress modernizing. Individual and corporate audit productivity as measured by cases closed per unit of staff time declined 31 and 47%, respectively, while field and telephone collection productivity declined over 20%. These productivity declines coupled with reduced staffing has translated to declines in coverage.
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The proportion of individual and corporate tax returns that were audited declined 63 and 60%, respectively, and the percentage of delinquencies closed by telephone and field collection declined by 15 and 45%, respectively. The decline in collection coverage reflected the collection programs’ inability to work a growing proportion of the delinquent cases referred from the compliance programs. By the end of fiscal year 2001, GAO estimates that the IRS had deferred collecting taxes from about 1.3 million taxpayers who owed about $16.1 billion. Absent significant operation change, IRS officials said that they had little expectation of reopening many deferred collection cases. Coverage in the non-filer program declined by 69% by the end of fiscal year 2001. The likelihood that delinquent taxpayers would experience enforced collection such as through levies placed on their wages or bank accounts declined about 64% from 1996 to 2001. Timing is critical. While the lack of controls can be risky in projects’ early states, it is essential that such controls be in place when projects enter detailed system design, development, and implementation. The IRS has not successfully followed through on its evaluations of its plans to improve the compliance of small businesses in its early intervention programs. Overall, the above weaknesses have reduced the incentives for voluntary compliance. Very limited data suggest that voluntary compliance may have begun to deteriorate. For example, the number of apparent individual nonfilers increased about three and one-half times faster than the individual tax filing population.
GAO-02-619T Testimony: IRS Faces Management Challenges in its Business Practices and Modernization Efforts – 4/15/02 Financial reporting weakness hinders availability of reliable and timely information to support decision-making. Management of unpaid tax assessments is hindered by record keeping deficiencies. Controls over tax revenue and refunds are not fully effective. Internal controls over tax receipts and taxpayer data are not adequate. Controls over administrative accounts and budgetary resources are not adequate. The lack of comparable performance measures and data hindered the assessment of the 2001 filing season. The IRS’s efforts to improve the efficiency of its OIC program, telephone assistance accessibility and accuracy, and employment tax compliance were hindered by insufficient program evaluation efforts. Budget justification is not always linked to performance goals.
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Computer security puts taxpayer data at risk despite improvements. The integrity of the operating system and the privacy of data are at risk. Additional information system controls are needed. Vulnerability in the e-file system remains, despite improvements. Business modernization progress has been made, but the IRS is not where it committed to be in infrastructure, application systems, and management controls. Despite projects entering critical stages, not all essential management controls are in place or functioning. For seven years, the GAO has assessed the IRS’s modernization attempts and its tax processing system; however, significant problems and risks still remain.
GAO-02-618T Abusive Tax Schemes – Challenges Remain – 4/11/02 The IRS conservatively estimates the following. There are 62,000 taxpayers with frivolous returns approximating $1.8 billion. There are 105,000 taxpayers with frivolous refunds approximating $3.1 billion. There are 65,000 taxpayers with abusive domestic trusts with tax losses approximating $2.9 billion. There are 505,000 taxpayers with offshore schemes with tax losses approximating $20 to $40 billion. The IRS faces substantial changes and lacks the means to assess progress. The increased scope of the abusive tax scheme problem is straining the IRS’s audit resources. Expanded efforts in this area have not been accompanied by performance goals or measures that Congress and the IRS can use to assess IRS’s progress. The IRS has not provided information on its staff year investments in combating abusive tax schemes. It is difficult to obtain a clear picture of all that is underway in the IRS relative to abusive tax schemes. There is a lack of centralization, strategies, goals, objectives, performance measures, or program results. Responsibility for the efforts was spread across various functions and groups within the IRS.
GAO-02-580T IRS 2003 Budget Request and Interim Results of 2002 Tax Filing Season – 4/10/02 The IRS’s plans for hiring and redirecting staff depend on several assumptions that could be optimistic. The IRS’s enforcement programs have historically suffered from unrealized savings or unexpected expenses.
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The IRS’s Congressional justification does not always provide an adequate link between the resources being requested and the IRS’s performance goals. There appear to be inconsistencies between the requested resources and the expected change in performance or workload. The IRS did not adequately support $1.63 billion of the $1.68 billion requested for its information system. The IRS’s budget is not well-linked to performance goals in some important areas. Congressional justification submitted by the IRS in support of its budget request does not explain how the IRS developed the labor and non-labor savings. A significant example of missing performance goals involves the IRS’s efforts to address major areas of systematic noncompliance. In February 2002, the IRS Commissioner identified four areas: Misuse of devices to hide income; Use of abusive corporate tax shelters to reduce taxes improperly; Failure to file and pay employment taxes; and Erroneous refund claims, including the EITC. Since the Business System Modernization (BSM) appropriation was established in fiscal year 1998, the GAO has consistently reported that the IRS has not developed adequate justification for its budget requests. The IRS did not develop its information systems request in accordance with these best practices of leading organizations. IRS officials simply took what was spent last year in the information technology (IT) budget categories and added the money to fund cost-of-living salary increases. IRS officials responsible for developing the IT operations and maintenance budget attributed the differences between IRS practices and those followed by leading organizations to the lack of an adequate cost accounting system, cultural resistance to change, and a previous lack of management priority. The use of electronic filing continues to grow, but not at a pace to achieve the IRS’s long-range goal. The IRS has experienced some improvements in telephone service, but the rate reduction credit is likely affecting taxpayers’ access to the IRS. The overall rate at which callers are reaching an assistor is lower because many callers are unable to get into the queue for assistance. There was a five-point decline in the percentage of callers who attempted to reach an assistor and actually got through and received service. The increased call volume led to callers hanging up, or they were advised by a recorded message that the IRS could not provide assistance.
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None of the measures currently reflects how many callers hung up while listening to the menu they hear when calling the IRS. Although the accuracy rate reported through mid-March 2002 is encouragingly high, the use of different measurement methods precludes valid comparison to the low accuracy rates reported by the IRS and TIGTA in 2000 and 2001. Despite some significant improvements in telephone service, the customer service representative level of service as of March 16, 2002, was lower than at the same point in time the previous year.
APPENDIX 2 GAO Reports Identifying IRS and Tax System Problems Presented under each GAO Report is a synopsis of the critical issues relevant to this article (paraphrasing and direct quoting).
GAO-03-243 Financial Audit IRS’s Fiscal Years 2002 and 2001 Financial Statements – 11/15/02 The GAO’s unqualified opinions on IRS’s fiscal years 2002 and 2001 financial statements were made possible by the continued extraordinary efforts of IRS senior management and staff to compensate for serious internal control and financial management systems deficiencies. The IRS’s actions, coupled with the continued use of costly, resource-intensive processes to compensate for the continued serious weaknesses in systems and controls, enabled the IRS to achieve Treasury’s goal. Nonetheless, it will remain a challenge for IRS management and staff to sustain the level of effort needed to produce reliable financial statements until the agency is able to fully address the underlying systems and internal control issues that have made this process so time consuming and resource intensive. Presently, the IRS continues to lack timely, accurate, and useful financial information and sound controls with which to make fully informed decisions and to ensure ongoing accountability, which is the end goal of the Chief Financial Officers (CFO) Act. One of the largest obstacles facing IRS management today continues to be the agency’s lack of a financial management system capable of producing the reliable and timely information its managers need to assist in making day-to-day decisions. Because of this systems issue and other factors, the IRS continues
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to face many of the pervasive internal control weaknesses that the GAO has reported each year since it began auditing its financial statements in fiscal year 1992. Many of the IRS’s longstanding systems and internal control weaknesses continued to exist, necessitating continued reliance on costly compensating processes, statistical projections, external contractors, substantial adjustments, and monumental human efforts to prepare a set of reliable financial statements. These costly efforts would not have been necessary if the IRS’s systems and controls had operated effectively. The effort it took placed a considerable strain on IRS resources and required substantial contractor support. It will be difficult for IRS personnel to sustain the level of effort needed to produce reliable and timely financial statements without addressing the underlying systems and internal control problems that cause this process to be so unnecessarily time consuming and expensive. Additionally, this process does not produce the reliable, useful, and timely financial and performance information the IRS needs for decision making on an ongoing basis, which is a goal of the CFO Act, nor can it fully address the underlying financial management and operational issues that adversely affect the IRS’s ability to effectively fulfill its responsibilities as the nation’s tax collector. The modernizing the IRS’s financial and operational systems will take years to fully achieve. The IRS continues to face the following key issues that represent material weaknesses in internal controls: In controls over the financial reporting process, In controls over unpaid tax assessments, In controls over the identification and collection of tax revenues due the federal government and over the issuance of tax refunds, resulting in potentially billions of dollars in improper payments and lost revenue to the federal government, In controls over property and equipment, In computer security controls, resulting in increased risk of unauthorized individuals being allowed to access, alter, or abuse proprietary IRS programs and electronic data and taxpayer information. The material weaknesses in internal controls noted above may adversely affect any decision by IRS’s management that is based, in whole or in part, on information that is inaccurate because of these weaknesses. In addition to the material weaknesses discussed above, the GAO identified two reportable conditions which, although not material weaknesses, represent significant deficiencies in the design or operation of internal controls that
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could adversely affect the IRS’s ability to meet the internal control objectives described in this report. The GAO has reported on these material weaknesses and reportable conditions in prior audits and has provided IRS numerous recommendations to address these issues. More than 60 of these recommendations were still open as of the date of this report.
GAO-03-143 Tax Administration IRS Needs to Further Refine Its Tax Filing Season Performance Measures – 11/22/02 The GAO identified instances in all four program areas where the individual measures or suites of measures did not meet some of its nine attributes. Some of these instances represent opportunities for IRS to further refine its measures. In all four program areas, we were unable, because of documentation limitations, to verify the linkages among the IRS’s goals and measures. Among other things, such linkages provide managers and staff with a road map that shows how their day-to-day activities contribute to attaining agency-wide goals. No documentation shows the complete linkage between agency-wide goals and telephone measures. Although telephone assistance management stated that their goals and measures generally aligned, we were unable to verify this because no documentation shows the complete relationship. The IRS determines customer satisfaction with its toll-free telephone assistance through a survey administered to taxpayers who speak with a customer service representative. We observed survey collection methods in Atlanta that were not always objective; that is, the administrators did not always follow prescribed procedures for selecting calls to participate in the survey. The reliability of five telephone quality measures is suspect. Telephone measures do not fully cover government-wide priorities. Overall alignment of electronic filing and assistance’s goals and measures are not fully documented. Two electronic filing and assistance measures had targets changed and lacked objectivity. Many field assistance measures lack clarity. Data collection process affects reliability of several field assistance measures. Alignment between the IRS’s goals and submission processing measures is uncertain. Five submission processing measures lack reliability. Although the measures satisfied many of the nine attributes, the GAO’s evaluation also showed that they do not have all the characteristics of successful performance measures. The most significant weaknesses include:
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makers about program performance,
Data collection methods that hamper objectivity and reliability, and Measures to cover government-wide priorities that are missing from the
Strategy and Program Plan.
GAO-03-50R IRS and Terrorist-Related Information Sharing – 10/21/02 Events preceding and following the attacks of September 11, 2001 spotlighted ineffective information sharing, particularly related to intelligence and law enforcement activities, as a serious weakness. Poor information sharing hinders effectively identifying vulnerabilities and coordinating efforts to detect attacks. Very seldom did an advisory mention anything specific to the IRS or the federal tax system.
GAO-02-848: IRS: Recommendations from Financial Audits and Other Reports – 7/30/02 Since the GAO’s first audit of the IRS’s financial statements in fiscal year 1992, its audits have identified a number of weaknesses in the IRS’s financial management operations. Based on the results of our recently completed fiscal year 2001 financial audit, the GAO is closing 27 recommendations due to actions the IRS has taken to address the issues that gave rise to them. Therefore, as of the date of this report, 62 of the GAO’s financial management recommendations remain open, 56 of which are short term in nature and six of which are long term in nature. The underlying weaknesses will likely continue to exist, impairing the quality and timeliness of the IRS’s financial information and increasing its exposure to losses, as well as impacting IRS’s ability to effectively fulfill its mission of providing top quality service to taxpayers. The GAO also found that many of the open audit recommendations have been outstanding for an extended period of time, including three recommendations that the GAO considers to be of the highest priority. The continued existence of the serious financial management weaknesses that gave rise to the remaining open recommendations represent serious obstacles that the IRS needs to overcome in order to achieve effective financial management and have available accurate, timely financial reporting and other information that is useful for day-to-day decision making.
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GAO-02-804 Performance Management Systems IRS’s Systems for Frontline Employees and Managers Align with Strategic Goals but Improvements can be Made – 7/12/02 IRS senior executives have no firm plans to monitor how well the group managers’ and frontline employees’ systems are being implemented or to assess whether changes need to be made, even though the IRS’s management processes call for obtaining data on how well programs are achieving their goals. Supporting behaviors described in the frontline employees’ performance management system do not always align with critical job responsibilities or with their organizational unit’s performance measures. Commitments were not always written so that managers could be held accountable for meeting them because they were not specific, outcome or output oriented, or easily monitored. The GAO’s analysis showed that about 85% of the enforcement group managers’ commitments, for both rating years, did not meet the remaining three IRS criteria for well-written commitments of being specific, outcome or output oriented, or easily monitored. The GAO found that the majority of commitments were broad, vague statements. The IRS has not established a monitoring mechanism to ascertain whether raters are implementing the new employee performance management systems as intended and has no plans to assess whether the new systems are achieving their objectives. Although the IRS would incur costs to assess whether its employee performance management systems achieve their objectives, the IRS’s strategic planning, budgeting and performance management guidance implicitly recognizes that such costs are properly part of a sound management system.
GAO-02-746R: Management Report: Improvements Needed in IRS’s Accounting Procedures and Internal Controls – 7/30/02 During fiscal year 2001, the IRS had a number of internal control issues that affected financial reporting, including safeguarding of assets. These issues concern policies and procedures over Receipt of taxpayer payments, Courier services that transport taxpayer data, Employee fingerprint records, Issuance of manual refunds, Release of tax liens,
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Recording of property and equipment (P&E) transactions, Linking of property and accounting records, Software licenses, Reimbursable receivables, and Recording changes in administrative account balances. The IRS did not have adequate controls over taxpayer payments received at certain field locations. IRS service center campuses did not ensure that couriers had undergone background checks. The IRS’s database to track fingerprint results was subject to technical constraints and human error. These issues resulted in numerous instances of erroneous or missing data. The IRS staff did not always perform or document required monitoring of manually-processed tax refunds. The IRS did not record the dates on which certificate of lien releases were mailed to courts and we noted long delays between the date of the IRS certificate of lien release and the date the local jurisdiction recorded its receipt. The IRS did not follow procedures for promptly recording assets on its property management system, resulting in delays in the proper accounting for hundreds of P&E items, such as microcomputers. The IRS did not adequately monitor and review reimbursable receivables to determine their validity or collectibility. The IRS did not have procedures to estimate and accrue material changes in administrative account balances throughout the fiscal year. The lack of these procedures going forward may preclude the IRS from having assurance that interim financial statements it is required to prepare for fiscal year 2002 per the Office of Management and Budget (OMB) Bulletin 01-09, Form and Content of Agency Financial Statements, are reliable. The IRS needs to strengthen controls over taxpayer receipts. During its fiscal year 2001 audit, the GAO found that service center campuses no longer accepted walk-in payments, but rather directed taxpayers to field offices. At the field offices visited, the GAO found that although IRS employees usually issued a receipt for walk-in payments, IRS had no policy requiring that field offices issue a receipt for all payments. The failure to maintain adequate control logs of all checks found during final candling increases the risk that not all checks will be accounted for and eventually credited to taxpayers’ accounts. The IRS needs better enforcement of courier service policy. Since November 1998, the GAO reported that the IRS did not have effective controls over courier services responsible for transporting taxpayer receipts.
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During the fiscal year 2001 audit, the GAO identified weaknesses in the IRS’s
enforcement of its courier service standards. The IRS needs to review and properly adjust receivables in its accounting records. During the fiscal year 2001 audit, the GAO continued to find control weaknesses over the IRS’s accounting for reimbursable activities, which resulted in IRS overstating its receivables for reimbursable activities. During fiscal year 2000, the GAO reported that the records IRS maintained regarding reimbursable receivables were not reliable and recommended that the IRS routinely review and age open reimbursable receivables to identify accounts that are no longer valid or collectible. The IRS improperly reported as receivables $711,000 of fees charged to taxpayers for photocopying tax documents. The IRS needs to develop procedures to estimate and accrue operating revenue and expenses. The GAO found that imputed costs on the IRS’s general ledger were understated by $406 million until the IRS made an adjusting entry after September 30, 2001. In addition, employee benefit payment expenses were understated by $73 million until the IRS made a year-end adjusting entry. Exchange revenues totaling over $108 million were not recognized in the administrative accounting records until the end of the fiscal year. Until the IRS establishes procedures for estimating and accruing imputed administrative costs and exchange revenues, it will not be able to produce reliable interim financial information.
GAO-02-733 Internal Revenue Service Efforts to Identify and Combat Abusive Tax Schemes have Increased, but Challenges Remain – 5/22/02 These abusive tax schemes represent a significant loss of tax revenue to the Treasury. Furthermore, tax schemes give the appearance that the tax system is unfair, which in turn can undermine taxpayer confidence in the tax system. Although abusive tax schemes are used in a small portion of the approximately 130 million individual income tax returns that yield about a trillion dollars in revenue, the estimated extent of tax schemes is nevertheless significant. In February 2002, IRS estimated that about 740,000 taxpayers used abusive tax schemes in tax-year 2000. The IRS detected approximately $5 billion in improper tax avoidance or tax credit and refunds claims, and it estimated that another $20 billion to $40 billion in taxes had not been identified and addressed related to offshore schemes.
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It is difficult to get a clear picture of all that is underway in the IRS – how much is new as opposed to reemphasized or reorganized, and how the pieces combine to form a planned, coordinated effort with specific, defined outcomes. No central office, group, or executive could provide us with an agency-wide focus or perspective on the IRS’s strategy, goals, objectives, performance measures, or program results. Responsibility for the efforts was spread across various functions and groups within the IRS.
GAO-02-711R IRS’s Budget Justification: Options for Structure and Content – 7/8/02 The following are some general options for displaying IRS’s request that differ from the presentation in the IRS’s fiscal year 2002: Focusing more on budget activities and programs and easy-to-follow linkages to measures, both performance measures and workload indicators; Relating the request to the IRS’s organizational structure; Relating the request to the IRS’s organizational structure and to measures; Highlighting IRS-wide goals; and Analyzing more than net changes to the previous year’s appropriation (referred to here as the budget base). Because of disagreements among the people whom we interviewed over the advisability of the different options discussed in this report, it is unlikely that all concerned parties will agree on the “right” ways. Any ideas adopted would need to meet Congressional needs and minimize the burden to the IRS in producing new presentations or information. Only the parties themselves can engage in the dialogue needed to decide what fulfills their respective needs.
GAO-O2-704 Internal Revenue Service: Improving Adequacy of Information Systems Budget Justification – 6/28/02 The IRS’s information systems request for operations and maintenance is not adequately justified. The IRS did not develop its IS request in accordance with these best practices of leading organizations. In particular, the largest elements of the IRS’s budget request are not projects or systems. Rather, they are requests for staffing levels or other services. In addition, in developing these requests, the IRS did not identify and assess the relative costs, benefits, and risks of specific projects or systems in these areas.
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Instead, according to IRS officials responsible for developing the IT operations and maintenance budget, they simply took what was spent last year in these categories and added the money to fund cost-of-living and salary increases. The IRS had adequately justified its $450 million Business Systems Modernization request, but it did not develop its $1.63 billion IS operations and maintenance request in accordance with the best practices of leading private- and public-sector information technology (IT) organizations. The IRS’s IS request for operations and maintenance is not adequately justified. These IRS officials attributed the gap between the IRS’s practices and those followed by leading organizations to the lack of an adequate cost accounting system, cultural resistance to change, and a previous lack of management priority.
GAO-02-558 Tax Administration IRS’s Innocent Spouse Program Performance Improved; Balanced Performance Measures Needed – 4/24/02 The IRS reached decisions on about 21% more cases than it received in fiscal year 2001, reducing some of the backlog from previous years. Because the IRS has not evaluated the Web site, the agency does not know how useful the Web site has been to taxpayers in determining their eligibility for innocent spouse relief. Limited data exist to determine the trend in innocent spouse workload immediately following passage of the Restructuring Act. The IRS did not systematically track innocent spouse cases until March 1999, about 8 months after the Act was passed. The IRS is gaining control over its innocent spouse workload but has not developed balanced measures. The effect of each of the individual IRS initiatives to process innocent spouse cases more timely, accurately, and consistently is difficult to separate and quantify. Although, in general, determining whether a case is ineligible does not require a significant amount of IRS time, agency officials are concerned about the portion of cases received that do not meet basic eligibility requirements. The IRS was not successful through fiscal year 2001 in reducing the average time to reach a decision on whether relief would be granted or to reach closure on cases, including all required notices, appeals, and transfers of taxpayers’ liabilities when full or partial relief was granted. Average times to decide and close cases continued to increase in the field offices and at the Cincinnati processing site through fiscal year 2001.
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Innocent spouse program management could be enhanced with more balanced performance measures and targets. In developing its innocent spouse web site, the IRS did not consider assessing the site’s usefulness to taxpayers. Since officials had not considered evaluating the Innocent Spouse Program web site when it was first created, they did not include features that would allow the collection of data for a meaningful evaluation. For example, IRS officials did not develop a capability for collecting information through web-site-based customer surveys or customer feedback links. The IRS’s upgraded innocent spouse web site will provide some, but not sufficient, information. Of the docketed cases that were settled by Appeals or Counsel, 55% resulted in Appeals’ absolving the taxpayer of the liability, 33% resulted in Appeals’ reducing the taxpayer’s liability; in 12% of the cases, the liability remained unchanged.
GAO-02-526 Tax-Exempt Organizations: Improvements Possible in Public, IRS, and State Oversight of Charities – 4/30/02 The IRS has neither data on the type and extent of possible compliance issues in the charity community nor results-oriented goals and strategies for its oversight of charities. Concerns arise about the adequacy of oversight because the IRS’s resources have not kept pace with the growth in the charitable sector, and some measures indicate that available resources may not be used as effectively as in the past. From 1996 through 2001, IRS staffing for overseeing exempt organizations fell by about 15%, The number of applicants to become tax-exempt charities increased 9%, The number of Forms 990 filed by charities increased 25%. The rate at which the IRS examined these returns rose from 0.64% in 1996 to 0.73% in 1998 and 1999, before falling to 0.43% in 2001. In 2000, the IRS had recognized 1.35 million tax-exempt organizations under Section 501(c), of which 820,000 (60%) were charities. Social welfare, labor, and business leagues accounted for 280,000 (21%) of the tax-exempt organizations. The remaining organizations (about 19%) were exempt under other Section 501(c) categories. The IRS has not identified how many of these organizations have ceased to be active, and these numbers are likely to be overstated.
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Little is known about form 990 data accuracy despite concerns of the IRS and others. Imbalances between the IRS’s charity oversight workload and resources necessitate better planning to improve compliance and resource decisions. The IRS has recognized that its oversight of charities and other tax-exempt organizations is limited and is formulating plans to measure tax-exempt organizations’ compliance levels and improve its oversight activities. Because the IRS does not have an accurate picture of charities’ compliance and it is unclear how its plans would yield such data, the IRS lacks key information for making decisions on how much charity oversight is needed, the amount of resources needed for the oversight, and how to improve its use of available resources. In addition, IRS’s plans for improving its oversight activities generally do not define what results it intends to achieve in overseeing charities. At least three related reasons help explain the decline in the number of charity examinations. First, the IRS has had to adjust the level of charity oversight given many other priorities involving all other types of taxpayers. Second, the resources devoted to oversight dropped for fiscal years 1996 through 2001. Last, the IRS moved revenue agents from doing examinations to processing the increased application workload. The staffing devoted to the IRS’s exempt organization function and oversight has declined in recent years. The IRS was unable to provide the staffing levels for reviewing charity applications and examining the Form 990. However, from fiscal years 1996 through 2001, total staffing for the exempt function has fallen from 958 to 811, or about 15%. New IRS approach to improve compliance and oversight will not cover all charities and due to resource limitations, IRS believes that at the present rate the completion of all planned studies will take until fiscal year 2008. The IRS has not identified what longer-range results it intends to achieve for charities. The IRS’s investment in reviewing charity applications and examining charity returns has not kept pace with the growth in the number of applications and returns. More informed decisions about the resources to devote to this investment could be made if the IRS had a better understanding of the type and extent of compliance problems in the charitable community as well as a clear plan for how the IRS would use its resources to achieve certain results, such as specific improvements in the compliance of charities. Neither of these is currently available, even though the IRS has initiatives to increase its staffing for all exempt organizations. Organizations are notified that the determinations process may take up to 120 days. The IRS has indicated that the average time to approve an application is currently 91 days.
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GAO-02-509 Taxpayers Overpaying Federal Taxes – 3/29/02 Over 2,000,000 taxpayers could have reduced tax liabilities in the amount of nearly $1 billion by itemizing rather than taking the standard deduction. Third parties prepared over 1,000,000 of these taxpayers’ tax returns. GAO-02-444 Political Organizations Data Disclosure and IRS’s Oversight of Organizations should be Improved – 7/17/02 The IRS has performed limited oversight of Section 527 organizations’ compliance with the law’s filing and reporting requirements and as a result, has provided little assurance that the data it disclosed on the Section 527 web site are timely, complete and correct. The IRS has made limited efforts to determine whether Section 527 organizations filed required forms or that the data reported on the forms are complete and correct. The IRS has not developed a strategic plan to carry out its responsibilities for ensuring that the requirements of the law are met. The IRS web site falls short of disclosing data to the public in an accessible manner because the site is difficult to use and lacks electronically searchable and downloadable data. Disclosure efforts do not address key limitations in the site’s accessibility – how easy the site is to use and the amount of electronically searchable data in the site. The IRS does not fully check whether all required data are included on Forms 8871 and 8872 it receives and that the data are correct. Also, IRS performs limited checks on the timeliness of filings and does not perform checks to determine whether all Section 527 organizations that should file have done so. The IRS did not have a program to regularly audit (i.e. ask for documented support on data reported) or match Form 8871 and 8872 data with other data reported by Section 527 or other organizations to help ensure timely, complete, and correct data. Nor has IRS imposed penalties for filing problems with Forms 8871 and 8872. Neither the IRS’s plan for tax-exempt activities nor the specific initiatives the IRS is planning to improve its disclosure and oversight activities define what level of disclosure and oversight it hopes to achieve, how it will achieve those levels of performance, and how progress will be measured for Section 527 organizations.
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GAO-02-414 Financial Audit IRS’s Fiscal Years 2001 and 2000 Financial Statements – 2/27/02 The financial statements do not include an estimate of the amount of taxes owed the federal government but which have not been identified by the IRS, often referred to as the “tax gap.” The GAO’s unqualified opinions on the IRS’s fiscal years 2001 and 2000 financial statements were made possible by the extraordinary efforts of IRS senior management and staff to compensate for serious internal control and systems deficiencies. The tremendous amount of hard work and commitment the IRS has demonstrated in recent years will no longer be sufficient to achieve this goal unless accompanied by systemic changes in how the IRS processes transactions, maintains its financial records, and reports its financial results. At present, the IRS continues to lack timely, accurate, and useful financial information and sound controls with which to make fully informed decisions and to ensure ongoing accountability. The IRS is continuing to work to address its serious control and systems deficiencies. The IRS significantly changed its cost classification structure during fiscal year 2001 and was unable to restate fiscal year 2000 balances for purposes of comparability. Consequently, the IRS is not presenting a comparative fiscal year 2000 statement of net cost. The IRS received a waiver from this reporting requirement from the Office of Management and Budget. One of the largest obstacles facing IRS management today is that the agency still does not have a financial management system capable of producing reliable and timely information its managers need to make day-to-day decisions. Because of this systems issue and other factors, it continues to face many of the pervasive internal control weaknesses that the GAO has reported each year since we began auditing IRS’s financial statements in fiscal year 1992. These costly efforts would not have been necessary if the IRS’s systems and controls operated effectively. Further actions are needed and the GAO continues to consider these issues to be material weaknesses. Misstatements may occur in other financial information reported by the IRS as a result of the internal control weaknesses described in this report. Because of the material weaknesses in internal controls discussed below, the IRS did not maintain effective internal controls over financial reporting (including safeguarding of assets) or compliance with laws and regulations, and thus did not provide reasonable assurance that losses, misstatements, and
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noncompliance with laws material in relation to the financial statements would be prevented or detected on a timely basis. The material weaknesses in internal controls noted above may adversely affect any decision by IRS’s management that is based, in whole or in part, on information that is inaccurate because of these weaknesses. The IRS has readily acknowledged its financial management systems do not comply with Federal Financial Management Improvement Act of 1996 (FFMIA) and the need to overhaul these systems as part of its broader systems modernization efforts. The GAO found that the IRS cannot report reliable cost-based performance measures relating to its various programs in accordance with the Government Performance and Results Act of 1993. During fiscal year 2001, the IRS did not have internal controls over its general ledger system adequate to provide reasonable assurance that its balances were current and accurate on an ongoing basis. The IRS did not record material transactions in its general ledger system until months after they occurred. The GAO found that the IRS continued to lack a cost accounting system capable of accurately and timely tracking and reporting the costs of IRS’s programs and projects to assist it in managing its costs. The IRS also continues to be unable to determine the specific amount of revenue it actually collects for three of the federal government’s four largest revenue sources – Social Security, hospital insurance, and individual income taxes. In addition, the IRS continues to be unable to determine, at the time payments are received, collections for the Highway Trust Fund or other trust funds that receive excise tax receipts. The IRS was compelled to make certain business decisions affecting the disposition of tens of billions of dollars without current and reliable underlying financial information. From 1996 to 1999, the IRS only followed-up on 21% of the over 53 million underreported individual income tax cases it identified, which accounted for about 41% of the over $65 billion in underreported taxes the IRS estimated on these cases. As of September 30, 2001, the IRS had either not started collection action or had stopped collection action in progress on unpaid tax assessment cases with outstanding balances totaling about $12 billion because it did not believe it had the resources to actively seek collection. The IRS’s management of unpaid assessments also continued to be hindered by inaccurate tax records. The GAO found errors in taxpayer accounts, which the IRS took a significant amount of time to correct.
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The ultimate solution to many of these issues is the successful modernization of IRS’s systems, which the IRS acknowledges will take several years to complete. Due in large part to perceived resource constraints, IRS selects only a portion of the questionable cases it identifies for follow-up investigation and action. The federal government is exposed to potentially significant losses from reduced revenue and disbursements of improper refunds. While it processes hundreds of millions of tax returns each filing season, the IRS must issue refunds within statutory time constraints or be subject to interest charges. Due to time and other constraints, the IRS relies extensively on detective controls, such as automated matching of returns with third-party data such as W-2s (wage and tax statements) to identify for collection underreported taxes and improper refunds. The IRS’s decisions to forgo follow-up examinations on invalid EITC claims and potentially underreported taxes were based in part on perceived resource constraints. As the GAO previously reported, the IRS does not have an integrated property management system that appropriately records P&E additions and disposals as they occur and links costs on the accounting records to property records. The GAO previously reported that internal control deficiencies over appropriated funds prevented the IRS from ensuring that its budgetary authority was routinely accounted for, reported, and controlled. Without adequate budgetary controls, the IRS cannot ensure the reliability of key budgetary information it needs on an ongoing basis to manage its operations and ensure that its obligations do not exceed budgetary authority. The IRS’s balance of undelivered orders was not accurate throughout fiscal year 2001 due to delays in recording expenditures. The IRS continued to have serious weaknesses in fiscal year 2001 with computer controls designed to protect computing resources such as networks, computer equipment, software programs, data, and facilities from unauthorized use, modification, loss, and disclosure. Collectively, these problems indicate material weaknesses in the IRS’s internal controls over information systems and data. During fiscal year 2001, the IRS’s controls over cash, checks, and related hardcopy taxpayer data it receives from taxpayers continued to be inadequate to sufficiently limit the risk of theft, loss, or misuse of such funds and data. The GAO found other weaknesses and inconsistencies in controls over taxpayer receipts and taxpayer data at service center campuses and field offices that have not yet been adequately addressed.
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These inconsistencies are further illustrated by control weaknesses found at commercial lockbox banks that process tax receipts on behalf of the IRS.
GAO-02-356 Business Systems Modernization: IRS Needs to Better Balance Management Capacity with Systems Acquisition Workload – 2/28/02 The increased risk of the IRS’s proceeding without these controls and capabilities has contributed to actual project cost, schedule, and performance shortfalls. To address the escalating risks facing the IRS on its Business Systems Management (BSM) program, the GAO recommended that the Commissioner of Internal Revenue reconsider the planned scope and pace of the BSM program as defined in the fifth expenditure plan, with the goal of better balancing the number of systems acquisition projects underway and planned with the IRS’s capacity to manage this workload. At a minimum, the commissioner’s reconsideration should include; Slowing ongoing projects and delaying new project starts to reduce Business Systems Modernization Office resource demands, Making correcting modernization management weaknesses a top priority, and A matter of top management attention, and reapplying resources – financial and human capital – available from slowed and delayed projects toward correction of control weaknesses. In summary, the GAO reported that attempting to acquire modernized systems before having the requisite management capability increases the risk that systems will experience cost, schedule, and performance shortfalls. The IRS’s modernization management capability is still not where it should be given The number of acquisition projects that are underway, The fact that several of these projects have already entered the critical building stage of their life cycles and are to begin deployment during calendar year 2002, and The IRS’s plan to begin additional projects. In the GAO’s view, reliance on a combination of existing immature processes and individual expertise and heroic efforts is a short-term solution to a longterm need. Given that these controls’ immaturity have already contributed to project cost, schedule, and performance shortfalls, and will likely lead to future shortfalls, the IRS needs a better strategy for mitigating the risks it faces in implementing its fifth expenditure plan. Despite important progress, key controls and capabilities have not yet been implemented.
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In effect, this plan means that the IRS will not implement mature acquisition processes on key projects until after initial system increments have passed critical, later life cycle phases. As a result, the IRS will continue to run the risk that these projects’ promised capabilities will not be delivered on time and within budget. The significance of this risk is magnified in light of the multiple dependencies that exist among projects, where for example, delays in one can cause cascading delays in others. The IRS does not have the means to adequately manage the interdependencies within and among projects, thus increasing the risk of project delays, overruns, and rework. The IRS has not yet implemented effective project cost and schedule estimating practices. What has and continues to challenge the IRS is implementing the planned management controls and capabilities. Until the IRS addresses its management control weaknesses, it will expose BSM to unnecessary risk.
GAO-02-353 IRS Can Improve Private Pension Compliance Studies – 4/12/02 The IRS study does not generally provide accurate estimates of 401(k) plan compliance. Shortcomings cut across important components of the 401(k) study, including questionnaire design, data collection, and data analysis.
GAO-02-336 Tax Abatements – 1/31/02 Better data on small business tax abatements is required. The IRS cannot readily identify small business taxpayers from all other taxpayers. Tax abatements for self-employed individuals did not always relate to business issues. Some employment tax filers were coded as small businesses even though they were subsidiaries of large corporations. Better electronic data on the nature of errors related to abatements is needed. The IRS has no data on taxpayer burden or IRS costs of abatements. The IRS needs to improve the number of staff, training of staff, and computer resources (cost analysis).
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Abatements cost hundreds of thousands of small business tax assessments totaling billions of dollars annually. Even the IRS concedes that it is a significant issue. More cost effective methods need to be researched.
GAO-02-311 Changes Needed in Offers in Compromise (OIC) Program – 3/15/02 OIC inventory and processing times grew because staffing increases were outpaced by program changes. Despite significant increases in the staff devoted to the OIC program, the IRS was unable to close as many cases as it received. The increased staffing was insufficient to handle the OIC program in terms of demand, processing steps, and hours needed. The extent to which IRS’s current initiatives would reduce OIC inventory and processing time is uncertain. The IRS’s two key initiatives of centralization and fast track processing have uncertain results. Lower-level staff is being utilized. Other initiatives aimed at limiting new submissions and improving processing efficiency also may have uncertain results. Plans for evaluations and data collection are incomplete and the goal for processing time has been verified. The IRS lacked data and written plans for partial payment installment agreements. The IRS proposal for a partial payment installment agreement program suffers from weaknesses similar to those in the OIC program initiatives.
GAO-02-234R IRS Guidance on Economic Analyses in Investment Business Cases – 5/9/02 Some aspects of the IRS’s guidance are inconsistent with commonly-held principles of public sector cost-benefit analysis. Most important, the guidance does not require the computation of a comprehensive social net present value (NPV), which is the standard criterion for deciding whether a government investment can be justified on economic grounds. The IRS’s IT modernization effort is broad in scope, complex, and high risk. The IRS’s NPV measures exclude some benefits and costs that would be included in a social NPV and improperly include transfer payments.
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The IRS’s guidance does not explain how other broad categories of transfer payments should be treated in the NPV computations. In fact, it makes no distinction between transfer payments and resource savings or costs. The IRS’s partial NPVs generally do not provide a clear basis for making decisions. Depending on what information the IRS’s guidance already requires project teams to compile, the supplementary analysis may require only minimal additional cost to complete. The IRS’s approach to computing cost savings and cost avoidance benefits contains an inconsistency. The correct way to define and compute a cost savings and/or avoidance measure depends on how that measure will be used. The IRS needs to compute recurring cost reductions relative to a reference case in order to complete the excess burden analysis.
GAO-02-92 Employment Tax Compliance – 2/20/02 The IRS takes several weeks to notify employers of employment tax delinquencies. Not filing a Form 941 return further delays notification of employers. The time from the date of delinquent deposit increases interest and penalties. Efforts to evaluate the IRS programs to prevent or reduce tax delinquency have experienced problems. Major information system improvements for business taxpayers will not be available until at least 2005.
IMPLICIT TAXES AND PROGRESSIVITY Harvey J. Iglarsh and Ronald Gage Allan ABSTRACT Scholars suggest that failure to include implicit taxes in analyses of vertical equity understates the progressivity of the tax system. This paper develops an analytic expression for imputing the implicit tax associated with tax-exempt bonds using the tax-exempt interest income reported on individual income tax returns. To measure progressivity, Kakwani indices are calculated using three definitions of income and three measures of tax liability. In addition, the indices are computed by adding implicit income to the income measure. Examination of the Kakwani indices leads to the conclusion that the tax system is progressive for all measures of tax liability. Total tax (explicit plus implicit), measured against explicit plus implicit income, is more progressive than explicit tax measured against explicit income. Including the implicit tax associated with tax-exempt interest in the measurement of tax progressivity increases the level of progressivity of the tax system slightly.
INTRODUCTION The difference between the pre-tax return of a fully-taxable asset and that of a tax-favored asset of equal risk can be viewed as an implicit tax. Such taxes have enjoyed extensive analysis for tax planning purposes (Scholes & Wolfson, 1992). The tax accounting research community has begun to apply research on implicit Advances in Taxation Advances in Taxation, Volume 15, 93–109 Copyright © 2003 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(03)15004-1
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taxes and their associated tax clienteles to questions of tax policy. For example, Anderson, Hill and Murphy (1995) included implicit taxes in a study of horizontal equity and concluded that, when both explicit and implicit taxes are included in an equity analysis, apparent horizontal inequities disappear and all that remains is variation due to market imperfections. This result might suggest that Congress, when enacting tax preferences, does not create horizontal inequities in the tax system. Wilkie (1992a) suggested that government studies of the impact of tax legislation in the 1980s understated the progressivity of the tax system because of a failure to include implicit taxes in the analyses. This article applies the implicit tax model to the most prominent tax-favored investment associated with the individual income tax, tax-exempt bonds. The issue studied is whether including implicit taxes in the computation of tax progressivity increases or decreases the measured progressivity of the tax system.
CONTEXT AND STRATEGY Implicit taxes occur when investors bid up the price of tax-favored investments relative to fully-taxed investments to obtain the tax-favored treatment. For example, tax-exempt bonds earn lower before-tax returns than do fully-taxable bonds. The difference in return is regarded as an implicit tax; i.e. a tax paid implicitly through the lower before-tax return. This tax typically is not paid directly to the taxing authority but rather, the taxpayer is viewed as acting as a transfer agent for the government with the taxpayer remitting a part of the tax to the beneficiary of a governmental subsidy or transfer payment. In the case of tax-exempt municipal bonds, the subsidy goes to the issuing municipality in terms of a lower interest rate than that of a fully-taxable bond. Tax-favored investments would seem to distort vertical equity. For example, high-income investors in tax-exempt bonds appear to grossly distort vertical equity by reducing their high explicit tax rate to a zero explicit tax rate on the bond interest. However, by examining implicit taxes, we see that these taxpayers actually convert high explicit tax rates into lower implicit tax rates. Thus, the vertical equity distortion may not be as great as it appears. Most previous research on implicit taxes has been done in a corporate context and has addressed a number of policy related issues. Stickney, Weil and Wolfson (1983), Scholes, Wilson and Wolfson (1990), and Shackelford (1991) found evidence that links implicit taxes to market competitiveness. Wilkie (1992b) provides evidence that reductions in explicit taxes (increases in tax subsidies) are associated with increases in implicit taxes (reductions in pre-tax return). Wilkie (1992a) suggests that government studies of the impact of tax legislation in the 1980s understated
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the progressivity of the tax system because of a failure to include implicit taxes in the analysis. Berger (1993) estimates the magnitude of the implicit tax created by the 1981 Research and Development tax credit. Through an event study, he finds evidence that suggests a negative shareholder wealth reaction for firms anticipated to pay implicit taxes without receiving explicit tax benefits. He also finds that the firms receiving credit benefits do not pay all the benefits to others in the form of implicit taxes but retain enough benefit to experience a significantly positive shareholder wealth reaction. Callihan and White (1999) present results indicating that implicit taxes are significantly negatively related to the pre-tax rate of return and firm market structure characteristics. Study of the role of implicit taxes within the individual income tax system has been focused on partial equilibrium analyses of tax-exempt bonds. Bailey (1974) laid out an analytical framework that attempted to explain and interpret the interaction between tax rate and tax system progressivity and the mechanism by which the tax system can induce people to misallocate resources. Although implicit taxes were not referred to as such, Bailey’s (1974, pp. 1157–1158) analytical framework showed “that the U.S. income tax must be proportional or progressive at the higher-income levels; any apparent drop-off in the effective rate of tax for very high incomes would be misleading because of sacrifice of pretax income to maximize income after tax.” Bailey (1974, p. 1174) further found that “[t]axpayers respond to tax inducements by overinvesting in the favored industries, and although such taxpayers appear to pay less than their ‘fair shares’ of tax, their tax avoidance accomplishes no more than to make effective personal income tax burdens approximately proportional to the higher income ranges.” Bailey also demonstrated that one should expect mild progressivity at high income levels on the basis of a check of his implicit tax theory against rough benchmark data on income flows. Zimmerman (1991) developed a framework for analyzing the efficiency associated with using tax-exempt bonds to transfer money from the federal government to state and local governments. He demonstrated that any taxpayer whose marginal tax rate exceeds the marginal tax rate that clears the municipal bond market receives a windfall. That is, the taxpayer receives a higher yield on the municipal bond than is necessary to induce him to buy the bond, which causes the federal revenue loss to be greater than the reduced borrowing costs of state and local governments. Anderson, Hill and Murphy (1995) examined the effect of including implicit taxes in the analysis of horizontal equity on individual returns. Using data from an experimental market study, they found evidence to support the hypothesis that, when both explicit and implicit taxes are considered, apparent horizontal inequities disappear, and all that remains is variation due to market imperfections.
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Inclusion of implicit taxes in horizontal equity analyses implies acceptance of the efficiency theorist view that tax preferred investments are capitalized in the market place (Feldstein, 1976, p. 124) and therefore, by definition, do not give rise to inequities when markets reach equilibrium. However, horizontal inequities might occur during the transition to equilibrium. Wilkie (1992a) suggests that inclusion of implicit taxes in analyses of vertical equity would lead to the acceptance of the tax system as being more progressive than it is currently regarded. This study tests this hypothesis by measuring the overall progressivity of the tax system with and without the inclusion of implicit taxes attributable to municipal bond interest. To determine the effect of including implicit taxes in measures of tax progressivity, Kakwani indices are calculated for several measures of income and for both explicit and implicit tax. Indices that include implicit taxes are compared with indices that exclude implicit taxes to determine the direction and magnitude of changes in progressivity.
SAMPLE DATA The data set for the empirical analysis is the 1988 Individual Public Use Tax File. The File was created by the IRS from unaudited individual income tax returns. To create the File, a population of 109,707,700 Forms 1040, 1040A, and 1040EZ from the year 1988 were classified into 39 sample strata. The 39 strata were based predominantly on the larger of total income or total loss amounts and the size of business receipts. Then, 95,713 returns were randomly selected from the strata. Sampling weights were obtained by dividing the number of returns filed per stratum by the number of sample returns actually received for that stratum. Estimates obtained from this File are intended to represent all returns filed for Income Tax Year 1988. Included in the File are 796 returns that reflect additional special taxes. These taxes are based on income not reported on the tax return (e.g. certain distributions from retirement plans). The returns in the File have a field that reflects whether a special tax computation was used to calculate tax liability, but no field records the amount of the extra tax. Previous empirical tax progressivity studies by Dunbar and Nordhauser (1991, p. 521) and Seetharaman and Iyer (1995, p. 55) eliminated these returns from their samples because these studies compare income with corresponding tax liability to measure progressivity. Following the method used in these studies, the 796 returns in the File were eliminated from our data base. The resulting sample used in this study contains 94,917 returns representing a population of about 109.2 million returns. Of this sample, 19,749 returns, representing a population of about 3.5 million returns (3.18% of the total population),
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record tax-exempt interest income. The total tax-exempt interest reported by the population was approximately $32.4 billion. All analyses in this article use the weighted data representing the entire population of 109.2 million returns.
IMPUTATION PROCEDURES Implicit taxes are not observable and therefore must be imputed. An imputation procedure is developed in this study for the implicit taxes rising from tax-exempt interest. The implicit tax (IMPTAX) associated with the interest on tax-exempt bonds is equal to the difference between the before-tax interest (IT ) that would have been generated by a similar investment in fully-taxable bonds and the tax-exempt interest (INT ), on a risk-adjusted basis. IMPTAX = I T − I NT
(1)
Fully-taxable interest is equal to the rate of return on fully-taxable bonds (Rb ) multiplied by the amount invested, which we refer to as the invested basis (BASIS). Substituting into Eq. (1) yields IMPTAX = R b BASIS − I NT
(2)
The invested basis is equal to the tax-exempt interest divided by the rate of return on tax-free bonds (Ra ). Substituting into Eq. (2) we obtain: Rb −1 (3) IMPTAX = I NT Ra Since each taxpayer has a distinct municipal bond portfolio and because municipal bonds vary in quality, we use Eq. (3) to obtain an upper and lower bound for the implicit tax. The lower bound is derived using high-grade Moody’s Aaa bonds, and the upper bound is derived using lower-grade Moody’s Baa bonds. First, the lower bound is calculated. Using Moody’s Corporate Aaa Bond Average for 1988 (9.71%) for the fully-taxable bond rate and Moody’s Aaa State and Local Note and Bond Average for 1988 (7.36%) for the equivalent tax-exempt rate on a riskadjusted basis, Eq. (3) yields an approximate expression for the implicit taxes associated with tax-exempt interest of: IMPTAX = 0.319I NT
(4)
Inserting the tax-exempt interest reported in 1988 into this formula gives a total implicit tax of approximately $10.3 billion for 1988.
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To calculate the upper bound we use Moody’s Corporate Baa Bond Average for 1988 (10.83%) for the fully-taxable bond rate and Moody’s Baa State and Local Note and Bond Average for 1988 (7.83%) for the equivalent tax-exempt rate on a risk-adjusted basis. Equation (3) yields an approximate expression for the implicit taxes associated with tax-exempt interest of: IMPTAX = 0.383I NT
(5)
Inserting the tax-exempt interest reported in 1988 into this formula gives a total implicit tax of approximately $12.4 billion for 1988. It is likely that the total amount of implicit tax lies somewhere between these two bounds.
IMPLICIT TAXES AND PROGRESSIVITY Kakwani Index The Kakwani tax progressivity index has been shown to be especially useful in the measurement of both tax progressivity and its impact on income inequality (Seetharaman & Iyer, 1995, p. 68). It is given by: K=
k HLC
(6)
where k equals the area below the Lorenz curve of before-tax income minus the area below the Lorenz curve of income tax after credits, and HLC equals the area below the hypothetical Lorenz curve.1 Figure 1 shows the Lorenz curve of taxable income, the Lorenz curve of income tax after credits plus alternative minimum tax, both using the 1988 data, and the hypothetical Lorenz curve. The horizontal axis represents the cumulative proportion of income recipients and the vertical axis represents the cumulative proportion of income and tax.2 The hypothetical Lorenz curve is the straight line from the origin with slope equal to 1. K is positive in the case of progressivity, zero for proportionality, and negative in the case of regressivity. The values of K fall between −2 and 1 (Seetharaman, 1994, p. 104). We determine the values of the Lorenz curves using 50 points on the horizontal axis from cumulative proportions of income recipients 2 to 100. To calculate areas under the Lorenz curves, we performed numerical integration using PSI-Plot, version 5, by Poly Software International. All integrals were computed over 50 equally-spaced intervals using the spline interpolation method.
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Fig. 1. Kakwani’s Index.
Measures of Income A number of definitions of income are used in tax research to classify taxpayers into groups. We use three definitions to provide some assurance that the conclusion will not depend on the income definition and to help identify the behavior of implicit taxes within the tax system. One definition of income is adjusted gross income (AGI). A second measure, taxable income, is defined as AGI minus: (1) the larger of the standard deduction or total itemized deductions; and (2) the exemption amount, with a floor for taxable income of zero. The third definition of income, expanded total income, is described in Allan and Iglarsh (1996) and includes some special adjustments for passive activities required by Tax Reform Act of 1986 transition rules. The definition of expanded total income is AGI plus tax-exempt interest income plus tax-exempt social security benefits plus IRA deduction (taxpayer and spouse) plus Keogh and SEP deduction plus total tax preferences plus passive activity loss (rental, partnership, and S-corporation activities) to the extent passive losses exceed passive income. Expanded total income tends to overstate income. For example, passive losses are added-back in the year realized, but they are not subtracted in the year applied. Taxable income, being reduced by exemptions and deductions, is the smallest of
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the three measures of income. Hence, progressivity measures derived from these definitions of income might be viewed as upper and lower bounds.
Measurement of Progressivity To measure the change in progressivity of the tax system when implicit taxes associated with tax-exempt interest are included in the computations, 21 Kakwani indices are calculated and displayed in Table 1. The table contains three rows corresponding to the three definitions of income used in this study. The first column contains Kakwani indices for income tax after credits plus alternative minimum tax (explicit tax) measured against the three types of income. In all three cases, the Kakwani indices are positive, indicating progressivity. Taxable income has the smallest index due to the net effect of exemptions and itemized or standard deductions, which cause a decrease in progressivity. This effect is consistent with results obtained by Seetharaman (1994, p. 112) and Young et al. (1999, p. 41) that itemized deductions as a whole are regressive. Columns 2 and 3 contain Kakwani indices for the total tax (explicit tax plus imputed implicit tax) measured against the three measures of income. Column 2 shows the results when Aaa bond rates are used to impute implicit taxes and column 3 when Baa rates are used. Again, all Kakwani indices are positive, indicating progressivity, with taxable income having the lowest index. Columns 1 through 3 show that when implicit tax is added to explicit tax, progressivity improves. Conceptually, the computation of progressivity indices that include implicit taxes requires the addition of “implicit income” (equal to implicit tax) to the measure of income.3 Columns 4 and 5 present the Kakwani indices for explicit tax adding implicit income to each of the three definitions of income, while columns 6 and 7 do the same for total tax. All 12 Kakwani indices are positive, indicating progressivity, with taxable income having the lowest values. When implicit tax is added to explicit tax, progressivity improves (as seen by comparing column 1 indices with columns 2 and 3 indices, column 4 indices with column 6 indices and column 5 indices with column 7 indices). The impact on the progressivity of the tax system by including implicit taxes in progressivity calculations is determined by comparing the Kakwani indices for explicit tax and explicit income, column 1, with the Kakwani indices for total tax and explicit plus implicit income, columns 6 and 7. For all three income definitions, the impact of including implicit taxes in measures of progressivity is a small increase in progressivity. Several possible reasons may account for the small upward impact on progressivity. First, consider the impact of the behavior of the tax clienteles created by the
Implicit Taxes and Progressivity
Table 1. Kakwani Indices (All Taxpayers). Income Type
Taxable income Adjusted gross income Expanded total income
Explicit Income Only
Explicit Plus Implicit Income
Explicit Tax (1)
Total Tax Aaa (2)
Total Tax Baa (3)
Explicit Tax vs. Explicit Plus Aaa Implicit Income (4)
Explicit Tax vs. Explicit Plus Baa Implicit Income (5)
Total Tax vs. Explicit Plus Aaa Implicit Income (6)
Total Tax vs. Explicit Plus Baa Implicit Income (7)
0.0938 0.1764 0.1720
0.0952 0.1786 0.1773
0.0954 0.1791 0.1783
0.0928 0.1754 0.1705
0.0926 0.1751 0.1702
0.0960 0.1789 0.1761
0.0966 0.1795 0.1770
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Table 2. Implicit Taxpayers by Marginal Tax Rate. Marginal Rate (%)
0 15 28 33 Total
Tax-Exempt Interest Taxpayers (%)
Dollar Value (%)
5.16 32.48 36.05 26.31
5.15 16.38 24.20 54.27
100.00
100.00
existence of tax-favored investments (Scholes & Wolfson, 1992, p. 96). Marginal investors are indifferent as to purchasing tax-exempt or taxable bonds. However, inframarginal investors with high marginal rates should prefer holding tax-favored, tax-exempt bonds, while inframarginal taxpayers with low marginal rates should hold fully-taxable bonds. Although this strategy may be preferred for inframarginal investors, Table 2 demonstrates that they do not actually behave as expected. This table presents a breakdown of the percentage of taxpayers with tax-exempt interest income and the percentage of the dollar value of tax-exempt interest classified by the marginal rates used in the 1988 tax rate schedules. In 1988, the top rate of 33% was phased-out at a taxable income level dependent on filing status and number of exemptions. To determine who are the marginal investors for municipal bonds, we calculate the marginal tax rates for which taxpayers would be indifferent between purchasing taxable or tax-exempt bonds. For Aaa bonds the rate would be (9.71 − 7.36)/9.71 = 24.2%. For Baa bonds the rate would be (10.83 − 7.83)/10.83 = 27.7%. Thus, marginal investors for municipal bonds would have marginal tax rates between 24.2 and 27.7%. Table 2 shows that 62.36% of municipal bond holders are above-marginal investors and they receive 78.47% of the tax-exempt interest. The remaining 37.64% of taxpayers holding municipal bonds are below-marginal investors who would receive a greater return holding taxable bonds. These taxpayers receive 21.53% of the tax-exempt interest. Thus, implicit taxpayers are more evenly spread throughout the rate spectrum than might be expected from theoretical analyses of the clientele effect. Since tax-exempt bondholders are present at all levels of taxable income, when implicit taxes are added to the tax burden, total tax is increased for both marginal and inframarginal investors and progressivity is only slightly improved. Adding implicit income to the income definition further complicates the analysis by reranking the taxpayers by income. When implicit income is added to the calculation, total income and total tax of individual implicit taxpayers is increased,
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which pushes some implicit taxpayers into higher income percentiles. As Suits (1977) notes, the calculation of progressivity depends on the distribution of income as well as the distribution of tax.
Filing Status Table 3 gives population, tax, and income totals for the sample arranged by filing status. Almost 44% of the population filed as married filing jointly. However, this filing status contains over 63% of the population showing tax-exempt interest. They account for over 65% of the dollar value of tax-exempt interest shown and over 71% of explicit taxes paid. The combined filing statuses of married filing separately, head of household, and surviving spouse account for 12% of the population. Moreover, these taxpayers account for only 4.5% of the taxpayers showing tax-exempt interest, 3.7% of the dollar value of tax-exempt interest, and 5.4% of explicit taxes. To examine the sensitivity of the results to filing status differences, the Kakwani indices have been recalculated for only the filing status married filing jointly. The 21 Kakwani indices for the married filing jointly sub-population are shown in Table 4. As with the entire population of taxpayers, all indices are positive and indicate progressivity. Each index in Table 4 is larger than its corresponding index in Table 1, showing increased progressivity for the married filing jointly filing status. Taxable income again has the lowest indices. Columns 1 through 3 show that when implicit tax is added to explicit tax, progressivity improves. Comparing column 1 with columns 6 and 7, for all three income definitions, the impact of including implicit taxes in measures of progressivity is a small increase in progressivity. The relative size of the increase is smaller than that occurring with the population of all taxpayers. Thus, the results for the filing status with the largest number of taxpayers showing tax-exempt interest does not significantly differ from the entire population.
Research Limitations and Extensions The data used in this study are for tax year 1988. In 1988, the highest marginal tax rate was 33%, reduced to 28% after a phase-out range. The marginal investors were estimated to have tax rates between 24.2 and 27.7%. For each of the tax years 1988 through 1995, Table 5 shows the highest marginal rate, Moody’s bond averages, and marginal investors’ tax rates. For 1988 through 1992, the highest marginal rate is 33%, and the marginal investors’ tax rates vary only slightly. Using the 1988 data, we concluded that
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Table 3. Filing Status. Tax-Exempt Interest ($Billions)
Explicit Taxable AGI Taxes Income ($Billions) ($Billions) ($Billions)
Single Married filing jointly Married filing separately Head of household Surviving spouse
23,762 64,402 1,507 5,200 46
48.1 48.0 1.7 11.3 0.1
2,829 16,291 309 317 3
1,108,930 2,206,377 38,650 112,556 5,927
9.89 21.30 0.63 0.56 0.01
93.1 293.5 6.1 15.7 0.2
486.6 1,438.1 28.5 102.0 1.2
717.2 2,108.6 38.9 199.1 2.0
Total
94,917
109.2
19,749
3,472,440
32.4
408.5
2,056.4
3,065.8
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Number of Population Number Returns Population with Returns (Millions) in Sample with Tax-Exempt in Sample Tax Exempt Interest Interest
Implicit Taxes and Progressivity
Table 4. Kakwani Indices (Married Filing Jointly). Income Type
Taxable income Adjusted gross income Expanded total income
Explicit Income Only
Explicit Plus Implicit Income
Explicit Tax (1)
Total Tax Aaa (2)
Total Tax Baa (3)
Explicit Tax vs. Explicit Plus Aaa Implicit Income (4)
Explicit Tax vs. Explicit Plus Baa Implicit Income (5)
Total Tax vs. Explicit Plus Aaa Implicit Income (6)
Total Tax vs. Explicit Plus Baa Implicit Income (7)
0.1109 0.2108 0.2091
0.1122 0.2125 0.2142
0.1125 0.2129 0.2152
0.1098 0.2097 0.2075
0.1095 0.2095 0.2071
0.1127 0.2127 0.2130
0.1133 0.2133 0.2138
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Table 5. Marginal Investors’ Tax Rates. Highest Marginal Rate
Moody’s Corp Aaa Bond Average
Moody’s Aaa State and Local Note and Bond Average
Moody’s Corp Baa Bond Average
Moody’s Baa State and Local Note and Bond Average
Marginal Investors Tax Rate Using Aaa Averages
Marginal Investors Tax Rate Using Baa Averages
1995 1994 1993 1992 1991 1990 1989 1988
39.6 39.6 39.6 31 31 33 33 33
7.59 7.97 7.22 8.14 8.77 9.32 9.26 9.71
5.80 5.77 5.38 6.09 6.56 6.96 7.00 7.36
8.20 8.63 7.93 8.98 9.80 10.36 10.18 10.83
6.10 6.17 5.82 6.48 6.99 7.29 7.40 7.83
23.6 27.6 25.5 25.2 25.2 25.3 24.4 24.2
25.6 28.5 26.6 27.8 28.7 29.6 27.3 27.7
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Year
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when implicit taxes are added to the tax burden, progressivity is only slightly improved. This result is likely to hold for 1989 through 1992 due to the stability of the highest marginal tax rates and marginal investors’ tax rates. In 1993, the highest marginal rate increases by 8.6%, while the marginal investors’ tax rates remain stable. Thus, it is possible that in 1993 and later years there is a larger clientele of above-marginal investors who invest in tax-exempt bonds, creating increased vertical inequity when implicit taxes are not considered. In this case, we may see a difference in magnitude of the change in progressivity measures when implicit taxes are added to the tax burden. A further study is required using post-1992 data to see if the results do change in magnitude due to the increase in spread between the highest marginal tax rate and the marginal investors’ tax rates. The implicit taxes computations used in this research are estimates based on tax return data. They are the most plausible estimates possible with the tax return data, but more detailed household income and portfolio data would permit refinements of the analysis. The models used in this research are static. The Kakwani indices for explicit taxes, implicit taxes, and total taxes are determined with the assumption that taxpayers’ tastes and preferences would remain constant even without the availability of tax-favored investments. This assumption is almost certainly not true, and although it is not obvious what the dynamic feedback effect of the removal of the federal tax exemption of municipal bond interest would have on the economy and taxpayers’ investment decisions, it is unlikely to be neutral.
SUMMARY AND CONCLUSIONS Including the implicit tax associated with tax-exempt interest in the measurement of tax progressivity slightly increases the measured progressivity of the tax system. Kakwani indices were calculated using three definitions of income, and with and without the addition of implicit income. For all definitions of income and tax measures, the tax system is progressive. Adding implicit income to definitions of income causes an upward reranking of some implicit taxpayers, dampening the impact on the measure of progressivity. Thus, unless future studies using post-1992 data show otherwise, it appears that the implicit tax associated with tax-exempt interest does not impact the measured progressivity of the personal income tax system sufficiently enough to justify the theoretical and technical development required to have implicit tax analysis accepted for purposes of making tax policy.
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NOTES 1. For a detailed discussion of the Kakwani index see Formby, Seaks and Smith (1984, pp. 298–303). 2. To construct Lorenz curves of a measure of income and tax, the population of taxpayers must be ranked from lowest to highest income, and then the cumulative proportions of income and tax are calculated. For each Lorenz curve, the horizontal axis represents the proportion of the population ranked from lowest to highest for the income measure being considered. Thus, to calculate Lorenz curves based on taxable income, taxpayers are ranked from lowest to highest taxable income. To calculate Lorenz curves based on AGI, the taxpayers must be reranked from lowest to highest AGI in order to calculate the cumulative proportion of AGI and tax. 3. Scholes and Wolfson (1992, p. 146) make this point in their discussion of the marginal tax rate.
ACKNOWLEDGMENTS The authors gratefully acknowledge PricewaterhouseCoopers for data support. We thank Pearl Richardson, Bruce Davie, David Joulfain, Jim Angel and Shelby Herman, the editor and reviewers for their helpful comments.
REFERENCES Allan, R. G., & Iglarsh, H. J. (1996). A cluster analysis of horizontal tax equity. The Journal of the American Taxation Association, 18(Spring), 31–47. Anderson, K. E., Hill, T. J., Jr., & Murphy, D. P. (1995). Horizontal equity and implicit taxes. The Journal of the American Taxation Association, 17(Fall), 89–100. Bailey, M. (1974). Progressivity and investment yields under U.S. income taxation. Journal of Political Economy, 82(November), 1157–1175. Berger, P. (1993). Explicit and implicit tax effects of the r&d tax credit. Journal of Accounting Research, 31(Autumn), 131–171. Callihan, D. S., & White, R. A. (1999). An application of the Scholes and Wolfson model to examine the relation between implicit and explicit taxes and firm market structure. The Journal of the American Taxation Association, 21(Spring), 1–19. Dunbar, A., & Nordhauser, S. (1991). Is the child care credit progressive? National Tax Journal, 44(December), 519–528. Feldstein, M. (1976). Compensation in tax reform. National Tax Journal, 29(June), 123–130. Formby, J. P., Seaks, T. G., & Smith, W. J. (1984). Difficulties in the measurement and comparison of tax progressivity: The case of North America. Public Finance, 39, 297–313. Scholes, M. S., Wilson, G. P., & Wolfson, M. A. (1990). Tax planning, regulatory capital planning, and financial reporting strategy for commercial banks. The Review of Financial Studies, 3, 625–650. Scholes, M. S., & Wolfson, M. A. (1992). Taxes and business strategy: A planning approach. Englewood Cliffs, NJ: Prentice-Hall.
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Seetharaman, A. (1994). An isolation of the effects of personal deductions, tax credits, and the tax rate schedule on U.S. individual income tax progressivity and income inequity. The Journal of the American Taxation Association, 16(Spring), 101–121. Seetharaman, A., & Iyer, G. S. (1995). A comparison of alternate measures of tax progressivity: The case of the child and dependent care credit. The Journal of the American Taxation Association, 17(Spring), 42–70. Shackelford, D. A. (1991). The market for tax benefits: Evidence from leveraged ESOPs. Journal of Accounting and Economics, 14, 117–145. Stickney, C. L., Weil, R. L., & Wolfson, M. A. (1983). Income taxes and tax-transfer leases: General Electric’s accounting Molotov cocktail. The Accounting Review, 58(April), 439–459. Suits, D. B. (1977). Measurement of tax progressivity. American Economic Review, 67(September), 747–752. Wilkie, P. J. (1992a). A critical analysis of tax distribution studies conducted by the congressional budget office. Washington, DC: Tax Foundation. Wilkie, P. J. (1992b). Empirical evidence of implicit taxes in the corporate sector. The Journal of the American Taxation Association, 14(Spring), 97–116. Young, J. C., Nutter, S. E., & Wilkie, P. J. (1999). A re-examination of the effects of personal deductions, tax credits and the tax rate schedule on income tax progressivity and income inequality. The Journal of the American Taxation Association, 21(Spring), 32–44. Zimmerman, D. (1991). The private use of tax-exempt bonds. Washington, DC: Urban Institute Press.
THE ASSOCIATION OF CAREER STAGE AND GENDER WITH TAX ACCOUNTANTS’ WORK ATTITUDES AND BEHAVIORS Suzanne Luttman, Linda Mittermaier and James Rebele ABSTRACT The ability of firms to retain valued knowledge and skills possessed by accounting professionals depends, in part, on creating a work environment that positively affects accountants’ job-related attitudes and behaviors. A first step in achieving this objective is to identify those variables that are related to accountants’ work attitudes and behaviors. Previous research has examined antecedent causes of, for example, accountants’ job satisfaction, performance, organizational commitment, and role stress. Two limitations of the extant research are that subjects have almost always been auditors and no consideration has been given to the fact that accountants may react differently to their work environment depending on where they are in their careers. This study addresses these two limitations of prior research by examining whether tax accountants’ work attitudes and behaviors differ across four common career stages: exploration, establishment, maintenance, and disengagement. The association of gender with tax accountants’ work attitudes was also tested. Results indicate that career stage is significantly related to tax accountants’ performance and job-related tension, but unrelated to job
Advances in Taxation Advances in Taxation, Volume 15, 111–143 © 2003 Published by Elsevier Ltd. ISSN: 1058-7497/doi:10.1016/S1058-7497(03)15005-3
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satisfaction, organizational commitment, work alienation, and role stress. A significant gender effect was found. These results for tax accountants differ somewhat from results for auditors (Rebele et al., 1996), indicating that a one-size-fits-all approach to managing work environments within accounting firms may not be effective in developing and retaining professional staff.
INTRODUCTION Prior research has examined the relationship between aspects of the accounting work environment and practicing accountants’ job-related attitudes and behaviors. Examples of this type of research include studies that have examined how accountants’ role stress is related to their job satisfaction and performance and studies examining relationships between accountants’ personal characteristics (e.g. personality type) and job satisfaction, performance, and turnover behavior (see, for example, Fisher, 2001; Fogarty et al., 2000; Rasch & Harrell, 1990; Rebele & Michaels, 1990; Senatra, 1980). Except for a few studies that tested whether age or job tenure affects accountants’ work attitudes and behaviors, researchers have not subdivided samples according to where in their careers different respondents might be. Grouping all respondents together implicitly assumes that where a person is in his or her career does not affect how the person interacts with his or her work environment. Research in non-accounting contexts has, however, shown that we can better understand how individuals relate to their jobs and are affected by their jobs when we consider how people might change over time (Morrow & McElroy, 1987; Van Maanen & Schein, 1979). The idea that we change in significant ways across the course of our careers is intuitively obvious. What is not so obvious are the types and patterns of changes that we might experience between when we start and stop working, or the effect that such changes might have on how we relate to our work environment. Career development theory provides several conceptual models that identify patterns of changing job concerns and potential consequences of such changes for job-related attitudes and behaviors (Smart & Peterson, 1994). Super (1957) provided one such model of career development and adjustment. Rather than assuming that all individuals in the same age range are in the same career stage, Super’s model assumes that many factors (e.g. physical, social, and psychological) determine a person’s career stage. Having a similar set of priorities, goals, and attitudes is a better indicator than is a similar age that individuals are in a particular career stage. The four career stages identified in Super’s (1957) model are exploration, establishment, maintenance, and disengagement. These labels are descriptive of concerns facing individuals currently in that particular career stage. For example,
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exploration-stage individuals are focused on finding the right occupation and with answering the “what do I want to do with the rest of my life?” question. Establishment-stage individuals have chosen their occupation and shifted their attention and efforts to securing their place in an organization or profession. Maintenance-stage individuals are concerned with maintaining their position in the organization, and may be intimidated by the skills of younger employees. In contrast, individuals in the disengagement career stage are more focused on making the transition from work to retirement. Cron and Slocum (1986) have shown that long before they reach retirement age, some individuals psychologically disengage from work. Sonnenfeld and Kotter (1982), Whiston (1990), and Smart and Peterson (1994) have provided significant support for Super’s career stages model. Using Super’s model, Rebele et al. (1996) found career stage to be associated with auditors’ job-related attitudes and behaviors in important ways. For example, auditors in the exploration career stage had the lowest levels of job satisfaction and organizational commitment and the highest levels of work alienation and role stress. These results indicate that auditors just beginning their careers have a difficult time adjusting to the work environment, a finding that suggests the need for job retention efforts designed specifically for entry-level auditors. Two important limitations of existing research are that auditors were almost always used as subjects and, except for Rebele et al. (1996), the moderating effect of career stage on the relationship between work environment and job-related attitudes and behaviors has not been examined. This study extends Rebele et al. (1996) by examining whether and how tax accountants’ career stage is related to their work attitudes. As noted by Benke and Rhodes (1980), work environments within public accounting firms differ across specializations and results from one group of professionals may not be generalizable to another group of professionals. Separately studying tax accountants and measuring and testing the effect of career stage will improve our understanding of how accountants relate to and react to their work environments. Beyond Rebele et al. (1996), this study also evaluates the association of gender with tax accountants’ work attitudes. Creating a positive work environment, including appropriate reward structures and retention opportunities, requires recognition of behaviors and attitudes that differ across genders.
HYPOTHESES DEVELOPMENT The basic purpose of this study is to examine whether tax accountants’ workrelated attitudes differ across the four career stages identified by Super (1957). Work attitudes examined in the study are job satisfaction, job performance,
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job-related tension, organizational commitment, work alienation, role conflict, and role ambiguity. This section reviews relevant empirical research as background for hypotheses about the association of career stage and tax accountants’ work attitudes (Hypotheses H1a through H1g) and the impact of gender on tax accountants’ work attitudes (Hypothesis 2). For completeness, we include non-accounting studies and accounting studies that measured career stage using demographic characteristics such as age or job tenure.
Job Satisfaction Research on the association between career stage and job satisfaction has produced mixed results. Studies by Slocum and Cron (1985), Cron and Slocum (1986), and Ornstein, Cron and Slocum (1989) found that the level of job satisfaction of salespeople increased as they progressed through the career stages. Results from other studies indicate that job satisfaction either does not increase across career stages (Van Maanen & Katz, 1976) or decreases across career stages (Churchill et al., 1976; Mount, 1984). Research in accounting contexts has also produced conflicting results. For example, Adler and Aranya (1984) found that CPAs’ intrinsic and extrinsic satisfaction increased over the first three career stages, but then diminished in the final career stage, while Rebele et al. (1996) found exploration-stage auditors had the lowest levels of job satisfaction, with satisfaction generally increasing over the next three career stages. Alternatively, Norris and Niebuhr (1983) found job satisfaction to be unrelated to career stage for accountants employed by Big 8 firms. The inconclusiveness of prior research findings leads to the following non-directional hypothesis: H1a. There is no significant difference in mean levels of tax accountants’ job satisfaction across the exploration, establishment, maintenance, and disengagement career stages.
Job Performance Although workers’ job performance often declines over career stages, research involving professional employees does not support this decline in performance (Cron & Slocum, 1986; Hall & Mansfield, 1975). This may be because experience and client relationships enable professionals in the later career stages to maintain relatively high performance levels. Rebele et al. (1996) found this positive relationship
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between career stage and performance, with exploration-stage auditors having the lowest level of job performance and disengagement-stage auditors the highest level of performance. Thus, the second hypothesis about tax accountants’ career stage and performance is: H1b. There is no significant difference in mean levels of tax accountants’ job performance across the exploration, establishment, maintenance, and disengagement career stages.
Job-Related Tension Stress is experienced, to varying degrees, by all employees and can arise from the physical work environment, the individual, the work group, or the organization (Matteson & Ivancevich, 1982). Physiological or psychological stressors on the job cause an employee to experience job-related tension. An individual’s ability to manage job-related tension should improve over time, although research has not extensively investigated the relationship between career stage and job tension. Results from the one available study (Rebele et al., 1996) show no significant relationship between auditors’ career stage and job-related tension. The third hypothesis is: H1c. There is no significant difference in mean levels of tax accountants’ job-related tension across the exploration, establishment, maintenance, and disengagement career stages.
Organizational Commitment The degree to which an individual feels committed to his or her organization may be related to career stage. It may be that exploration-stage individuals bring high expectations to the workplace and can become critical of their organizations when these expectations are not met (Hall, 1976). Promotions and raises received by those in the establishment and maintenance career stages tend to lead these individuals to perceive their organizations more favorably. A research review conducted by Rhodes (1983) found that younger employees tend to be less committed to their organizations than older employees. The relationship between career stage and organizational commitment has been examined in several accounting studies, with mixed results. Adler and Aranya (1984) found older accountants to be more committed to their organizations than were younger accountants. Aranya and Ferris (1984) found a positive relationship
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between accountants’ level in an organization and organizational commitment, while McGregor et al. (1989) found management accountants’ organizational tenure related to their organizational commitment. Rebele et al. (1996) found a positive relationship between career stage, measured using Super’s model, and organizational commitment and Lynn et al. (1996) found professional tenure to be positively related to organizational commitment. Several studies (Ferris, 1981; Harrell et al., 1986; Norris & Niebuhr, 1983) found no relationship between accountants’ career stage and commitment to their organizations. Because prior research has produced mixed results regarding the relationship between accountants’ career stage and organizational commitment, the fourth hypothesis is: H1d. There is no significant difference in mean level of tax accountants’ organizational commitment across the exploration, establishment, maintenance, and disengagement career stages.
Work Alienation An individual who “cares little about the work, approaches work with little energy and ambition, and works primarily for extrinsic rewards” (Rebele et al., 1996, p. 245) is said to be alienated from his/her work (Dubin, 1956; Moch, 1980). Work alienation is the opposite of job involvement (Kanungo, 1979; Lefkowitz et al., 1984; Organ & Greene, 1981), which would be the work attitude preferred by employers. Two studies have examined the relationship between career stage and accountants’ work alienation or job involvement. Rebele et al. (1996) found auditors’ career stage to be negatively related to work alienation, with exploration-stage auditors exhibiting the highest levels of work alienation. Lynn et al. (1996) found a positive relationship between accountants’ career stage and job involvement. Thus, the fifth hypothesis, concerning the relationship between tax accountants’ career stage and work alienation, is: H1e. There is no significant difference in mean levels of tax accountants’ work alienation across the exploration, establishment, maintenance, and disengagement career stages.
Role Stress Role stress includes both role conflict and role ambiguity, with role conflict reflecting an incompatibility of expectations between a role sender and a
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role incumbent and role ambiguity referring to existing uncertainty about job expectations, methods for fulfilling job expectations, and/or the consequences of job performance (Kahn et al., 1964). Both role conflict and role ambiguity should decline as individuals progress in their careers (Cron, 1984; Walker et al., 1975). Role conflict should decline across career stages because: (1) more experienced individuals will likely have learned how to resolve or cope with conflict; (2) over time, individuals may build up psychological defense mechanisms to screen out conflicting demands; and (3) individuals who cannot cope with conflict will likely change jobs. Role ambiguity should decline over time as individuals obtain more information about what supervisors expect of them and about how to meet these job expectations. Although role stress has been examined in several prior accounting studies (e.g. Fisher, 2001; Senatra, 1980), only Rebele et al. (1996) tested the relationship between career stage and role stress. Their findings indicate that external auditors’ role ambiguity declined over the four career stages, but, except for exploration-stage auditors having the highest levels of role conflict, career stage was unrelated to role conflict. The sixth and seventh hypotheses address the relationship between tax accountants’ career stage and role stress. They are: H1f. There is no significant difference in mean levels of tax accountants’ role conflict across the exploration, establishment, maintenance, and disengagement career stages. H1g. There is no significant difference in mean levels of tax accountants’ role ambiguity across the exploration, establishment, maintenance, and disengagement career stages.
Gender The association between the work environment and job-related attitudes and behaviors may be affected by gender. For example, Weeks et al. (1999) found differences in businesspersons’ responses to ethical judgment scenarios across genders. Lynn et al. (1996) found some differences in accountants’ work attitudes across career stage for females, but not for males. Given the increasing number of women employed in accounting positions, identifying gender differences in work attitudes and behaviors has become very important. As such, the final hypothesis is: H2. There is no significant difference in mean levels of tax accountants’ work attitudes between genders.
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RESEARCH METHOD This section explains how the above hypotheses were tested and how the data were analyzed. Included in the section are descriptions of the subjects and a discussion of the reliability of measures used in the study.
Data Collection Participants were tax accountants employed by four large international accounting firms. Questionnaires were distributed by a tax partner whose cover letter supported the completion of the survey. (The questionnaire is presented in the Appendix.) Questionnaires were placed in sealed, self-addressed, postage-paid envelopes by the respondents and mailed to the researchers. One-hundred and forty-four questionnaires were distributed and 118 completed questionnaires were returned to the authors, for a response rate of 82%. Eleven questionnaires were incomplete, so data from 107 responses were used in the analysis. Respondents had been with their firms for an average of more than three years and had an average of five years of tax experience. Approximately 35% of the respondents were at the staff level, 29% were seniors, 27% managers, and 9% were tax partners. Table 1 presents information about tax accountants classified as being in the exploration, establishment, maintenance, and disengagement career stages. The average number of years with the firm (firm tenure), years of tax experience, and years in public accounting are provided in the upper portion of Table 1. The lower portion of Table 1 provides demographic information (gender, position in the firm, and highest educational degree obtained) for each respondent by career stage.
Measures The reliability of the measures provided by the instruments used in this study has been established through previous research in both accounting and non-accounting contexts. For example, job satisfaction was measured using Hoppock’s (1935) four-item scale, which has been validated in repeated studies involving more than 20,000 subjects (McNichols, Stahl & Manley, 1978). In accounting, the Hoppock job-satisfaction measure has been used by Harrell and Stahl (1984), Harrell and Eickhoff (1988), Rasch and Harrell (1990), and Rebele et al. (1996). Psychometric evaluations have shown the 13-item role conflict scale and the 10-item role ambiguity scale developed by Rizzo, House and Lirtzman (1970)
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Table 1. Characteristics of Tax Professionals Within Each Career Stage. Exploration
Establishment
Maintenance
Disengagement
31.4 3.2 4.6 4.5
29.1 3.1 3.9 3.5
30.6 2.8 5.9 6.2
45.0 8.25 17.50 11.25
Exploration
Establishment
Maintenance
Disengagement
Total
Gender Male Female
12 11
25 21
26 5
3 1
66 38
Total
23
46
31
4
104a
Position Partner Manager Senior Staff
1 7 6 9
1 9 13 24
6 11 12 4
2 2 0 0
10 29 31 37
Total
23
47
33
4
107
8 10 5 0
27 12 8 0
21 8 3 1
3 1 0 0
59 31 16 1
23
47
33
4
107
Age Mean firm tenure Mean tax experience Mean public accounting experience Frequencies
Education Bachelor’s degree Master’s degree Doctoral degree Other Total a Three
participants did not respond to this question.
to be reliable measures of both role conflict and role ambiguity (Gregson et al., 1994; Jackson & Schuler, 1985; Schuler et al., 1977). These 23 items were used to evaluate role stress in this study. Mowday, Steers and Porter (1979) developed a 15-item scale to measure organizational commitment. It was used previously in accounting research by Adler and Aranya (1984), Harrell et al. (1986), and Rebele et al. (1996). Job-related tension was measured through a scale developed by Lysonski (1985) and used by Rebele et al. (1996). This scale measures respondents’ perceptions of how their jobs affect their physical health in terms of tension, anxiety, worry, stress, and fatigue. The work-alienation scale (Miller, 1967) measures an individual’s like or dislike for work on this dimension. Respondents self-rated their job performance
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using a modified version of a 26-item scale previously used by Rebele et al. (1996). Prior research has measured career stage using variables that Dillard and Ferris (1989) have characterized as being either demographic (e.g. age, job title, years at the firm, and years in the position) or cognitive/psychological (perceptual). Perceptual approaches to measuring career stage have been shown to account for more variability in job attitudes than do demographic-based measures (Chao, 1990; Cron & Slocum, 1986; Morrow et al., 1990; Ornstein et al., 1989; Rush et al., 1980). Career stage was measured in this study using the perceptual-based Career Concerns Inventory (CCI) developed by Super, Zelkowitz and Thompson (1981). Questions included in the CCI identify those career concerns that are currently most important to a respondent. Current issues identified by a respondent are then used to classify that person into one of the four career stages. A study of 457 Australian workers, with approximately equal numbers of males and females, supports the factorial validity and consistency of the CCI with Super’s four career stages (Smart & Peterson, 1994). Rebele et al. (1996) used the CCI to identify external auditors’ career stages. Table 1 shows significant variability of demographic variables within each career stage. For example, most “staff” tax accountants were classified as being in the establishment career stage using the CCI, although these same individuals would have been classified as exploration-stage if the demographic variable, job title, had been used as the career stage measure. There were partners and managers in the exploration stage, another inconsistency if researchers were to use a demographic variable (such as job tenure) to classify individuals into career stages rather than using the individuals’ own perceptions about their current career stage. By using the CCI to identify career stage, respondents are correctly classified based on their survey responses. For example, partners and managers deciding whether to make their careers with the CPA firm or to seek/accept other career opportunities available to experienced accountants would indicate responses suggesting they are dealing with the “what do I want to do with the rest of my life” question. Thus, they would properly identify themselves as being in the exploration career stage. Table 2 reports means, standard deviations, mean item response ranges by respondents (with the possible range of responses indicated in parentheses), number of items, and reliability estimates (Cronbach’s coefficient alpha) for each measure used in the study. All job outcomes and role stress survey questions were measured on a 7-point scale with the exception of job-related tension, which (to maintain consistency with previous studies) was measured using a 6-point scale. The Career Concerns Inventory, used to identify career stages, measured responses on a 5-point scale.
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Table 2. Scale Means, Standard Deviations, Ranges, Number of Items, and Reliabilities. Scale
Mean
S.D.
Response (Possible) Range
Items
Coefficient Alpha
Job outcomes Job satisfaction Job performance Job-related tension Organizational commitment Work alienation
4.87 5.49 3.76 5.02 3.05
0.89 0.68 0.87 0.97 1.18
1.75–6.25 (1–7) 3.13–7.00 (1–7) 1.27–5.73 (1–6) 1.93–6.73 (1–7) 1.00–7.00 (1–7)
4 26 11 15 5
0.86 0.76 0.85 0.89 0.81
Role stress Role ambiguity Role conflict
3.18 3.33
1.00 0.94
1.00–5.40 (1–7) 1.23–6.15 (1–7)
10 13
0.84 0.84
Career stages Exploration Establishment Maintenance Disengagement
3.28 3.09 2.79 1.71
0.94 0.69 0.70 0.66
1.27–5.00 (1–5) 1.53–5.00 (1–5) 1.20–4.40 (1–5) 1.00–4.53 (1–5)
15 15 15 15
0.95 0.94 0.92 0.93
Reliability of the survey questions was measured using Cronbach’s coefficient alpha, is the most widely used measure of internal consistency. It is appropriately used when survey responses have a multiple-point rating system (e.g. 1–7 ranking on the “agree/disagree” scale). The maximum possible value for Cronbach’s alpha is one when the correlation between the variables is one. All measures in the current study have sufficiently high reliability, as indicated by coefficients alpha ranging from 0.76 to 0.95 (Nunnally, 1978). The “items” column in Table 2 indicates the number of questions from the survey instrument used in the measurement of each job attitude, role stressor, or career stage.
Data Analysis Procedures Multivariate analysis of variance (MANOVA) was used to assess the overall relationship between tax accountants’ career stage and work attitudes and between gender and work attitudes. MANOVA is appropriately used when there is a between-groups factor and the analysis involves a single predictor variable (career stage or gender) and multiple criterion variables (job satisfaction, performance, tension, organizational commitment, work alienation, and role stress) measured
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on interval scales. MANOVA allows the researcher to perform a single test that determines whether a significant difference (indicated by a single multivariate F-statistic) exists between career stages when compared to all of the work attitudes simultaneously. If there are significant differences using MANOVA (i.e. across career stages or gender with respect to at least one work-related attitude), then univariate analysis of variance (ANOVA) is conducted to identify which groups differ. If significant univariate F results are found, follow-up tests determine the specific work attitudes on which the groups differ (contrasts).
RESULTS Results are presented in Table 3. Panel A of Table 3 presents results for the hypothesized relationships between tax accountants’ career stage and work attitudes. The figures in the first four columns of Panel A represent the mean summated scale (summing response scores across items to create an overall scale on each construct for each respondent) for each career stage. The univariate F-values column report the ANOVA results, and the “significant contrasts” column identifies those career stages exhibiting significantly different levels of job attitudes. Work Attitudes Multivariate analysis of variance (MANOVA) results indicate that tax accountants’ career stage is significantly related to their work attitudes (multivariate F = 1.62, p < 0.05). However, univariate analysis of variance (ANOVA) results indicate that only job performance (Hypothesis 1b) and job-related tension (Hypothesis 1c) are significantly different across career stages. Job performance increased through the exploration, establishment, maintenance, and disengagement career stages, while contrast results show that exploration-stage tax accountants had significantly higher levels of job-related tension than did their colleagues in the disengagement career stage. No significant differences across career stages were found for job satisfaction (Hypothesis 1a), organizational commitment (Hypothesis 1d), work alienation (Hypothesis 1e), and both role conflict and role ambiguity (Hypotheses 1f and 1g).
Gender Multivariate analysis of variance results presented in Panel B of Table 3 indicate that tax accountants’ gender is related to their work attitudes (multivariate
Panel A: Work Attitudes and Career Stages Exploration (EX)a
Establishment (ES)a
Maintenance (MA)a
Disengagement (DN)a
17.9 41.3 43.8 71.6 16.7 35.8 42.1
20.0 44.2 40.9 74.9 14.1 30.6 43.2
19.4 44.7 42.5 75.5 16.4 31.9 45.9
20.8 47.8 34.5 77.5 14.5 25.3 34.5
Male
Female
Univariate F-Values
18.6 43.9 42.2 71.7 15.9 32.7 45.7
20.1 42.5 41.8 77.4 14.0 32.2 39.5
3.44** 1.09 0.03 3.14** 1.55 0.05 5.44*
Job satisfaction Job performance Job-related tension Organizational commitment Work alienation Role ambiguity Role conflict
Univariate F-Values 1.85 2.68* 2.14** 0.41 1.40 1.99 1.21
Significant Contrastsb
EX, DN
The Association of Career Stage
Table 3. Results for Work Attitudes of Tax Professionals by Career Stage and Gender.
Panel B: Work Attitudes and Gender
Job satisfaction Job performance Job-related tension Organizational commitment Work alienation Role ambiguity Role conflict ∗p
< 0.05. < 0.10. a Figures represent the mean summated scale of questions for each work attitude. b Only significant contrasts are reported. ∗∗ p
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F = 2.52, p < 0.05). Univariate ANOVA results indicate that male and female tax accountants differed on levels of job satisfaction, organizational commitment, and role conflict. Specifically, female tax accountants were more satisfied with their jobs, more committed to their organizations, and reported less role conflict than did their male colleagues. Interactions between gender and career stage were not significant.
DISCUSSION AND CONCLUSIONS Results from this study indicate that career stage is generally unrelated to tax accountants’ work attitudes, although evidence was found that exploration-stage tax accountants have significantly lower levels of job performance and significantly higher levels of job-related tension. Gender was significantly related to tax accountants’ satisfaction, organizational commitment, and role conflict, with females reporting higher levels of satisfaction and commitment and a lower level of role conflict. Comparing the results of this study with Rebele et al.’s (1996) findings for external auditors supports Benke and Rhodes’ (1980) observation that not all professionals within public accounting firms react the same to their work environment, or even perceive their work environment in the same way. With the exception of role conflict, the same work attitudes examined in this study were found by Rebele et al. (1996) to be significantly related to external auditors’ career stage. The results of these two studies indicate that a “one-size-fits-all” approach to career development and retention in professional accounting firms may not be most effective in improving job-related attitudes and performance. Comparing results from the Rebele et al. (1996) study and this study should be done with caution because subjects for the two studies came from different firms and different geographic locations. Future research using auditors and tax accountants from offices of the same firms is needed to more conclusively establish whether or not there are differences in how these groups of professionals interact with their work environments. The results of this current study should be interpreted in light of the limitations that all measures in the study are self-reported, that the sample included only four disengagement-stage tax accountants, and that the questionnaire was somewhat long and fatigue factors could have affected the results. Professional services firms must effectively and efficiently use their intellectual capital, or knowledge, in order to offer superior client service. Developing and retaining high-performing professionals is essential for public accounting firms to remain competitive, while the departure of trained professional staff compromises a firm’s ability to serve its clients and to obtain new clients or
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offer new services (Hermanson et al., 1995; Hooks & Cheramy, 1994). Both developing and retaining professionals depends, to some extent, on creating a work environment that positively affects job-related attitudes. Understanding how accounting professionals’ work attitudes and behaviors are affected by the work environment or personal characteristics should help firms create career development and training programs that most benefit their professional staff. Using a career stages framework, this study has shown that tax professionals just beginning their careers are not adjusting well to the public accounting work environment. Firms should pay particular attention to developing and retaining valued employees in this “at risk” group of tax accountants. Results from this study and the prior study by Rebele et al. (1996) have implications for researchers who are examining the work attitudes and behaviors of accounting professionals. The most important implication is that researchers should divide samples by specialization, career stage, and gender. Separate analyses then should be performed on these different groupings to best identify and evaluated differences in work attitudes and behaviors across groups.
ACKNOWLEDGMENTS Suzanne Luttman gratefully acknowledges the support provided by the Robert and Barbara McCullough Chair at Santa Clara University.
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Dubin, R. (1956). Industrial workers’ worlds: A study of the central life interest of industrial workers. Social Problems, 3, 131–142. Ferris, K. R. (1981). Organizational commitment and performance in a professional accounting firm. Accounting, Organizations and Society, 6, 317–326. Fisher, R. T. (2001). Role stress, the type A behavior pattern, and external auditor job satisfaction and performance. Behavioral Research in Accounting, 13, 143–170. Fogarty, T. J., Singh, J., Rhoads, G. K., & Moore, R. K. (2000). Antecedents and consequences of burnout in accounting: Beyond the role stress model. Behavioral Research in Accounting, 12, 31–67. Gregson, T., Wendell, J., & Aono, J. (1994). Role ambiguity, role conflict, and perceived environmental uncertainty: Are the scales measuring separate constructs for accountants? Behavior Research in Accounting, 6, 144–159. Hall, D. T. (1976). Careers in organizations. Pacific Palisades, CA: Goodyear. Hall, D. T., & Mansfield, R. (1975). Relationships of age and seniority with career variables of engineers and scientists. Journal of Applied Psychology, 60, 201–210. Harrell, A., Chewning, E., & Taylor, M. (1986). Organizational-professional conflict and the job satisfaction and turnover intentions of internal auditors. Auditing: A Journal of Practice and Theory (Spring), 109–121. Harrell, A., & Eickhoff, R. (1988). Auditors’ influence-orientation and their affective responses to the “big eight” work environment. Auditing: A Journal of Practice and Theory, 7, 105–118. Harrell, A., & Stahl, M. J. (1984). McClelland’s trichotomy of needs theory and the job satisfaction and work performance of CPA firm professionals. Accounting, Organizations and Society, 9, 241–252. Hermanson, R. H., Carcello, J. V., Hermanson, D. R., Milano, B. J., Polansky, G. A., & Williams, D. Z. (1995). Better environment, better staff. Journal of Accountancy (April), 39–43. Hooks, K. L., & Cheramy, S. J. (1994). Facts and myths about women CPAs. Journal of Accountancy (October), 79–86. Hoppock, R. (1935). Job satisfaction. Harper and Row. Jackson, S. E., & Schuler, R. S. (1985). A meta-analysis and conceptual critique of research on role ambiguity and role conflict in work setting. Organizational Behavior and Human Decision Process (August), 16–78. Kahn, R. L., Wolfe, D. M., Quinn, R. P., Snoek, D. J., & Rosenthal, R. A. (1964). Organizational stress: Studies in role conflict and ambiguity. Wiley. Kanungo, R. N. (1979). The concepts of alienation and involvement revisited. Psychological Bulletin, 86, 119–138. Lefkowitz, J. M., Somers, M. J., & Weinberg, K. (1984). The role of need level and/or need salience as moderators of the relationship between need satisfaction and work alienation-involvement. Journal of Vocational Behavior, 24, 142–158. Lynn, S. A., Cao, L. T., & Horn, B. C. (1996). The influence of career stage on work attitudes of male and female accounting professionals. Journal of Organizational Behavior, 17, 135–149. Lysonski, S. (1985). A boundary theory investigation of the product manager’s role. Journal of Marketing (Winter), 26–40. Matteson, M. T., & Ivancevich, J. M. (1982). Managing job stress and health. New York: Free Press. McGregor, C. C., Jr., Killough, L. N., & Brown, R. M. (1989). An investigation of organizationalprofessional conflict in management accounting. Journal of Management Accounting Research (Fall), 104–118.
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McNichols, C. W., Stahl, M. J., & Manley, T. R. (1978). A validation of Hoppock’s job satisfaction measure. Academy of Management Journal (December), 737–742. Miller, G. A. (1967). Professionals in bureaucracy: Alienation among industrial scientists and engineers. American Sociological Review (October), 755–768. Moch, M. K. (1980). Job involvement, internal motivation, and employees’ integration into networks of work relationships. Organizational Behavior and Human Performance, 25, 15–31. Morrow, P. C., & McElroy, J. C. (1987). Work commitment and job satisfaction over three career stages. Journal of Vocational Behavior, 30, 330–346. Morrow, P. C., Mullen, E. J., & McElroy, J. C. (1990). Review – vocational behavior 1989: The year in review. Journal of Vocational Behavior, 37, 121–195. Mount, M. K. (1984). Managerial career stage and facets of job satisfaction. Journal of Vocational Behavior, 24, 340–354. Mowday, R. T., Steers, R. M., & Porter, L. W. (1979). The measurement of organizational commitment. Journal of Vocational Behavior (April), 224–247. Norris, D. R., & Niebuhr, R. E. (1983). Professionalism, organizational commitment and job satisfaction in an accounting organization. Accounting, Organizations and Society, 9, 49–59. Nunnally, J. C. (1978). Psychometric theory (2nd ed.). McGraw-Hill. Organ, D. W., & Greene, C. N. (1981). The effects of formalization on professional involvement: A compensatory process approach. Administrative Science Quarterly, 26, 237–252. Ornstein, S., Cron, W. L., & Slocum, J. W., Jr. (1989). Life stage vs. career stage: A comparative test of the theories of Levinson and Super. Journal of Organizational Behavior, 10, 117–133. Rasch, R. H., & Harrell, A. (1990). The impact of personal characteristics on the turnover behavior of accounting professionals. Auditing: A Journal of Practice and Theory (Spring), 90–102. Rebele, J. E., & Michaels, R. E. (1990). Independent auditors’ role stress: Antecedent, outcome, and moderating variables. Behavioral Research in Accounting, 2, 124–153. Rebele, J. E., Michaels, R. E., & Wachter, R. (1996). The relationship of career stage to job outcome and role stress: A study of external auditors. Advances in Accounting, 14, 241–258. Rhodes, S. R. (1983). Age-related differences in work attitudes and behavior: A review and conceptual analysis. Psychological Bulletin, 93, 328–367. Rizzo, J. R., House, R. J., & Lirtzman, S. I. (1970). Role conflict and ambiguity in complex organizations. Administrative Science Quarterly, 15, 150–163. Rush, J. C., Peacock, A. C., & Milkovich, G. T. (1980). Career stages: A partial test of Levinson’s model of life/career stages. Journal of Vocational Behavior, 16, 347–359. Schuler, R. S., Aldag, R. J., & Brief, A. P. (1977). Role conflict and ambiguity: A scale analysis. Organizational Behavior and Human Performance, 20, 111–128. Senatra, P. T. (1980). Role conflict, role ambiguity and organizational climate in a public accounting firm. The Accounting Review (October), 594–603. Slocum, J. W. & Cron, W. L. (1985). Job attitudes and performance during three career stages. Journal of Vocational Behavior (April), 126–145. Smart, R. M. & Peterson, C. C. (1994). Super’s stages and the four-factor structure of the adult career concerns inventory in an Australian sample. Measurement and Evaluation in Counseling and Development (January), 243–257. Sonnenfeld, J., & Kotter, J. P. (1982). The maturation of career theory. Human Relations, 35, 19–46. Super, D. E. (1957). The psychology of careers. New York: Harper and Brothers. Super, D. E., Zelkowitz, R. S., & Thompson, A. S. (1981). Career development inventory: Adult form I. New York: Teachers’ College, Columbia University.
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Van Maanen, J., & Katz, R. (1976). Individuals and their careers: Some temporal considerations for work satisfaction. Personnel Psychology, 29, 601–616. Van Maanen, J., & Schein, E. H. (1979). Toward a theory of organizational socialization. In: B. Staw (Ed.), Research in Organizational Behavior (Vol. 1, pp. 209–264). Greenwich, CT: JAI Press. Walker, O. C., Churchill, G. A., & Ford, N. M. (1975). Organizational determinations of the industrial salesman’s role conflict and ambiguity. Journal of Marketing (January), 32–39. Weeks, W. A., Moore, C. W., McKinney, J. A., & Longenecker, J. G. (1999). The effect of gender and career stage on ethical judgment. Journal of Business Ethics (July), 301–311. Whiston, S. C. (1990). Evaluation of the adult career concerns inventory. Journal of Counseling and Development, 69, 78–80.
APPENDIX A SURVEY OF TAX PROFESSIONALS’ CAREER CONCERNS These questions are designed to obtain your perceptions of your tax position and your reactions to it. This is not a test. There are no right or wrong answers. Please answer all questions frankly and honestly. Your confidentiality will be protected at all times. Under no circumstances will your individual responses be divulged to anyone or any organization. PLEASE ANSWER ALL ITEMS IN THE QUESTIONNAIRE. PART I . . . ABOUT YOUR ORGANIZATION Listed below are statements that represent possible FEELINGS tax professionals might have about the ORGANIZATION for which they work. For each statement, please CIRCLE the scale value which indicates your LEVEL of AGREEMENT or DISAGREEMENT. 1 2 3 4 5 6 7 Strongly Moderately Slightly Neither Agree Slightly Moderately Strongly Disagree Disagree Disagree Nor Disagree Agree Agree Agree I am willing to put in a great deal of effort beyond that normally expected in order to help this organization be successful. I talk about this organization to my friends as a great organization to work for. I feel very little loyalty to this organization.
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1 2 3 4 5 6 7 Strongly Moderately Slightly Neither Agree Slightly Moderately Strongly Disagree Disagree Disagree Nor Disagree Agree Agree Agree I would accept almost any type of job assignment in order to keep working for this organization. I find that my values and the organization’s values are very similar. I am proud to tell others that I am part of this organization. I could be just as happy working for a different organization as long as the type of work was similar. This organization really inspires the very best in me in the way of job performance. It would take very little change in my present circumstances to cause me to leave this organization. I am extremely glad that I chose this organization to work for over others I was considering at the time I joined. There’s not too much to be gained by sticking with this organization indefinitely. I often find it difficult to agree with this organization’s policies on important matters relating to its employees. I really care about the future of this organization. For me this is the best of all possible organizations to work for. Deciding to work for this organization was a definite mistake on my part.
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PART II . . . ABOUT YOUR SUPERVISOR Listed below are statements which might describe your SUPERVISOR (the person to whom you report). For each statement, please CIRCLE the scale value which indicates your LEVEL of AGREEMENT or DISAGREEMENT. 1 2 3 4 5 6 7 Strongly Moderately Slightly Neither Agree Slightly Moderately Strongly Disagree Disagree Disagree Nor Disagree Agree Agree Agree My supervisor makes working on my tax job more pleasant. My supervisor decides what shall be done and how it shall be done. My supervisor is highly skilled in all aspects of the tasks his/her subordinates perform. My supervisor keeps to himself/herself. My supervisor asks that we follow standard rules and regulations. My supervisor gives little advance notice of changes. My supervisor is not willing to make changes. My supervisor maintains definite standards of performance. My supervisor doesn’t look out for the personal welfare of the tax group. No one knows taxes better than my supervisor. My supervisor leaves it to me to develop my own ways of doing my lob. My supervisor is friendly and approachable. My supervisor rarely puts our suggestions into operation. My supervisor schedules the work to be done. Because of my supervisor’s lack of competence, I usually do not take his/her advice on how I should do my job.
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1 2 3 4 5 6 7 Strongly Moderately Slightly Neither Agree Slightly Moderately Strongly Disagree Disagree Disagree Nor Disagree Agree Agree Agree My supervisor helps me overcome problems which hinder me in carrying out my tax job. My supervisor makes sure that his/her role is understood by members of our tax group. My supervisor does not let me know what is expected of me on the job. My supervisor treats us as his/her equals. My supervisor does little things to make it pleasant to be a member of the tax group. Relative to other supervisors I have known or worked for, I think my current supervisor possesses much less tax expertise.
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PART III . . . SATISFACTION WITH YOUR JOB Below you will find a number of statements which describe how you might feel about your job. Please CIRCLE the alternative that most accurately describes your feelings about your job. Which of the following shows how much of the time you feel satisfied with your job? 1. Never 2. Seldom 3. Occasionally 4. About half of the time 5. A good deal of the time 6. Most of the time 7. All of the time
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Choose the statement below that best tells how well you like your lob. 1. I hate it. 2. I dislike it. 3. I don’t like it. 4. I am indifferent to it. 5. I like it. 6. I am enthusiastic about it. 7. I love it. Which one of the following best tells how you feel about changing your job? 1. 1 would not exchange my job for any other. 2. I cannot think of any jobs for which I would exchange. 3. I am not eager to change my job, but I would do so if I could get a better job. 4. I would like to exchange my present job for another one. 5. I would like to change both my job and my occupation. 6. I would take almost any other job in which I could earn as much as I am earning now. 7. I would quit this job at once if I could. Which one of the following shows how you think you compare with other people? 1. No one dislikes his/her job more than I dislike mine. 2. I dislike my job much more than most people dislike theirs. 3. I dislike my job more than most people dislike theirs. 4. I like my job about as well as most people like theirs. 5. I like my job better than most people like theirs. 6. I like my job much better than most people like theirs. 7. No one likes his/her job better than I like mine. PART IV . . . ABOUT YOUR PERFORMANCE A tax professional’s PERFORMANCE is measured by many criteria – adequate planning, maintaining relationships with clients, etc. For each performance criterion listed below, CIRCLE the scale value which indicates your LEVEL OF SUCCESS relative to other tax professionals doing similar work. For any criterion which does not apply to your position, please circle the scale value for Not Applicable.
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1 Much Less Successful Than the Others
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4 About the Same as the Others
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7 Much More Successful Than the Others
8 Not Applicable
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Willingness and ability to accept responsibility. Ability to effectively utilize staff and plan work assignments. Ability to identify and develop practical workable solutions to problems. Ability to win confidence and respect of clients. Level of creativity exhibited in adapting to unique problems. Knowledge and experience reflected in adherence to known and accepted procedures and principles. Ability and desire to work effectively with people. Level of judgement exercised.
PART V . . . YOUR OPINIONS ABOUT YOUR JOB Listed below are statements which might describe FEELINGS you have about YOUR WORK. For each statement, please CIRCLE the scale value which indicates your LEVEL of AGREEMENT or DISAGREEMENT. Several questions relate to your work group, which is defined in this study as the smallest professional work unit in which you participate, e.g. a tax group or department.
I feel that I am my own boss in most matters relating to my job. Clear, planned goals and objectives exist for my job. I am allowed to make my own decisions without checking with anyone.
1 Strongly Disagree
2 Moderately Disagree
3 Slightly Disagree
4 Neither Agree Nor Disagree
5 Slightly Agree
6 Moderately Agree
7 Strongly Agree
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There is definitely a work group with which I identify on my job. I have to buck rules and/or policies in order to carry out assignments. How things are done on this job is pretty much up to me. I am allowed to do as I please on my job. I do not know if I utilize my time properly on my job. My workload seems to be at about the right level. I make up my own rules on this job. I am constantly being checked on for policy, rules, and/or procedural violations. I know what my job responsibilities are. I work with groups which operate quite differently. There is no specific policy/rules manual relating to my job. Whatever the situation on my job, there is a written procedure or policy to deal with it. I feel certain about how I will be evaluated for my next pay raise. There is a lack of policies and guidelines to help me on my job. I have to work under vague directions and/or orders.
1 Strongly Disagree
2 Moderately Disagree
3 Slightly Disagree
4 Neither Agree Nor Disagree
5 Slightly Agree
6 Moderately Agree
7 Strongly Agree
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On my job I frequently receive incompatible requests from two or more people. My job gives me a chance to do the things that I do best. Going through proper channels is constantly stressed in this organization. Explanations of what has to be done on this job are clear. I do not like the type of work I am doing. This organization keeps a written record of everyone’s performance. My work is my most rewarding experience. I do things on my job that are apt to be accepted by one person and not by others. Whenever I have a problem on my job, I am supposed to go to a specific person for a solution. My work group sticks together through thick and thin. I do not know if my performance is acceptable to my supervisors. I can depend upon members of my work group for help on the job. I feel as though I’m being watched to make sure I comply with company policies.
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1 Strongly Disagree
2 Moderately Disagree
3 Slightly Disagree
4 Neither Agree Nor Disagree
5 Slightly Agree
6 Moderately Agree
7 Strongly Agree
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My work gives me a feeling of pride in having done the job well. Members of my work group defend each other from criticism by outside departments. I receive assignments without adequate management support to execute them. I am required to do things on my job that should be done differently. I am required to do unnecessary tasks on my job. I receive assignments without the proper resources to complete them. I feel certain about how much authority I have on my Job. I really don’ t feel a sense of pride or accomplishment in the type of work that I do. Everyone in my work group has a specific job to do. Members of my work group get along well together. I work under incompatible company policies and guidelines. I do not know exactly what is expected of me on my job.
1 Strongly Disagree
2 Moderately Disagree
3 Slightly Disagree
4 Neither Agree Nor Disagree
5 Slightly Agree
6 Moderately Agree
7 Strongly Agree
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There is a complete written job description for my position. I have to do things on my job that are against my better judgement. I have to follow strict company operating procedures at all times. I frequently have much more to do than I can handle during the time available at work. My work is consistent with my personal values. I have challenging work. There is a great deal of incentive for me in my job to try and do better. In light of my training, education and preparation, my job is very appropriate for my abilities. My job allows me to be creative and use my own ideas if I wish. I have little control and final say about what I do on my job. My job gives me the opportunity to learn new skills and techniques. The major satisfaction in my life comes from my job. The most important things that happen to me involve my work. I’m really a perfectionist about my work.
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1 Strongly Disagree
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3 Slightly Disagree
4 Neither Agree Nor Disagree
5 Slightly Agree
6 Moderately Agree
7 Strongly Agree
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I live, eat, and breathe my job. I am very much involved personally in my work. Most things in life are more important than work.
1 Strongly Disagree
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PART VI . . . YOUR JOB AND YOUR HEALTH With respect to the effect your job has on your health, please indicate your AGREEMENT or DISAGREEMENT with each statement listed below by CIRCLING the appropriate response according to the following scale.
My job tends to directly affect my health. I work under a great deal of tension. I have felt nervous as a result of my job. If I had a different job, my health would probably improve. Job worries sometimes get me down physically. Problems associated with my job have kept me awake at night. I have felt nervous before beginning a new assignment. I often “take my job home with me” in the sense that I think about it when doing other things. I breathe a sigh of relief when I am able to travel out of town. I often wonder whether it’s all worth it. I have worried, after making a decision, whether I did the right thing.
1 Strongly Disagree
2 Disagree
3 Slightly Disagree
4 Slightly Agree
5 Agree
8 Strongly Agree
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PART VII . . . ABOUT YOUR COMMUNICATION AND COORDINATION ACTIVITIES Please describe the extent to which each of the following activities is part of your job by CIRCLING the appropriate response according to the following scale:
Represent my firm to outsiders. Review assignment plans and/or results with clients. Work outside my primary office at least 60 days per year. Review and evaluate assignments in process. Supervise the activities of others. Prepare reports for external agencies (e.g. IRS, SEC). Request assistance from individuals in other areas/departments of the firm. Prepare and give several progress reports per month. Write or dictate at least five letters per week. Act as a liaison with other areas/departments in the firm. Regularly read professional (business) newspapers, magazines, or journals. Regularly seek information or advice from members of organizations (e.g. IRS, AICPA, etc.) outside my firm. Regularly serve as a source of information or advice for members of organizations (e.g. IRS, AICPA, etc.) outside my firm. Frequently make or receive telephone calls as a normal course of doing my job. Regularly seek information or advice from individuals in other departments (e.g. auditors). Regularly serve as a source of information or advice for individuals in other departments (e.g. auditors, firm management).
1 Definitely Not Part of My Job
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5 A Significant Part of My Job
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PART VIII . . . ABOUT YOUR CAREER DEVELOPMENT This section consists of statements about your CAREER CONCERNS. How much THINKING or PLANNING have you done in these areas? For each statement below, please CIRCLE the scale value which indicates your LEVEL of THINKING or PLANNING. (1) (2) (3) (4) (5)
Have not yet had to think seriously about this. A growing concern; beginning to become important. A strong concern at the present time; actively engaged in this. Still some concern but declining in importance. No longer a concern; past that stage.
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Career Concerns Clarifying my ideas about the type of work I would really like to do. Deciding what I really want to do for a living. Finding what line of work I am really best suited for. Learning more about various kinds of opportunities that might be open to me. Learning what skills and training are required for certain jobs in which I think I might be interested. Choosing among the best career alternatives I now see. Choosing a job, among the several that interest me, that will provide the most challenge. Finding a line of work that really appeals to me. Making sure of my current occupational choice. Choosing a job that will really be satisfying for me. Getting started in my chosen field. Deciding how to qualify for the work I now want to do. Meeting people who can help me get started in my chosen field. Finding the opportunity to do the kind of work I really like. Making specific plans to achieve my current career goals. Settling down in a job that I can really stay with. Making a place for myself in my organization. Doing things that will help me stay in my chosen job. Achieving stability in my occupation. Making my place in my organization secure. Developing a reputation in my organization. Making a reputation in my line of work. Becoming a dependable producer. Becoming especially skillful in my work. Winning the support of my supervisor and employers. Planning how to get ahead in my established field of work. Getting ahead in the organization. Doing the things that make people want me. Finding ways of making my competence known. Advancing to a more responsible position. Maintaining the occupational position I have achieved. Holding my own against the competition of new people entering the field.
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Adapting to changes introduced since I became established in my job. Keeping in tune with the people I work with. Keeping ahead of the workers below me. Reading the new literature and publications in my field. Attending meetings and seminars on new methods. Visiting places where new developments can be seen. Taking part in non-work (leisure time) activities that will help me keep up-to-date in my work. Getting refresher training. Identifying new problems to work on. Finding out about new opportunities as my field changes. Deciding what new fields to open up or develop. Developing new skills to cope with new needs and opportunities. Developing special knowledge or new skills to help me improve on the job. Developing easier ways of doing my work. Concentrating on things I can do as I get older. Cutting down on my working hours. Avoiding excess occupational pressures. Developing more hobbies to replace work interests. Finding out what types of activities I would really like to engage in after retirement. Planning for retirement. Making sure I can have a good life when I retire. Talking to retired friends about the problems they faced and the adjustments they made when they retired. Setting aside enough assets for retirement. Finding an area of the country in which to retire. Having a good life in retirement. Having friends I can enjoy in retirement. Making good use of the increased free time that comes with retirement. Doing the things I’ve always wanted to do but never had the time for because of my work.
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PART IX . . . ABOUT YOUR DECISION MAKING The work group was defined earlier as the smallest professional work unit in which you participate, e.g. a tax group or department. This section asks about the nature of the decisions you make as a work group member. The questions deal with how often you encounter certain situations in your decision-making activities relative to the fulfillment of your job responsibilities. Please CIRCLE the appropriate scale value.
How often do you feel you need additional information for making job-related decisions? How often are you sure about what approaches would be best for dealing with job-related problems that arise on an assignment? How often are you certain about how to deal with changes in social, economic, political, or technical conditions outside your firm? When dealing with people outside your work group, but within your firm, how often do you feel you have enough information to know how they want the job done? How often are you certain about the best way to approach job-related problems that arise in other departments in your firm? How often is it difficult for you to determine if a job-related decision is a correct one? How often do changes in leadership within your firm or department affect your decision making on job-related issues? How often are you in doubt about how to obtain information necessary for making job-related decisions? How often do changes in social, economic, political, or technical conditions outside your firm affect your job-related decision making? How often can you tell whether you have met the expectations of those with whom you deal outside your work group, but inside your firm? How often are you uncertain about how to meet the expectations of those with whom you deal within your work group? How often are you able to predict accurately the outcomes of your job-related decisions? How often do technological advances or changes in the law affect your decision making on job-related issues?
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PART X . . . CLASSIFICATIONS Please answer the following questions about yourself. Remember that all responses will remain totally confidential and will be used only in aggregate statistical analyses. 1. Please indicate your highest level of education (check one): 1. Bachelor’s Degree Master’s Degree (e.g. M.S., M.B.A.) 2. 3. Doctoral Degree (e.g. Ph.D., D.B.A., J.D.) 4. other 2. What is your present position? (check one) 1. Partner Manager 2. 3. Senior 4. Staff other (please specify) 5. 3. What is your date of birth? 4. What is your sex? 1. Male
2. Female
5. How long have you worked in your present position?
years
6. How long have you worked for your firm?
years
7. How long have you worked in the tax area?
years
8. How long have you worked in public accounting?
years
THANK YOU for responding to these questions. Please feel free to make any comments below.
THE DETERMINANTS OF STAFF ACCOUNTANTS’ SATISFACTION WITH SERVICES AT KOREAN DISTRICT TAX OFFICES Tae sup Shim ABSTRACT Like the Internal Revenue Service (IRS), the Korean Internal Revenue Service (KIRS) has implemented many changes to improve customer satisfaction since 1999. However, the Customer Satisfaction Index for KIRS services was low when compared with that of private companies. Therefore, it is important that the KIRS identify which dimensions of its services have an impact on its customers’ satisfaction. In this regard, the objectives of this study are: (1) to categorize KIRS services into a smaller number of dimensions; and (2) to find which dimensions have a significant effect on customer satisfaction. Data were collected using questionnaires filled out by staff accountants in tax preparation firms in Korea, and 322 questionnaires were analyzed by structural equation modeling using LISREL. Analysis of data showed that the respondents evaluated KIRS services in terms of seven dimensions: Politeness, Service by Telephone/Fax, Accuracy/Quickness, Easiness of Requesting Services, Cleanness of Office, Accommodation, and Equitable Service. Therefore, the current approach of the KIRS, which has developed diagnostic tools without identifying the dimensions of its services, needs
Advances in Taxation Advances in Taxation, Volume 15, 145–171 Copyright © 2003 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(03)15006-5
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to be changed. Also, the three dimensions (Equitable Service, Politeness, and Accuracy/Quickness) had significantly positive impacts on customer satisfaction. This result implies that the KIRS may need to focus its efforts more on these three dimensions, rather than on all dimensions of its services. In addition, because of the similarities in the changes of the KIRS and those of the IRS, the findings of this study may be applied to improving some parts of the IRS.
INTRODUCTION Like the Internal Revenue Service (IRS), since 1999, the Korean Internal Revenue Service1 (KIRS) has implemented many changes to deliver better services to taxpayers. For example, the KIRS changed its organizational structure to a functional structure like a private company. The KIRS reduced the number of its offices to improve the efficiency of its operation.2 The KIRS also established two new divisions within each office for taxpayers. One division is the Division of Taxpayer Protection, which protects taxpayers’ rights and handles taxpayers’ complaints from their perspectives.3 The other division is the Taxpayer Service Center, which provides one-stop service for taxpayers. In addition to these organizational changes, the KIRS has implemented new procedures for improving customer satisfaction (e.g. electronic tax return filing and electronic tax payment system). The KIRS also continues to educate its employees to provide better services for its customers. The KIRS contends that the overall customer satisfaction for KIRS services has increased with these modernizing changes (KIRS, 2000). Even with the changes in the KIRS, however, the Consumer Satisfaction Index was somewhat low, 59 in 2000 (Korea Production Center, 2001),4 when compared with those of many for-profit firms. Many private companies have improved their customers’ satisfaction through the systematic steps suggested by marketing research. According to various marketing research (Dabholkar, Shepherd & Thorpe, 2000a; Lee, Lee & Yoo, 2000; Stafford, Stafford & Wells, 1998), those who want to improve consumer satisfaction must: (1) identify the dimensions of their services; (2) find which dimension has a significant effect on consumer satisfaction; and then (3) focus their efforts on this (these) dimension(s) of services. If the KIRS adopts these systematic procedures, the KIRS may better improve its customers’ satisfaction. In this regard, it would be useful for the KIRS to identify which dimension(s) of its services can improve customer satisfaction. That is, the research on the relationship between the dimensions of KIRS services and its customers’ satisfaction may help the KIRS to develop systematic methods to better serve its customers.
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However, little research has examined the relationship between the dimensions of KIRS services and its customers’ satisfaction. Previous studies concerning KIRS services were interested in the absolute value of customer satisfaction scores, rather than in developing the diagnostic tools to improve customer satisfaction. Therefore, the objectives of this research are: (1) to categorize KIRS services5 into a smaller number of dimensions; and (2) to find which dimensions have a significant effect on customer satisfaction. The results of this study would help the KIRS to focus its efforts on improving some specific dimensions of its services that have direct impacts on its customers’ satisfaction. The improvement of customer satisfaction also would increase taxpayers’ compliance, which then would increase the tax revenue collected by the KIRS.6 Data were collected using questionnaires filled out by staff accountants in tax preparation firms in Korea, and 322 questionnaires were analyzed by structural equation modeling7 using LISREL. Analysis of the data showed that, first, the respondents evaluated KIRS services in terms of seven dimensions: Politeness, Service by Telephone/Fax, Accuracy/Quickness, Easiness of Requesting Services, Cleanness of Office, Accommodation, and Equitable Service. Second, three dimensions (Equitable Service, Politeness, and Accuracy/Quickness) have significant positive impacts on customer satisfaction. The remainder of this article is organized as follows: The next section provides a theoretical background of the study and develops hypotheses. This is followed by the research method and the data analysis. Finally, the last section draws conclusions and makes suggestions for future research.
THEORETICAL BACKGROUND AND HYPOTHESES To identify which dimensions of KIRS services have a significant effect on customer satisfaction, a review of literature dealing with the evaluation of service quality, and about the relationship between the evaluation of service quality and customer satisfaction follows.
Evaluation of Service Quality Customers usually evaluate a firm’s service by its service quality. Unlike the quality of goods, which can be measured objectively, service quality is an abstract and elusive construct because of its intangibility, heterogeneity, and inseparability of production and consumption (Parasuraman, Zeithaml & Berry (PZB), 1985). In the absence of objective measures, an alternative approach used for assessing the
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quality of a firm’s service is to measure consumers’ perceptions of service quality (PZB, 1988). There are two important issues related to the consumers’ perception of service quality: The first issue concerns the measurement model that measures the perceived service quality. The second is the dimensionality of service quality.
Service Quality Measurement Models Since PZB (1985) proposed their measurement model to measure perceived service quality, there has been controversy on how service quality should be measured.8 Three alternative models to measure service quality have been suggested. Performance-Minus-Expectation Measurement Model PZB (1985) developed a service quality measurement model based on Oliver’s (1980) disconfirmation model, which views consumer satisfaction as a function of performance and expectation disconfirmation. PZB proposed that service quality is the difference between actually perceived service (performance) and expected service (expectation). Many researchers have used this concept. Despite its popularity, however, several analysts have argued that this measure has serious shortcomings that limit its usefulness (see Brown, Churchill & Peter, 1993; Cronin & Taylor, 1992; Teas, 1993). Performance-Only Measurement Model Cronin and Taylor (1992) stated that service quality can be conceptualized as similar to an attitude, and suggested using only perceived service (performanceonly) as a measure of service quality. Their empirical study also found that the performance-only measure reflected long-term service quality attitudes better than PZB’s measure in cross-sectional studies. Direct Comparison Measurement Model Brown et al. (1993) argued that PZB’s model could lead to several psychometric problems, and suggested direct comparison measures. In their research, they asked their subjects to make a direct comparison of their perceptions of service quality to their expectations of service quality. They found that the direct comparison measure does no damage to a substantive theory of PZB. This measure also enabled subjects to compare directly their perceptions and expectations and did not restrict them to some arbitrary, linear difference. In addition, their empirical study indicated that this measure outperformed PZB’s measure in terms of a number of important
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psychometric and statistical considerations (e.g. reliability, discriminant validity and variance restriction effects). Dabholkar et al. (2000a) found that the direct comparison measure and the performance-only measure are superior to PZB’s measure. They also recommended the direct comparison measure when diagnostic analysis is the objective. In practice, this measure eliminates the need to include separate expectation questions in the survey, thereby cutting questionnaire length in half, simplifying data collection procedure, and reducing respondent fatigue (Dabholkar et al., 2000b). Therefore, the present study used the direct comparison measure to measure KIRS service quality.
Dimensionality of Service Quality The second issue in the evaluation of service quality is its dimensionality. This study reviewed two related theoretical issues: (1) the number of items for measuring service quality (i.e. single-item vs. multiple-item measurement); and (2) the dimensionality of the measures when multiple items are used. Single-Item vs. Multiple-Item Measurement for Service Quality Because multiple-item measurement may validate measures and disentangle the distorting influences of measurement errors before testing theory (Bagozzi & Yi, 1991), it is more useful than single-item measurement. Therefore, this study used multiple items for assessing KIRS service quality. Through an empirical test, PZB (1988) developed a 22-item instrument, called SERVQUAL, for measuring customer perceptions of service quality in private service organizations. But Carman (1990) argued that SERVQUAL was not a universal measure that could be applied to any service. Babakus and Boller (1992) also maintained that a measurement system needs to be refined to consider the specific service under study. Because the KIRS is a non-for-profit organization and government agency, the characteristics of KIRS services may be similar to those of other non-for-profit organizations and local government offices. Therefore, the current study developed multiple items for measuring KIRS service quality based on prior research on other non-for-profit organizations and local government services (Oh, 1998; Scott & Shieff, 1993). Dimensionality of Service Quality When multiple items are used, there may be items that represent the same unobserved construct. Thus, multiple items could be grouped or categorized
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into a smaller number of dimensions. It is very useful to identify the dimensionality of services, for it can provide a valuable diagnostic tool by indicating which dimensions significantly influence consumer satisfaction (Stafford et al., 1998). Through an empirical test, PZB (1988) found five dimensions in the service quality of private service organizations. However, Babakus and Boller (1992) pointed out that the dimensionality of service quality might depend on the type of services under study. Because the KIRS is a monopoly, with involuntary taxpayers as customers, KIRS services can be expected to differ in nature from the general services that have been the focus of prior research. As such, the dimensionality of KIRS services may be different from that of other services. The first purpose of the present study is to find the dimensionality of KIRS services, and to compare it with those of other services, especially that of private services suggested by PZB (1988)9 and that of local government services proposed by Scott and Shieff (1993). This purpose is stated in the following hypothesis. Hypothesis 1. The dimensionality of KIRS services is the same as that of private services proposed by PZB (1988), and that of local government services suggested by Scott and Shieff (1993).
Service Quality and Customer Satisfaction Another issue in the research of service quality is the direction of causality between service quality and customer satisfaction. Many marketing researchers (Cronin &
Fig. 1. A Comprehensive Framework for the Antecedents and Consequences of Service Quality. Source: Dabholkar et al. (2000a); Journal of Retailing (2000), 76(2).
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Taylor, 1992; Dabholkar et al., 2000a; Lee et al., 2000) argued and empirically showed that perceived service quality is an antecedent of customer satisfaction. Including the relationship between these two concepts, Dabholkar et al. (2000a) suggested the comprehensive model in Fig. 1. The model shows the relationship among the dimensionality of service quality, overall service quality, customer satisfaction and behavioral intention. In the present study, the above comprehensive model was modified in two ways. First, Dabholkar et al. (2000a) found that overall service quality and customer satisfaction were distinctive concepts, but these two concepts were highly correlated. In addition, assessments of customer satisfaction are a useful final check on the quality delivery process (Stafford et al., 1998). Therefore, the current study measured only customer satisfaction. Second, the present research did not consider customers’ behavioral intention, which was included in the comprehensive model, because unlike the consumers of the private sectors, the customers of the KIRS generally have no right to choose other KIRS district offices. Thus, as shown in Fig. 2, the present study included only the dimensionality of service quality and customer satisfaction. The influence of each dimension in service quality on customer satisfaction may vary across the types of service industry. For example, Responsiveness of employee (the willingness of the employee to provide service) was found to be more important in the people-based industry than in the facility/equipment-based industry (Lee et al., 2000). In this sense, it is important to identify which dimensions of KIRS service quality have a significant effect on customer satisfaction. The second purpose of this study, therefore, is to find the specific service dimensions that have a significant impact on customer satisfaction. This purpose is stated in the following hypothesis. Hypothesis 2. All dimensions of KIRS service quality have significant influence on customer satisfaction.
RESEARCH METHOD Method and Subjects Because the focus of this study was on measuring customers’ perception of service quality and their satisfaction, a survey was used. The staff accountants of tax preparation firms in Korea were chosen as respondents. In Korea, many taxpayers usually use tax preparation firms to file their tax returns.10 The staff accountants of tax preparation firms usually go to KIRS district offices to do their businesses on
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behalf of taxpayers. Consequently, the staff accountants may evaluate the service quality and express their satisfaction for KIRS service better than other users do. In addition, the staff accountants usually go to every KIRS district office, for tax returns need to be submitted to a KIRS office that has jurisdiction over the residential area of the taxpayer. In this regard, this study was designed to measure the overall customer satisfaction for the KIRS district offices in general, not a specific KIRS office.11
Measures Items for Measuring KIRS Service Quality This study developed multiple items for assessing customers’ perceived service quality as suggested by PZB (1991). However, because PZB’s items were for private service organizations, the current research did not include some items that were not appropriate for KIRS services (e.g. Do you feel safe in your transactions with XYZ company?). Also, some items were added that had been used in other related research; i.e. Scott and Shieff (1993) for local government,12 Oh (1998) for non-for-profit organizations,13 and other non-academic studies for the KIRS14 (e.g. Rest areas for customers, Convenience of parking, Providing equitable service). At first, 33 tentative items were developed. Staff accountants of tax preparation firms (who did not participate in this study) reviewed the relevance and appropriateness of the items. After this procedure, certain items were deleted or revised. In the actual survey, 32 questions were used to measure KIRS service quality (see Appendix A). Customer Satisfaction Interestingly, several researchers have measured overall customer satisfaction using a single item. However, a single-item measure makes it impossible to ascertain the reliability of this construct (Dabholkar et al., 2000a). Hence, this research used two items to measure the customer satisfaction of KIRS services: one is for an absolute satisfaction index of KIRS services, and the other is for a relative satisfaction score compared with other civil services (see Appendix B). Questionnaire and Procedures A questionnaire was developed that included 32 items for measuring perceived service quality and two items for assessing overall customer satisfaction. The questionnaire also included an item for identifying the frequency of uses of KIRS district office services per month, and some items for assessing pertinent
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demographic information of the subjects. Seven-point scales were used to measure service quality and customer satisfaction. Tax preparation firms in Incheon and Pucheon15 in Korea were chosen at random. The research staff visited the firms and explained the purpose of the research. The questionnaires were given to staff accountants who agreed to participate in this study. Most of the completed questionnaires were collected directly by the research staff from the respondents at the firms. Others were mailed by the respondents to the researcher at a college address in pre-stamped envelopes. To diversify the respondents, the number of respondents at each firm did not exceed six.16 A total of 504 questionnaires were passed out in November 1999. Of these, 457 questionnaires were returned by December 1999. Forty-nine questionnaires, in which the subjects did not complete all items for measuring service quality and consumer satisfaction, were not included in the data analysis. Sixty questionnaires, filled out by those who did not use KIRS district office services more than three times per month, also were not included, for their uses of KIRS services was thought to be insufficient to express their perceptions for service quality and customer satisfaction adequately. Twenty-six questionnaires, which were not filled out by the subjects of this study (e.g. managers of tax preparation firms), were excluded from the data analysis. Therefore, the number of usable questionnaires was 322, giving a 63.89% usable rate. Most of the respondents were female (90.1%) with an average of 4.65 years of tax return preparation experience.17 The mean of their ages was 25.24 years.
DATA ANALYSIS Descriptive Statistics The means of customer satisfaction measured in this study were as follows (1-very dissatisfied, 7-very satisfied): the absolute satisfaction index of KIRS services was 3.36 (standard deviation: 1.10) and the relative index was 3.48 (standard deviation: 1.21).18 The means were not high, which meant KIRS services needed to be improved to provide more satisfactory services. The descriptive statistics of items for measuring KIRS service quality are depicted in Table 1. According to the descriptive statistics, items related to the cleanness of office or employee’s clothes had higher means, but items related to politeness of employees had lower means. The KIRS should focus its efforts on the dimensions that had lower service quality.
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Table 1. Descriptive Statistics of KIRS Service Quality Items.a Service Items
Dimensionb
Item Mean
S.D.
Mean
S.D.
1. Courtesy of KIRS employees 2.97 1.38 2.94 1.05 2. Providing detailed and polite explanations 2.99 1.29 3. Easy explanations for the requested services 3.14 1.26 4. Willingness to help you on the basis of your circumstances 2.68 1.28 5. Willingness of KIRS employees to understand customer’s needs 2.93 1.25 ................................................................................................. 6. Providing polite consultation by telephone 3.75 1.45 3.37 1.19 7. Easy accessibility by telephone 3.23 1.47 8. Doing your business by telephone/fax instead of walk-in 3.15 1.43 ................................................................................................. 9. Providing the exact service that you requested 3.35 1.35 3.35 0.99 10. KIRS employees requesting unnecessary documents or procedure 3.18 1.31 11. KIRS employees having good knowledge of their services 3.77 1.15 12. Providing services at the time they promise to do so 3.46 1.34 13. Frequency of performing the service correctly on your first visit 3.55 1.25 14. Quickness in providing requested services 3.40 1.24 15. Providing prompt action/explanation to correct errors 3.06 1.28 16. Notifying customers of delayed services 2.84 1.35 ................................................................................................. 17. Waiting time before receiving services 3.20 1.32 4.10 1.13 18. Understandability of forms used to request KIRS services 4.24 1.38 19. Amount of forms used to request KIRS services 3.99 1.22 20. Procedure for requesting KIRS services 4.07 1.38 ................................................................................................. 21. Cleanness of offices and physical facilities 4.84 1.25 4.70 1.08 22. Neatness of KIRS employees’ clothes 4.58 1.13 23. Having modern equipment (telephone/fax) 4.35 1.24 ................................................................................................. 24. Providing materials explaining KIRS services 4.03 1.30 3.72 1.08 25. Rest areas for customers 3.51 1.47 26. Facilities set up for customers’ convenience 3.96 1.45 27. Convenience of parking 3.21 1.50 28. Service of information desk (employees, signs) 3.77 1.40 29. Location of KIRS office 3.84 1.49 ................................................................................................. 30. Providing equitable service without consideration of your status 31. Providing equitable service without consideration of your age 32. Providing equitable service without consideration of your gender a b
1-much poorer than expected, 7-much better than expected. Dimensions in Table 1 were identified through the data analysis in Table 3.
3.40 3.32 3.46
1.47 1.48 1.49
3.39
1.39
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Dimensionality of KIRS Services The first purpose of this study was to find the dimensionality of KIRS services. To do this, the present study used the purification procedure for analyzing a multiple-item construct.19 This procedure performs exploratory factor analysis (EFA) to identify the dimensionality of a number of variables, and then it conducts confirmatory factor analysis (CFA) to verify the dimensionality specified in EFA. Using these procedures, the 32 items for measuring KIRS service quality in the questionnaire were grouped into a smaller number of dimensions. Exploratory Factor Analysis (EFA) To ascertain the dimensionality and factor structure for the 32 items used in this research, an EFA using the FACTOR routine in SPSS was performed. Because the data were not normally distributed, a principal component analysis was used as an extraction technique. An oblique rotation was used, for there was no fully detailed theory about the relations among the 32 items. After the EFA was conducted, seven dimensions were identified (see Table 2). The seven distinct dimensions and the factor loadings of the 32 items on each factor are depicted in Table 2. To distinguish the seven dimensions more clearly, this study deleted some items. First, one item whose dominant factor loading was smaller than 0.4 was deleted.20 Another item, which had factor loadings greater than 0.4 on two dimensions, also was deleted. These deletions resulted in seven dimensions with 30 items. The intercorrelations among the seven dimensions were less than 0.439, suggesting that the dimensions were probably distinct. Cronbach’s alpha coefficient for each dimension was computed to estimate the reliability of each scale. One item in Dimension 3 was deleted, for it decreased the reliability of that dimension. After deletion of this item, the 29-item instrument had a reliability of 0.9377. All coefficient alphas of each factor exceeded the recommended criterion, 0.70 (see Table 3). Therefore, this research used the remaining 29 items in the following analysis. Confirmatory Factor Analysis (CFA) CFA was used to verify the seven-dimension structure identified in the EFA. As recommended by Anderson and Gerbing (1988), a CFA using LISREL 8 was performed to find out the goodness-of-fit of the EFA model. The current study used a correlation matrix as its input data. Also, a weighted least squares (WLS) estimation method was used, because the data were not normally distributed. The LISREL analysis produced the following goodness-of-fit indices:21 Goodness-of-fit index (GFI) = 0.987, Adjusted Goodness-of-fit index (AGFI) = 0.984, Normed fit index (NFI) = 0.984, and Root mean square residual (RMSR) = 0.0468. All indices met
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Table 2. Seven Dimensions and Oblique-Rotation Factor Loadings of 32 Items.a Service Items
Dimension 1
3
4
5
6
7
0.759 0.851 0.736 0.646 0.596 0.732 0.846 0.687 0.666 0.355 0.414 0.812 0.840 0.808 0.685 0.438 0.542 0.860 0.716 0.786
0.429 0.605
−0.736 −0.754 −0.508
TAE SUP SHIM
1. Courtesy of KIRS employees 2. Providing detailed and polite explanations 3. Easy explanations for the requested services 4. Willingness to help you on the basis of your circumstances 5. Willingness of KIRS employees to understand customer’s needs 6. Providing polite consultation by telephone 7. Easy accessibility by telephone 8. Doing your business by telephone/fax instead of walk-in 9. Providing the exact service that you requested 10. KIRS employees requesting unnecessary documents or procedureb 11. KIRS employees having good knowledge of their services 12. Providing services at the time they promise to do so 13. Frequency of performing the service correctly on your first visit 14. Quickness in providing requested services 15. Providing prompt action/explanation to correct errors 16. Notifying customers of delayed services 17. Waiting time before receiving servicesc 18. Understandability of forms used to request KIRS services 19. Amount of forms used to request KIRS services 20. Procedure for requesting KIRS services 21. Cleanness of offices and physical facilities 22. Neatness of KIRS employees’ clothes 23. Having modern equipment (telephone/fax)d 24. Providing materials explaining KIRS services
2
Service Items
Dimension 1
25. Rest areas for customers 26. Facilities set up for customers’ convenience 27. Convenience of parking 28. Service of information desk (employees, signs) 29. Location of KIRS office 30. Providing equitable service without consideration of your status 31. Providing equitable service without consideration of your age 32. Providing equitable service without consideration of your gender Eigenvalue % of variance explained Cumulative% of variance explained
2
3
4
5
6
7
0.703 0.758 0.796 0.523 0.607 −0.859 −0.878 −0.864 11.75 36.73 36.73
2.89 9.02 45.75
1.85 5.79 51.54
1.58 4.95 56.49
1.36 4.24 60.73
1.11 3.48 64.21
1.02 3.19 67.40
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Table 2. (Continued )
a Only
the greatest factor loadings (in absolute value) of each item are depicted (except item 23). item which its dominant loading is smaller than 0.4. c An item which decreased Cronbach’s alpha. d An item which had factor loadings greater than 0.4 on two dimensions. b An
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an acceptable level (GFI, AGFI, NFI ≥ 0.9, RMSR ≤ 0.05). The seven-dimension model of this study had an acceptable level of fit. Reliability, Convergent Validity and Discriminant Validity Using the results of the CFA, the 29-measure/7-dimension model of this study was evaluated on three criteria: reliability, convergent validity and discriminant validity. The reliability indices of all dimensions (as shown in Table 3) exceeded the recommended level (Cronbach’s alpha ≥ 0.70, construct reliability ≥ 0.7 and variance extracted22 ≥ 0.50). As such, each dimension had acceptable reliability. If path coefficients from a dimension to its corresponding items are significant at p < 0.01 (i.e. t > 2.58), then the convergent validity is obtained (Challaglla & Shervani, 1996; Sujan, Weitz & Kumar, 1994). The t-values of all items used in this study satisfied the generally acceptable cut-off level of 2.58, so the items in this study had adequate convergent validity. Discriminant validity among dimensions is achieved when the dimension’s correlations differ significantly from 1.00 (Bagozzi & Yi, 1991). Because the confidence interval of each dimension in the present study did not reach 1.00, discriminant validity of the data was attained for all dimensions. These analyses suggested that the measures of this study had acceptable levels of reliability, convergent validity and discriminant validity. Dimensionality of KIRS Services: Labeling KIRS Services Items with higher factor loadings are considered more important and have greater influence on selecting a name or label to represent a dimension (Hair, Anderson, Tatham & Black, 1998, p. 114). Based on the items having higher loadings, the seven dimensions are Politeness, Service by Telephone/Fax, Accuracy/Quickness, Easiness of Requesting Services, Cleanness of Office, Accommodation, and Equitable Service. Table 3 contains the names of the seven dimensions. This dimensionality of KIRS services was compared with those of private services and local government services. First, in comparison with the dimensionality of private services suggested by PZB (1988),23 the seven dimensions of the current study included all five dimensions of the PZB’s study. However, the classification of all measures was not congruent.24 In addition, three dimensions of the current study (Service by Telephone/Fax, Easiness of Requesting Services, and Equitable Service) were not found in the PZB’s study. Second, compared with the dimensionality of local government services studied by Scott and Shieff (1993), the dimensions of KIRS services were found to be somewhat different from those of local government services. Only the two dimensions of Scott and Shieff’s study were found to be similar to some dimensions of this study. That is, some items in the first and second dimensions of their study could be included
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Table 3. Label of KIRS Services.a Dimensionb
Service Items
Cronbach’s Alpha
Construct Reliability
Variance Extracted
No.
Label
D4
Politeness
Providing detailed and polite explanations Courtesy of KIRS employees Easy explanations for the requested services Willingness to help you on your circumstances Willingness to understand customer’s needs
0.8707
0.8899
0.6189
D7
Service by Telephone/Fax
Easy accessibility by telephone Providing polite consultation by telephone Doing your business by telephone/fax
0.7627
0.7838
0.5480
D1
Accuracy/ Quickness
Frequency of performing service correctly on first visit Providing service at the time they promise to do so Quickness in providing requested services Providing prompt action/explanation to correct errors Providing the exact service that you requested Notifying customers of delayed services KIRS employees having good knowledge of services
0.8899
0.8943
0.5486
D3
Easiness of Requesting Services
Understandability of forms to request KIRS services Procedure for requesting KIRS services Amount of forms to request KIRS services
0.8174
0.8391
0.6362
D6
Cleanness of Office
Neatness of KIRS employees’ clothes Cleanness of offices and physical facilities
0.7984
0.8317
0.7120
D2
Accommodation
Convenience of parking Facilities set up for customers’ convenience Rest areas for customers Location of KIRS office Providing materials explaining KIRS services Service of information desk
0.8481
0.8715
0.5332
D5
Equitable Service
Equitable service without consideration of your age Equitable service without consideration of gender Equitable service without consideration of status
0.9300
0.9450
0.8514
a b
The items in the same dimension were re-ordered by the higher factor loading. D4 means Dimension 4 in Table 2.
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in the Politeness, Accuracy/Quickness, Accommodation and Equitable Service25 dimensions of the present research.26 However, the other dimensions of this study were not found in their study. Thus, the first result of this study indicated that the dimensionality of KIRS services was found to be somewhat different from that of private services suggested by PZB (1988) and that of local government services studied by Scott and Shieff (1993). Hence, Hypothesis 1, which hypothesized all dimensions were the same as those of other services, was partially supported.
Relationships Between Service Quality and Customer Satisfaction The second purpose of this research was to find which dimensions of service quality had an influence on customer satisfaction. To achieve this purpose, the individual relationship between the service quality in each dimension of KIRS services and customer satisfaction was examined by using the research model shown in Fig. 2. The research model included 29 items and seven dimensions for KIRS services, and two customer satisfaction items used in the questionnaire. Overall Fit of the Research Model Before examining the results of this study, the overall fit of the research model used in this study was assessed to ensure that the model is an adequate representation of the entire set of causal relationships. The LISREL analysis, using a correlation matrix and the WLS method, produced the following goodness-of-fit indices: GFI = 0.988, AGFI = 0.986, NFI = 0.986, and RMSR = 0.0457. All indices met an acceptable level (GFI, AGFI, NFI ≥ 0.9, RMSR ≤ 0.05), which indicated that the research model had a reasonably good representation of the data. The combined effect of these seven dimensions explained 63.4% of the variance of customer satisfaction in this study. The Relationship Between Service Quality in Each Dimension and Customer Satisfaction To examine the relationships between the service quality in each dimension of KIRS services and customer satisfaction, this study conducted structural equation modeling analysis with LISREL 8. The structural equation modeling method is rapidly gaining in popularity as a way to investigate causal relations in nonexperimental data (McDonald, 1999, p. 367). This method has the ability to incorporate unobserved concepts (i.e. the seven dimensions in the current study) into the analysis (Hair et al., 1998, p. 585), and allows exogenous variables (i.e. the 29 measured items in this study) to be correlated.27 The LISREL analysis was performed using a correlation matrix and the WLS method.
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Fig. 2. The Relationships between Service Quality and Customer Satisfaction. Notes: Ellipses mean the dimensions of KIRS service, and the measured variables are represented by rectangles. Straight arrows among ellipses indicate causal relationships. Numbers on each straight arrow are the standardized coefficient (t-value) of each dimension (→ Significant at p < 0.01). Curved arrows denote correlations.
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To find which dimension of KIRS services has a significant effect on customer satisfaction, the structural coefficients between the KIRS service dimensions and customer satisfaction were analyzed (see Fig. 2). The Equitable Service, Politeness and Accuracy/Quickness dimensions of KIRS services were found to have significant influences on customer satisfaction at p < 0.01.28 In addition, the means of the service quality items related with these three dimensions were not high (see Table 1), which means the KIRS may need to focus its efforts more on these three dimensions, rather than on all dimensions of KIRS services. However, the other dimensions of KIRS services were found to be unimportant to customer satisfaction. The Cleanness and Accommodation dimensions are related with the physical attributes of KIRS offices. Lee et al. (2000) found that the physical attribute dimension was a more important factor in the facility/equipmentbased industry than in the people-based industry. As the KIRS is a people-based organization, these two dimensions might not be important in determining customer satisfaction. In addition, the means of the service quality items related with these two dimensions also were higher than those of other dimensions (see Table 1). Therefore, too much investment in improving its physical conditions (e.g. building new offices) needs to be reconsidered. The Service by Telephone/Fax dimension also was found to have no significant effect on customer satisfaction, for the respondents in this study usually do not use telephone or fax in using KIRS services. The second result of this study indicated that only some dimensions of KIRS services had significant effects on customer satisfaction. Therefore, Hypothesis 2, which hypothesized all dimensions of the KIRS services had impacts on customer satisfaction, was partially supported.
CONCLUSION The current study identified the dimensionality of KIRS services, and examined the relationship between KIRS service quality in each dimension and customer satisfaction. The data were obtained from 322 survey responses and were evaluated using structural equation modeling with LISREL. First, the results of this study showed that KIRS services were categorized into seven dimensions: Politeness, Service by Telephone/Fax, Accuracy/Quickness, Easiness of Requesting Services, Cleanness of Office, Accommodation, and Equitable Service. The dimensionality of KIRS services was found to be different from that of private services suggested by PZB (1988), and that of local government services suggested by Scott and Shieff (1993). By categorizing KIRS services into the seven dimensions, the first result of the current study may help
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the KIRS to develop diagnostic tools in each dimension of its services. This means that the current approach of the KIRS, which has developed diagnostic tools without identifying the dimensions of its services, needs to be changed. Second, the dimensions of Equitable Service, Politeness, and Accuracy/ Quickness had significant effects on customer satisfaction. In addition, the means of the service quality items related with these three dimensions were low, which means the respondent did not evaluate the service quality of these three dimensions highly. Therefore, the second result of this study implies that if the KIRS is to deliver more improved service to customers, it may need to focus its efforts on these three dimensions, rather than on all dimensions of its services. Using the results of this study, the KIRS may reevaluate many recent changes that have been implemented since 1999. For example, continuing education for KIRS employees in delivering good services to its customers may be desirable, because through continuing education it is possible to emphasize the importance of the Equitable Service, Politeness and Accuracy/Quickness dimensions. However, too much investment in building new offices needs to be reconsidered, for the Cleanness Dimension was highly evaluated by the respondents of this study and had no significant effect on customer satisfaction. In addition, the KIRS may be able to develop more diagnostic tools in each dimension of its services. The KIRS also may concentrate its resources on improving some specific dimensions which had significant effects on customer satisfaction (i.e. Equitable Service, Politeness and Accuracy/Quickness). Through these efforts, the KIRS may be able to serve its customers more efficiently. Although this study was based on the survey of KIRS services, the results may have implications for the IRS as well. Since 1999, the KIRS has followed the similar modernizing changes that the IRS has implemented since 1998. For example, the KIRS changed its organization structure to a functional structure like the IRS, and established a new division, the Division of Taxpayer Protection, which is similar to the Taxpayer Advocate Service of the IRS. The KIRS also has emphasized customer satisfaction as has the IRS. Because of the similarities in these recent changes of the KIRS and those of the IRS, the findings of this study may provide evidence to help improve some parts of the IRS. Also, the research method used in this study would be used to obtain data on the IRS. The analysis of the data would provide evidence to expand the conclusions reached by Harmelink and VanDenburgh (2002) and Hite (2002). The results of this study should be interpreted with caution for several reasons. First, the subjects of this study were staff accountants. Because there are many types of customers of KIRS services (e.g. taxpayers who prepare and submit their tax returns by themselves) and each customer has different needs, the generalization of this study should be viewed with caution. Second, customer
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satisfaction may be biased by the gender, age and status of the respondents. Most of the respondents in this study were female and were young (average 25.24 years old). Third, since the present study is an exploratory research for KIRS services, the items used in the current study are not perfect measures for KIRS services. Because the dimensions in the study are dependent on the specific items included in the survey, more elaborate items for measuring KIRS services need to be developed. In addition, the order of the questions could affect the respondents, but the present study does not control this effect. To overcome the limitations and to improve generalizability, replication studies using more delicate measures for KIRS services and a larger sample may be needed. Despite the above limitations, this study does provide a basis for evaluating KIRS services and for improving KIRS services to better serve the customers of the KIRS.
NOTES 1. Though the official name of the KIRS is National Tax Service, this research uses KIRS. 2. The KIRS reduced the number of its district offices from 134 to 99 in 1999. Now the KIRS has six regional offices, 99 district offices and 27 branch offices. There is at least one district tax office in each big city in Korea, and some big cities (like Seoul, Pusan and Incheon) have more than one district tax office. Like the IRS, the KIRS provides various services for taxpayers including tax consulting and tax complaints solving. 3. This is similar to the Taxpayer Advocate Service of the IRS. 4. This is the same as the IRS. In the case of the IRS, the Consumer Satisfaction Score of paper tax return filers was 48 (zero is the lowest and 100 is the highest possible score) in 2000 (American Customer Satisfaction Index, 2001). Hite (2002) found that most taxpayers were satisfied with the IRS audit process. But Harmelink and VanDenburgh (2002) show that the IRS is not providing adequate service. Also, they indicate that there is a systematic failure in the IRS taxpayer assistance. 5. In this study, KIRS services include all services that the KIRS can deliver to its customers. 6. The KIRS insisted that its tax revenue increased due to the increased customer satisfaction (KIRS, 2000). 7. Structural modeling method is also called path analysis with latent variables or LISREL. 8. Lee et al. (2000) reviewed prior research on the controversy concerning service quality measurement models. 9. Though many researchers have found the dimensionality of various service industry types, they are mainly based on PZB (1988). Therefore, the current research compared the dimensionality of KIRS services with that of PZB (1988). 10. In Korea, taxpayers can prepare or file their tax return by themselves or by using a tax preparer. Only a qualified Certified Public Tax Accountant (CTA), including a Certified Public Accountant or a lawyer registered as a CTA, can offer tax preparation services. In
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case of individual income tax of 1998, 39.6% of individuals (75.1% of individual income tax paid in 1998) submitted tax returns with supporting documents (e.g. financial statements, tax invoices or receipts) to the KIRS. Professional tax preparers prepared 71.6% of these tax returns (93.1% of tax amount) (KIRS, 1998). 11. In this research area, there are five KIRS district offices. 12. Scott and Shieff (1993) used 42 variables for measuring consumer satisfaction of New Zealand’s local government. 13. Oh (1998) prepared 32 variables, based on PZB (1991), for measuring consumer satisfaction of Korean civil services, including ward offices and drive license service department. 14. Korean Productivity Center, Korean Management Consulting, and Hyundai Research Institute developed many items for measuring KIRS services. 15. These cities are located west of Seoul, the capital of Korea. 16. The average number of staff accountants per tax preparation firm in this research was six. 17. In Korea, most of the staff accountants in tax preparation firms are female, and they usually go to the KIRS to do their business. 18. The correlation between two measures was 0.756. 19. Singh and Rhoads (1991) summarized the purification procedure to identify the dimensions of multiple-item construct. 20. In a sample of 322 respondents, a factor loading of 0.3 is required for significance (Hair et al., 1998, p. 112). However, this research used a stricter criterion, 0.4, to improve the quality of research. 21. This study did not use chi-square, because it is too sensitive to sample size differences, especially for cases in which the sample size exceeds 200 respondents. It also is sensitive to departures from normality (Hair et al., 1998, p. 655). 22. The meaning and computation of construct reliability and variance extracted can be found on pp. 636–637 in Hair et al. (1998). 23. PZB (1988) suggested five dimensions of service quality: Tangibles (physical facilities, equipment, and appearance of personnel), Reliability (ability to perform the promised service dependably and accurately), Responsiveness (willingness to help customers and provide prompt service), Assurance (knowledge and courtesy of employees and their ability to inspire trust and confidence), and Empathy (caring, individualized attention the firm provides its customers). 24. The table below compares the dimensions and items of the Parasuraman, Zeithaml and Berry’s study with those of the present study. Parasuraman, Zeithaml and Berry
Present study
Dimension
Item
Dimension – Item number
Tangibles
XYX company (XYZ) has modern-looking equipment XYZ’s physical facilities are visually appealing XYZ’s employees are neat-appealing Materials associated with the service are visually appealing at XYZ
Cleanness of office – 23 Cleanness of office – 21 Cleanness of office – 22 Accommodation – 24
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Parasuraman, Zeithaml and Berry
Present study
Dimension
Item
Dimension – Item number
Reliability
When XYZ promises to do something by a certain time, it does so When you have a problem, XYZ shows a sincere interest in solving it XYZ performs the service right the first time XYZ provides its services at the time it promises to do so XYZ insists on error-free records
Accuracy/Quickness – 12
Responsiveness
Assurance
Empathy
Employees tell you exactly when services will be performed Employees give you prompt service Employees are always willing to help you Employees are never too busy to respond to your requests
Politeness – 5 Accuracy/Quickness – 13 Accuracy/Quickness – 12 – Accuracy/Quickness – 12 Accuracy/Quickness – 14 Politeness – 4 –
The behavior of employees instills confidence in customers You feel safe in your transactions with XYZ Employees of XYZ are consistently courteous with you Employees have the knowledge to answer your questions
–
XYZ gives you individual attention XYZ has operating hours convenient to all its customers XYZ has employees who give you personal attention XYZ has your best interests at heart Employees understand your specific needs
– –
– Politeness – 1 Accuracy/Quickness – 11
– Politeness – 4 Politeness – 5
Notes: The dimensions and the item number of the present study are in Tables 1 and 3.
The Tangibles dimension of PZB was divided into the Cleanness and the Accommodation dimensions of the current study. The items in the Reliability and Responsiveness dimensions of PZB were mostly included in the Accuracy/Quickness dimension. Also, the items in the Assurance and Empathy dimensions of PZB were mainly classified into the Politeness dimension of the current research. 25. Oh (1998) also found the Equitable Service dimension in the service quality of non-profit-organization service.
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26. The items of the first and the second dimensions of Scott and Shieff’s study are as follows: Scott and Shieff
Present Study
Dimension
Item
Dimension – Item number
Interpersonal aspects of Council employee/public interactions
Employees help citizens as part of their job Employees are not too busy to answer questions Employees redirect questions competently Employees are familiar with the regulations Employees are polite and courteous Employees treats citizens with respect Employees interact well with citizens Employees are accountable to the public Council keeps promises Council treats all citizens fairly Council maintains strict confidentiality of information Senior employees interact with the public Employees explain policies in easy terms Council is concerned about its citizens Council constantly reviews policies and procedures
Politeness – 4
Interaction speed and accessibility of Council
Offices are conveniently situated Modern technology provides rapid information Provide simple explanations of policies Employees listen carefully to requests Council vehicles are modern Council executes promises timeously Council provides specific times for service performance
– Accuracy/Quickness – 9 Accuracy/Quickness – 11 Politeness – 1 Politeness – 1 Politeness – 3 – Accuracy/Quickness – 12 Equitable service – – Politeness – 3 Politeness – 4 Accuracy/Quickness – 11 Accommodation – 29 Accommodation – 23 Politeness – 3 Politeness – 5 Accommodation – 23 Accuracy/Quickness – 12 Accuracy/Quickness – 16
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Scott and Shieff (1993) suggested six dimensions of local government service: Interpersonal aspects of Council employee/public interactions, Interaction speed and accessibility of Council, Extended service provision (4 items including “Council provides cultural services”), Consultative development (2 items including “Council has a well-defined vision”), Planning orientation (2 items including “Council plans people/building relationships”), and Business development (2 items including “Council stimulates business investment”). Because of rarity of the study for local government service, more research is needed on the dimensionality of local government. 27. Most marketing research on consumer satisfaction used LISREL. 28. If the respondents who used KIRS services less than three times in a month were included in the data analysis, the results were changed. The Politeness dimension still had a significant effect on customer satisfaction (t-value: 3.952, p < 0.01). The Equitable Service dimension also had a significant impact, but its significant level dropped (t-value: 1.582, p < 0.10). The effects of the other dimensions were not significant.
ACKNOWLEDGMENTS The author gratefully acknowledges the helpful comments and suggestions of the editor and two anonymous reviewers. Also, the author appreciates the financial support of Incheon City College.
REFERENCES American Customer Satisfaction Index (ACSI). (2001). http://www.theacsi.org/government/govt-all01.html Anderson, J. C., & Gerbing, D. W. (1988). Structural equation modeling: A review and recommended two-step approach. Psychological Bulletin, 103(3), 411–423. Babakus, E., & Boller, G. W. (1992). An empirical assessment of the SERVQUAL scale. Journal of Business Research, 24, 253–268. Bagozzi, R., & Yi, Y. (1991). Multitrait-multimethod matrices in consumer research. Journal of Consumer Research, 17(4), 426–429. Brown, T. J., Churchill, G. A., Jr., & Peter, J. P. (1993). Improving the measurement of service quality. Journal of Retailing, 69(1), 127–139. Carman, J. M. (1990). Consumer perceptions of service quality: An assessment of the SEVQUAL dimensions. Journal of Retailing, 66(1), 33–55. Challaglla, G. N., & Shervani, T. A. (1996). Dimensions and types of supervisory control: Effects on salesperson performance and satisfaction. Journal of Marketing, 60(1), 89–105. Cronin, J. J., Jr., & Taylor, A. (1992). Measuring service quality: A reexamination and extension. Journal of Marketing, 56(3), 55–68. Dabholkar, P. A., Shepherd, C. D., & Thorpe, D. I. (2000a). A comprehensive framework for service quality: An investigation of critical conceptual and measurement issues through a longitudinal study. Journal of Retailing, 76(2), 139–173.
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Dabholkar, P. A., Shepherd, C. D., & Thorpe, D. I. (2000b). Executive summaries. Journal of Retailing, 76(2), 131–132. Hair, J. F., Jr., Anderson, R. E., Tatham, R. L., & Black, W. C. (1998). Multivariate data analysis (5th ed.). Englewood Cliffs, NJ: Prentice-Hall. Harmelink, P. J., & VanDenburgh, W. M. (2002). The failure of the IRS to provide top quality service. Advances in Taxation, 14, 137–158. Hite, P. A. (2002). The preparer effect on IRS customer satisfaction. Advances in Taxation, 14, 159–183. Korea Production Center (2001). http://www.ncsi.or.kr/ncsi/paper/2001 02 ncsi.html Korean Internal Revenue Service (KIRS) (1998). Statistical yearbook of national tax. Seoul, Korea: KIRS. Korean Internal Revenue Service (KIRS) (2000). http://www.nts.go.kr/File/ Lee, H., Lee, Y., & Yoo, D. (2000). The determinants of perceived quality and its relationship with satisfaction. The Journal of Service Marketing, 14(3), 217–231. McDonald, R. P. (1999). Test theory: A unified treatment. Mahwah, NJ: Lawrence Erlbaum. Oh, C. T. (1998). Management priority of service quality dimensions: Focused on the civil administration service. Journal of Korean Association for Public Administration, 32(2), 77–95. Oliver, R. L. (1980). A cognitive model of the antecedents and consequences of satisfaction decisions. Journal of Marketing Research, 17(4), 460–469. Parasuraman, A., Zeithaml, V. A., & Berry, L. L. ( P Z B ) (1985). A conceptual model of service quality and its implications for future research. Journal of Marketing, 49(4), 41–50. Parasuraman, A., Zeithaml, V. A., & Berry, L. L. ( P Z B ) (1988). SERVQUAL: A multiple-item scale for measuring consumer perceptions of service quality. Journal of Retailing, 64(1), 12–40. Parasuraman, A., Zeithaml, V. A., & Berry, L. L. ( P Z B ) (1991). Refinement and reassessment of the SERVQUAL scale. Journal of Retailing, 67(4), 420–450. Scott, D., & Shieff, D. (1993). Service quality components and group criteria in local government. International Journal of Service Industry Management, 4(4), 42–45. Singh, J., & Rhoads, G. K. (1991). Boundary role ambiguity in marketing-oriented positions: A multidimensional, multifaceted operationalization. Journal of Marketing Research, 28(3), 328–338. Stafford, M. R., Stafford, T. F., & Wells, B. P. (1998). Determinants of service quality and satisfaction in the auto casualty claims process. The Journal of Service Marketing, 12(6), 426–440. Sujan, H., Weitz, B. A., & Kumar, N. (1994). Learning orientation, working smart, and effective selling. Journal of Marketing, 58(3), 39–52. Teas, R. T. (1993). Expectations, performance evaluation, and consumers’ perceptions of quality. Journal of Marketing, 57(4), 18–34.
APPENDIX A Items for Measuring KIRS Service Quality The following items describe the services you might receive when you do business with the Korean Internal Revenue Service (KIRS). When you carried out your business at a KIRS office, how close did the service of the KIRS come to your expectations? If the service was much poorer than expected, please circle 1, or if the service was much better than your expectations, circle 7.
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Service Item
Service Quality Poorer
1. Courtesy of KIRS employees 2. Providing detailed and polite explanations 3. Easy explanations for the requested services 4. Willingness to help you on the basis of your circumstances 5. Willingness of KIRS employees to understand customer’s needs 6. Providing polite consultation by telephone 7. Easy accessibility by telephone 8. Doing your business by telephone/fax instead of walk-in 9. Providing the exact service that you requested 10. KIRS employees requesting unnecessary documents or procedure 11. KIRS employees having good knowledge of their services 12. Providing services at the time they promise to do so 13. Frequency of performing the service correctly on your first visit 14. Quickness in providing requested services 15. Providing prompt action/explanation to correct errors 16. Notifying customers of delayed services 17. Waiting time before receiving services 18. Understandability of forms used to request KIRS services 19. Amount of forms used to request KIRS services 20. Procedure for requesting KIRS services 21. Cleanness of offices and physical facilities 22. Neatness of KIRS employees’ clothes 23. Having modern equipment (telephone/fax) 24. Providing materials explaining KIRS services 25. Rest areas for customers 26. Facilities set up for customers’ convenience (vending machine, public phone) 27. Convenience of parking
Better
1 1 1 1
2 2 2 2
3 3 3 3
4 4 4 4
5 5 5 5
6 6 6 6
7 7 7 7
1
2
3
4
5
6
7
1 1 1
2 2 2
3 3 3
4 4 4
5 5 5
6 6 6
7 7 7
1 1
2 2
3 3
4 4
5 5
6 6
7 7
1
2
3
4
5
6
7
1
2
3
4
5
6
7
1
2
3
4
5
6
7
1 1
2 2
3 3
4 4
5 5
6 6
7 7
1 1 1
2 2 2
3 3 3
4 4 4
5 5 5
6 6 6
7 7 7
1
2
3
4
5
6
7
1 1 1 1 1 1 1
2 2 2 2 2 2 2
3 3 3 3 3 3 3
4 4 4 4 4 4 4
5 5 5 5 5 5 5
6 6 6 6 6 6 6
7 7 7 7 7 7 7
1
2
3
4
5
6
7
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Service Item
Service Quality Poorer
28. Service of information desk (employees, signs) 29. Location of KIRS office 30. Providing equitable service without consideration of your status 31. Providing equitable service without consideration of your age 32. Providing equitable service without consideration of your gender
Better
1
2
3
4
5
6
7
1 1
2 2
3 3
4 4
5 5
6 6
7 7
1
2
3
4
5
6
7
1
2
3
4
5
6
7
APPENDIX B Items for Assessing Customer Satisfaction
Very Dissatisfied 1. How satisfied are you with overall KIRS service? 2. How satisfied are you with overall KIRS service compared with other civil services?
Very Satisfied
1
2
3
4
5
6
7
1
2
3
4
5
6
7
Note: This questionnaire is translated into English for publishing. The original questionnaire is written in Korean.
TAX POLICY EFFECTIVENESS AS MEASURED BY RESPONSES TO LIMITS PLACED ON THE DEDUCTION OF EXECUTIVE COMPENSATION Toni Smith ABSTRACT Internal Revenue Code §162(m), which applies to public corporations, was designed to reduce executive compensation and strengthen its relation to performance. This article examines the effectiveness of the code section. While the results reflect a continual increase in the compensation of a group of key executives for the years reviewed, evidence is found in support of the performance-based objectives of §162(m). Findings indicate a shift away from salary and toward bonus payments over the time period examined. Further, the link between compensation and performance appears to have strengthened slightly after the enactment of §162(m).
INTRODUCTION One public outcry that caught the attention of legislators in the early 1990s concerned the compensation of corporate executives. The compensation issue, which continues to generate legislative attention,1 was a two-fold problem incorporating the beliefs that U.S. executives were greatly over compensated Advances in Taxation Advances in Taxation, Volume 15, 173–195 Copyright © 2003 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(03)15007-7
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and that this excessive compensation was not related in any way to performance (Levin, 1991). Because their voting rights with respect to compensation were limited, shareholders were not empowered to correct this problem directly.2 As an alternative to a more direct intervention, congressional representatives were pressed into action on the shareholders’ behalf. These shareholder concerns regarding the compensation issue were addressed legislatively by the Revenue Reconciliation Act of 1993 (RRA 93), which, in turn, created Internal Revenue Code §162(m). This subsection established a new tax rule: the annual deduction allowed for the compensation of the CEO and the four next-highest paid executives of publicly-held U.S. corporations would be limited to $1 million per person. Legislators also made clear their reason for this change: to reduce the excessive compensation being paid to top executives by limiting the corresponding income tax deduction (Research Institute of America, 1993). On the surface, RRA 93 was a clear and direct response to shareholder concerns. Along with establishing this rule, however, RRA 93 also carved out an important exception. The “performance-based” exception to §162(m) enabled firms to compensate executives in amounts that were both unrestricted and considered to be in compliance with the law provided the payments were a function of some measurable and predetermined achievement. Because conforming to the performance-based exceptions to §162(m) preserves tax deductions, it can be inferred that aligning compensation with performance was also a legislative goal even though it was not so stated. In response to the rule of §162(m) and its exceptions, affected firms (those compensating executives at amounts exceeding $1 million annually) had three basic options. First, they could disregard the limitation, continue with their current compensation program and forgo the deduction of any remuneration above the $1 million cap. Alternatively, assuming firms were paying (market comparable) wages that exceeded $1 million annually, employers could reduce compensation so that it no longer exceeded the cap. The final, and perhaps most attractive option, was for firms to restructure their compensation contracts in such a way that the wage payments became performance-based and, therefore, deductible. The current research addresses the question of whether §162(m) met its objectives by examining firm responses to this legislation. In particular, the examination focuses on the restructuring of compensation plans. Specifically, this study examines the executive compensation reported by a sample of publicly-held U.S. corporations for the years 1992–1996. This analysis extends the work of previous researchers in two primary ways. First, rather than being limited to salary and bonus payments, the entire compensation package is examined. Second, the analyses extend beyond the CEO to include the compensation packages of other named executive officers (NEOs) affected by this legislation. Previous work
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has focused exclusively on payment of salary and bonus paid to the CEO alone (Balsam & Ryan, 1996; Harris & Livingstone, 1998; Rose & Wolfram, 2000). This study finds evidence in support of the performance-based objectives of RRA 93. As a percentage of total compensation, the results indicate a shift away from salary and toward bonus payments over the time period examined. Furthermore, the most pronounced effects are those associated with the CEO and the highest paid NEO. In addition to the shift toward performance-based payments, the results also indicate that compensation is more closely tied to performance, especially as measured by firm net income, after RRA 93 than it was in the preceding years. Contrary to one of the legislative goals, the results reflect a continual increase in both cash and stock option-based compensation for the years reviewed. The timing of the increases, moreover, does not reflect a clear demarcation coordinated with the imposition of RRA 93. The topic of compensation, even after the reform investigated by this study, however, remains a controversial issue. For instance, in February of 1999 and again in July of 2001, a bill was introduced (and reintroduced) to further limit compensation deductions (U.S. House of Representatives, 1999, 2001). Accordingly, the results drawn from this investigation have important implications for tax policy makers. Specifically, the degree of legislative effectiveness uncovered in this research is an important source of feedback for those involved in the regulatory process. As legislative discussions continue on the subject of excessive executive compensation, knowledge of the impact of RRA 93 will be instrumental in the formation of future regulations. This article is organized into five sections as follows. The next section provides a discussion of the hypotheses and related literature. This is followed by a description of the research methodology including measurement concepts, sample selection and statistical methods. The fourth section provides a discussion of the results. The final section concludes and contains a discussion of the study’s limitations and implications for future research.
HYPOTHESES DEVELOPMENT The limitations placed on the deduction of executive compensation by RRA 93 represented yet another in a very long line of restrictions (i.e. life insurance, club dues, sky boxes) related to the remuneration of those employees deemed to be highly compensated. Taken as a whole, these tax restrictions constitute a trend toward limiting deductions for certain business expenditures. According to Frost (1988, p. 58), “The point is, tax deductions are not supposed to help business people live high on the hog.”
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Previous work related to the effects of §162(m) focused on the CEO and was limited to the examination of salary or salary and bonus. Based on a reading of the text of proxy statements, Balsam and Ryan (1996) found that in response to this legislation, firms modified CEO compensation plans in ways that would preserve tax deductions while minimizing other consequences such as shareholder criticism or the loss of tax preferences. Harris and Livingstone (1998) found firms paying less than $1 million in salary and bonus annually to their CEOs prior to the enactment of §162(m) actually increased these payments so that compensation approached the deduction limitation after the passage of RRA 93. Rose and Wolfram (2000) document a reduction in salary growth for those firms paying CEOs salaries in excess of $1 million. The current study extends this line of research by including the entire compensation package of a group of key executives in the analyses. Further, this research examines shifts in the types of compensation paid to these key executives. Figures 1 and 2 contain information regarding the total cash compensation and stock options granted for all executives of the sample firms. As shown in the figures, both total cash (the sum of salary, bonus, restricted stock awards, long-term incentive payouts and all other) compensation (Fig. 1) and number of stock options granted (Fig. 2) increased annually for all executives. This result, for the CEO in particular, reflects a well-established trend (Hanson, 1999; Harris & Livingstone, 1998; Reingold & Grover, 1999). The growth in stock option plans also has been documented (Gunsauley, 2002; Morgenson, 1998) previously.
Fig. 1. Average Total Cash Compensation. Notes: Monetary amounts have been adjusted to remove the effects of inflation. Effective year 1 is this first year in which §162(m) became effective.
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Fig. 2. Average Number of Options Granted. Note: Effective year 1 is this first year in which §162(m) became effective.
An implied goal of RRA 93 was to align executive compensation to corporate performance. This could be viewed as an alternative goal to that of reducing remuneration. Policy effectiveness, therefore, would be evidenced by a shift away from traditional salaries toward performance-based, bonus-type remuneration.3 In the current study, the assessment of the performance-based objectives of RRA 93, incentive compensation is defined as the bonus paid to the executives under investigation. This selection was made for two reasons. First, bonus payments typically are considered a reflection of performance (Chen & Lee, 1995; Lambert & Larcker, 1987; Murphy, 1985). Second, other than salary, bonus is the largest component of compensation. It is also the most-frequently granted form of incentive compensation. In general, 82–94% of the sample firms paid bonuses during the five-year period currently under investigation. To isolate the variation in each compensation component, separate examinations of salary and bonus as a percentage of total compensation are necessary. For firms, a switch toward performance-based compensation would have the presumably desirable effect of creating conformity with §162(m) (preservation of the deduction of the entire expenditure) while maintaining (or, potentially increasing) the level of total compensation. The first and second hypotheses examine the compensation mix issue. H1. As a percentage of total executive compensation, the relative weight of salary compensation decreased after the enactment of RRA 93. H2. As a percentage of total executive compensation, the relative weight of bonus compensation increased after the enactment of RRA 93.
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A switch to bonus-type compensation alone, however, does not necessarily indicate that the remuneration is more closely linked to performance. A bonus could, for instance, simply be a retention award; that is, one dependent strictly upon longevity (Lublin, 1998) rather than performance. Policy effectiveness related to the alignment of pay and performance dictates not only an increased reliance on bonus-type remuneration, but also a relationship between performance and compensation. Specifically, a stronger relationship between performance and compensation after enactment or RRA93 would be consistent with policy effectiveness. The third hypothesis is: H3. The link between executive compensation and performance is stronger after RRA 93 than it was in previous years.
RESEARCH METHOD Measurement of Compensation and Performance Executive compensation is made up of a variety of components, including salary, bonus, options, long term incentive payouts, stock appreciation rights, restricted stock awards and other payments. Some earlier work in this area has focused exclusively on the payments of salary and bonus (Harris & Livingstone, 1998; Healy et al., 1987; Lambert & Larcker, 1987). To incorporate the entire remuneration package, hypothesis tests in the current research define compensation as total payments (the sum of salary, bonus, restricted stock awards, long-term incentive payouts and all other compensation). The number of options granted in each year is considered separately. The valuation of options is a complex and unresolved issue. Neither regulatory agencies nor news publications consistently rely on a common option valuation method related to the reporting of total compensation. Griner and Stone (1995) considered the issue of option valuation complexity and found differences of more than $10 million in annual CEO compensation attributable to the valuation technique itself. The SEC recommends the use of the Black-Scholes options pricing model or an assumed stock growth rate in the valuation of option grants (Griner & Stone, 1995). The IRS, conversely, generally considers only the income realized upon the exercise of options in determining taxable compensation (§421). An alternative to each of these methods is to include the change in the value of shares underlying options in the determination of annual compensation. Because the current study focuses on changes in compensation components over time, an examination of the number of options granted achieves this and avoids the
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potential complexities related to valuation issues. This measure also is logical because options are de facto performance based under RRA 93 and, therefore, exempt from the limitations of §162(m). Because the value of options does not enter into the $1 million limitation, an examination of the number of shares granted will provide evidence of policy effectiveness. A second compensation measurement issue relates to the years in which each firm experienced CEO turnover. For the sample used in this research, CEO turnover was common; 36% of the firms changed CEOs at least once during the years 1992–1997. Deduction limitations apply to covered employees. Section 162(m)(3), as it relates to the CEO, defines a covered employee as someone who, as of the close of the taxable year, is the chief executive officer of the taxpayer or is an individual acting in such a capacity. Previous research, however, has used the combined compensation of all chief executives in years when there was more than one CEO in office (Healy et al., 1987; Jensen & Murphy, 1990). This combined approach is logical for two reasons. First, utilizing partial year amounts could generate misleading conclusions. Archer Daniels Midland (ADM), for instance, changed CEOs with 10 weeks remaining in its fiscal year ending in 1997. In all other years, ADM paid salaries to the CEO of $2.8–3.6 million. The CEO who took office near the end of the year, however, was paid a salary of only $803,282. Relying exclusively on the compensation paid to the CEO in office on the last day of the year does not appear to accurately reflect the firm’s costs related to having a chief executive officer, nor does it address the spirit of shareholder concerns giving rise to RRA 93. Second, an alternative to combining compensation would be to omit these “change firms” from the sample. Omission, however, would remove a substantial portion of the sample and presumably impair the analyses. The sample used in this study would decrease from 340 to 217 firms.4 Accordingly, like that of previous research, the approach taken in this study is to examine the total cost related to staffing the office of the chief executive, rather than the compensation related to any particular individual. This combination issue does not apply to the measurement of other executives’ compensation. An ordinal ranking based on applicable remuneration dictates which non-CEO officers will be associated with deduction limitations. Section 162(m)(3), as it relates to the other named executive officers (NEOs), defines covered employees as follows: the total compensation of such employee for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the four highest compensated officers for the taxable year (other than the chief executive officer). In total, then, five officers of each corporation are subject to the terms of §162(m).
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Also, unlike the levels of compensation realized by the CEO, NEOs in office for only a partial year generally are not paid amounts large enough to warrant reporting to the shareholders. While there are NEOs in office for only portions of years, their compensation generally falls below the reporting requirements simply because other officers receive greater remuneration. For the purposes of the current research, classification as an NEO is dependent only upon the total annual cash compensation of officers who are not CEOs. This strict monetary definition of NEOs removes the issues related to part-year combinations that were addressed in measuring CEO compensation. In this study, CEO compensation is measured differently from the compensation of the NEOs. This difference, however, also is a reflection of the special stature of CEOs. As previously discussed, much of the academic literature focuses exclusively on the CEO. The popular press similarly focuses on the CEO. What perhaps remains unknown is whether CEOs are noticeably more highly compensated relative to NEOs based on their special importance to firms. There are a small number of firms, for instance, with executive vice presidents whose total cash compensation exceeds that of the CEO (e.g. Lockheed and WR Grace). This study, by examining the compensation of a group of executives, will provide some evidence related to this situation. The definition of performance also merits additional consideration. In an effort to facilitate the implementation of the new deduction guidelines, the IRS has specified valid business criteria upon which fully deductible compensation can be based. Specifically, stock price, market share, earnings per share, return on equity, costs and sales are considered acceptable performance measures (§1.162–27(e)(2)(i)). These performance measures do not have to reflect increases; maintaining the current level or minimizing decreases are acceptable achievements. Further, these items can be observed from the individual employee, business unit or corporate perspective. The accounting literature also has identified performance measures upon which compensation is based. Net income (Healy et al., 1987), return on equity (Lambert & Larcker, 1987), assets (Conference Board, 1998), and sales growth (Murphy, 1985) are among those factors considered influential for executive compensation. As most of the above items define performance in terms of amounts reported in financial statements, collinearity is a potential problem. To circumvent this issue, performance for purposes of the current research is defined in terms of stock price, sales growth and net income. Finally, all items are similarly measured at the end of each firm’s fiscal year. The three models used to examine each performance measure are: Compij = 0 + 1 SGij +
(1)
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Compij = 0 + 2 EARNij +
(2)
Compij = 0 + 3 PRICEij +
(3)
where, Compij = Executive compensation for firm i, year j; SGij = Sales growth for firm i, year j; EARNij = Accounting earnings for firm i, year j; PRICEij = Stock price for firm i, year j; and ij = error term for firm i, year j.
Sample The sample is composed of those firms listed on the 1994 Fortune 500 (Fortune, 1995). 1994 was selected because it was the year in which the legislation under investigation first became effective. If a firm responded to RRA 93, then the initial reaction probably will occur in the first effective year. Unlike previous studies, which focused exclusively on the CEO (Balsam & Ryan, 1996; Harris & Livingstone, 1998; Rose & Wolfram, 2000) and defined compensation as the sum of salary and bonus (Harris & Livingstone, 1998; Healy et al., 1987), the current study examines the total compensation paid to a group of key employees. This data set represents an important contribution to the literature because it comprehensively examines the compensation components and employees covered by this legislation. Hypothesis tests use data from Compustat and from the Summary Compensation Table contained in the 1992–1997 proxy statements DEF 14A, as filed with the Securities and Exchange Commission (SEC) and available online through the SEC’s EDGAR database. The Summary Compensation Table contains salary, bonus, number stock options granted, long-term incentive payouts and general categories of other compensation for each firm’s CEO and the four next-highest paid executives (SEC, 1993). Only those companies filing electronically with the SEC are included in the EDGAR database. The specific variables used in this research are the compensation amounts paid to the chief and named executive officers (CEO and NEOs) of each firm. Data limitations permit analysis of the CEO and the three next-highest paid officers only. Because the fourth-highest paid NEO was not consistently reported by the sample firms, that employee is not included in the analysis. Another limitation is related to the nature of the data source itself. All compensation information was retrieved from online sources. Firms not filing electronically for all years of the study, therefore, may have supplied incomplete information
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Table 1. Study Sample. Final Sample
Number of Firms
Fortune listing
500
Outlier Changed fiscal year end Stock not publicly traded Merged or split up during 1992–1997 Data not available through EDGAR or Compustat
1 4 10 25 120
Sample tested
340
(in the context of the current research). As noted above, the insufficient data often precluded the inclusion of at least one executive in the research database. To remove the effects of general price level changes, dollar denominated amounts are deflated by the consumer price index (1992 = 100).5 Further, all of the data exhibit strong skew. As the statistical methods used to test the hypotheses assume that the underlying data are normally distributed, log transformations were performed prior to testing. In addition to removing one outlier firm, other firms were removed on the basis of incomplete data. Those companies that changed fiscal years or corporate structure (by merger or split up) also were removed from the sample. These firms were removed because in at least one year, they reported partial periods that could not be incorporated with the other reported time periods. Table 1 contains information about the sample firms. The final data set consists of 340 firms, or 68% of the population firms. Testable time periods were established based on the first effective year of §162(m). The compensation limitations first applied to years beginning on or after January 1, 1994. Accordingly, for firms with calendar year ends, year 1, the initial year of effectiveness, is the accounting period ending on December 31, 1994. For all firms with fiscal year ends, year 1 is the accounting period ending in 1995. As a result, year 1 could be 1994 or 1995. Effective years, and the periods for which data have been collected, are identified in Table 2.
Statistical Tests This research relies on a variety of statistical analyses. Testing the first and second hypotheses utilizes analysis of variance (ANOVA) techniques to compare the means of each pre- and post-enactment year. Oneway ANOVA is appropriate for
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Table 2. Effective Years. Effective Year
−2 −1 1 2 3
Accounting Period Calendar Year End
Fiscal Year End
1992 1993 1994 1995 1996
1993 1994 1995 1996 1997
this analysis because it is used to compare each of the five annual means of the compensation measures. Also, the ANOVA tests are well suited to this analysis because they, unlike other statistical methods (Kazmier, 1988), are not impaired by the small number of years (five) examined. To further investigate the ANOVA results, Tukey’s HSD cell-wise comparisons are made. These comparisons extend the ANOVA and are effective because they stratify the years (treatments) into homogeneous groups based on mean values. Evaluation of the composition of these groups and their means indicates both the point (year) at which a statistically significant change occurs and the direction (increasing or decreasing) of the shift. While some multiple comparison tests are limited to paired data (i.e. least significant differences), Tukey’s method is well suited to this (5-year) data set because it examines all possible groupings (Box et al., 1978) and is not dependent upon equal sample sizes when there are three or more treatments (Daniel & Terrell, 1992). Ordinary least squares (OLS) regression analysis is used to test the third hypothesis. Specifically, individual OLS regressions are produced for each year and each performance measure. Additional regression analyses are performed on the pre- and post-RRA 93 periods as well. A combined examination of  and R2 indicates size and importance, respectively, of performance measures in executive compensation.
RESULTS Hypotheses 1 and 2 The first and second hypotheses analyze the mix of compensation components by examining the weights of salary and bonus in the compensation package (excluding stock options). Weights attributable to salary and bonus payments are computed by separately dividing each variable by total cash compensation. Total
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Table 3. CEOs. Panel A: Anova Results Variable
Degrees of Freedom
Salary/Total cash compensation Bonus/Total cash compensation
4 4
F
p-Value
17.624 5.837
0.000 0.000
Panel B: Tukey HSD Homogeneous Subsets Effective Year
Salary/Total Cash Compensation n
Subset for ␣ = 0.05 1
−2 −1 1 2 3
340 340 340 340 340
Bonus/Total Cash Compensation
2
n 3
4 52%
42% 39%
44% 42%
47% 44%
Subset for ␣ = 0.05 1
340 340 340 340 340
27% 31%
2
31% 33% 33% 32%
Sig.
0.38 0.76 0.46 1.00 0.05 0.59 Note: Total Cash Compensation = (Salary, Bonus, Other annual, Long-term incentive payout, Restricted stock awards and All other).
cash compensation is defined as the sum of salary, bonus, other annual, restricted stock awards, long-term incentive payouts, and all other compensation. The statistical tests show that, for all executives, the weight of salary compensation decreased while the weight of bonuses increased during the five-year period. For the four executives examined, the results of ANOVA and Tukey tests6 are notably similar. Tables 3, 4, 5, and 6 report the ANOVA results (Panel A) and subset means (Panel B) for the CEO, 1st NEO, 2nd NEO and 3rd NEO, respectively. Of note is the composition of the post-RRA 93 salary subsets and the pre-RRA 93 bonus groups; in general, stratification occurs around the enactment of RRA 93. The CEO’s salary experiences the most gradual increases. As reported in Table 3, the CEO’s salary is divided among four homogenous subsets. While an abrupt shift around the enactment of RRA 93 is not found, gradual change toward performance-based remuneration is apparent. Demarcation of salary weights in pre- and post-RRA 93 years is clearer for NEOs. As reported in Tables 4, 5
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Table 4. Highest-Paid NEOs. Panel A: Anova Results Variable
Degrees of Freedom
Salary/Total cash compensation Bonus/Total cash compensation
4 4
F
p-Value
11.687 3.558
0.000 0.007
Panel B: Tukey HSD Homogeneous Subsets Effective Year
Salary/Total Cash Compensation n
Subset for ␣ = 0.05 1
−2 −1 1 2 3
340 340 340 340 340
Bonus/Total Cash Compensation
46% 44% 41%
2
47% 46% 44%
n 3 52% 47%
Subset for ␣ = 0.05 1
340 340 340 340 340
26% 30% 30%
2
30% 31% 30% 30%
Sig.
0.07 0.10 0.07 0.08 0.92 Note: Total Cash Compensation = (Salary, Bonus, Other annual, Long-term incentive payout, Restricted stock awards and All other).
and 6, for all NEOs a single homogeneous subset captures all post-enactment years (effective years 1, 2 and 3). The second subset for all NEOs appears to be a transitional period. The first subset consistently contains both pre-RRA93 years and the highest salary percentages. The weight of bonus continually increases throughout the five-year time frame examined in the current research. These increases, however, are slightly more difficult to assess. Year −2 is consistently the lowest and the overall weight increases are between 4 and 6% during the five-year time period. For two NEOs, however, the high point occurs in year 1, when §162(m) first became effective. Both the 1st and the 2nd NEO reached a peak bonus percentage (31%) in year 1. That rate then decreased slightly, down to 30%, in years 2 and 3. Even with this decrease, however, bonuses for the highest-paid and second highest-paid NEOs became a larger part of these individuals’ compensation package. Table 7 provides an additional measure of support for the first hypothesis. Salaries, even after adjusting for inflation, have increased for all executives;
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Table 5. Second Highest-Paid NEOs. Panel A: Anova Results Variable
Degrees of Freedom
Salary/Total cash compensation Bonus/Total cash compensation
F
4 4
p-Value
9.690 4.123
0.000 0.003
Panel B: Tukey HSD Homogeneous Subsets Effective Year
Salary/Total Cash Compensation n
Subset for α = 0.05 1
−2 −1 1 2 3
340 340 340 340 340
Bonus/Total Cash Compensation
48% 46% 45%
2
51% 48%
n 3 54% 51%
Subset for α = 0.05 1
340 340 340 340 340
26% 29%
2
29% 31% 30% 30%
Sig.
0.46 0.46 0.24 0.07 0.78 Note: Total Cash Compensation = (Salary, Bonus, Other annual, Long-term incentive payout, Restricted stock awards and All other).
during the five years studied, the CEO’s salary has increased by 11% overall, the 1st NEO’s 6%, the 2nd NEO’s 8%, and the 3rd NEO’s 9%. The bulk of those increases, however, occurred very early, between effective years −2 and −1. The later years witness little or no gains. The CEO’s salary, in fact, decreased from effective year 2 to effective year 3. The first and second hypotheses are supported because increases in the weights of bonus are accompanied by decreases in the weights of salary. This result provides a degree of evidence that is consistent with legislative effectiveness regarding the performance-based objectives of compensation reform. Specifically, the mix of components has shifted in favor of performancebased, rather than entitlement, amounts. Assessing the performance-based goals, however, is a two-part test. While the first and second hypotheses are supported, the effectiveness of the deduction limitations with regard to performance-based objectives also must incorporate the results of the third hypothesis test.
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Table 6. Third Highest-Paid NEOs. Panel A: Anova Results Variable
Degrees of Freedom
Salary/Total cash compensation Bonus/Total cash compensation
F
4 4
p-Value
9.836 4.517
0.000 0.001
Panel B: Tukey HSD Homogeneous Subsets Effective Year
Salary/Total Cash Compensation n
Subset for ␣ = 0.05 1
−2 −1 1 2 3
Bonus/Total Cash Compensation
332 332 332 332 332
51% 49% 48%
n
2
53% 51% 49%
3 56% 53%
Subset for ␣ = 0.05 1
332 332 332 332 332
2
26% 29%
29% 30% 30% 30%
Sig.
0.19 0.16 0.09 0.06 0.89 Note: Total Cash Compensation = (Salary, Bonus, Other annual, Long-term incentive payout, Restricted stock awards and All other).
Hypothesis 3 The third hypothesis continues the examination of the performance-based objectives of the deduction limitations. Regression analysis separately examines the relationships among three performance measures and total cash compensation and number of options granted. Descriptive statistics for the three independent Table 7. Salary Increases. Year
CEO 1st NEO 2nd NEO 3rd NEO
Annual Percentage Increase in Inflation-Adjusted Salary −1
1
2
3
Overall
7% 3% 6% 5%
3% 3% 2% 3%
2% 1% 0% 0%
−1% 0% 0% 1%
11% 6% 8% 9%
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Table 8. Descriptive Statistics (Performance Measures, N = 340). Descriptive Statistics
Effective Year −2
EARN (Millions $) Mean Std. Dev.
1
2
3
212.8 1,555.7
398.9 879.9
504.1 919.6
473.2 911.7
647.9 998.6
26.9 14.1
28.1 14.7
27.3 14.5
31.4 18.0
34.4 20.2
34.7 1,310.9
148.6 1,481.1
509.2 1,949.0
470.1 1,708.6
389.9 2,192.0
PRICE ($) Mean Std. Dev. SG (Millions $) Mean Std. Dev.
−1
EARN = Accounting earnings; PRICE = Stock price; and SG = Sales growth.
variables are presented in Table 8. As with all monetary compensation variables, performance measures were deflated by CPI (1992 = 0). These deflated values, however, were highly skewed. To remove the skew, natural log transformations were made and used in the regression analyses that follow. This analysis, the results of which are reported in Tables 9–12, provides modest evidence in support of the legislative goals of strengthening the pay-performance link. Specifically, total cash compensation appears to be related to EARN Table 9. CEOs (Regression Analysis). Effective Year
EARN  (Sig.)
PRICE R2
 (Sig.)
SG R2
 (Sig.)
R2
Total cash compensation −2 0.193 (0.000) −1 0.197 (0.000) 1 0.265 (0.000) 2 0.282 (0.000) 3 0.252 (0.000)
0.138 0.141 0.224 0.238 0.198
0.125 (0.059) 0.174 (0.016) 0.273 (0.000) 0.375 (0.000) 0.309 (0.000)
0.011 0.017 0.041 0.085 0.053
0.110 (0.001) 0.113 (0.004) 0.105 (0.000) 0.169 (0.000) 0.102 (0.001)
0.048 0.039 0.052 0.137 0.045
Number of options granted −2 0.206 (0.000) −1 0.057 (0.083) 1 0.056 (0.000) 2 0.056 (0.000) 3 0.062 (0.074)
0.067 0.014 0.077 0.077 0.012
−0.092 (0.494) −0.232 (0.105) 0.010 (0.944) 0.168 (0.168) −0.264 (0.077)
0.002 0.010 0.000 0.007 0.011
0.198 (0.002) 0.042 (0.054) 0.139 (0.009) 0.208 (0.000) 0.051 (0.467)
0.064 0.002 0.033 0.068 0.003
EARN = Accounting earnings; PRICE = Stock price; and SG = Sales growth.
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Table 10. Highest-Paid NEOs (Regression Analysis). Effective Year
EARN  (Sig.)
PRICE R2
 (Sig.)
SG R2
 (Sig.)
R2
Total cash compensation −2 0.220 (0.000) −1 0.190 (0.000) 1 0.257 (0.000) 2 0.254 (0.000) 3 0.237 (0.000)
0.156 0.139 0.224 0.186 0.164
0.148 (0.024) 0.153 (0.023) 0.215 (0.001) 0.204 (0.004) 0.400 (0.000)
0.015 0.015 0.031 0.025 0.086
0.152 (0.000) 0.101 (0.005) 0.107 (0.000) 0.162 (0.000) 0.108 (0.001)
0.085 0.037 0.067 0.130 0.045
Number of options granted −2 0.212 (0.000) −1 0.151 (0.004) 1 0.252 (0.000) 2 0.172 (0.001) 3 0.202 (0.000)
0.080 0.034 0.086 0.046 0.055
−0.230 (0.054) −0.016 (0.885) −0.016 (0.897) −0.031 (0.781) −0.157 (0.224)
0.015 0.000 0.000 0.000 0.005
0.218 (0.000) 0.099 (0.121) 0.145 (0.004) 0.194 (0.000) 0.098 (0.077)
0.085 0.014 0.039 0.073 0.017
EARN = Accounting earnings; PRICE = Stock price; and SG = Sales growth.
and PRICE. EARN, in particular, is significant for all executives in all years. Coefficients increase and range from 0.190 to 0.282. In addition, this relationship, while not particularly powerful, has strengthened over time. While R2 peaks briefly around effective year one (above 0.22 for all executives) and then decreases slightly, the general trend is increasing. Table 11. Second Highest-Paid NEOs (Regression Analysis). Effective Year
EARN  (Sig.)
PRICE R2
 (Sig.)
SG R2
 (Sig.)
R2
Total cash compensation −2 0.222 (0.000) −1 0.203 (0.000) 1 0.252 (0.000) 2 0.259 (0.000) 3 0.266 (0.000)
0.207 0.190 0.269 0.229 0.258
0.184 (0.002) 0.191 (0.002) 0.222 (0.000) 0.276 (0.000) 0.382 (0.000)
0.029 0.029 0.039 0.055 0.097
0.108 (0.001) 0.007 (0.023) 0.098 (0.000) 0.164 (0.000) 0.106 (0.000)
0.056 0.022 0.062 0.150 0.055
Number of options granted −2 0.187 (0.000) −1 0.156 (0.004) 1 0.228 (0.000) 2 0.209 (0.000) 3 0.180 (0.000)
0.060 0.035 0.069 0.060 0.048
−0.222 (0.045) −0.083 (0.488) −0.044 (0.714) 0.092 (0.394) −0.063 (0.593)
0.016 0.002 0.000 0.003 0.001
0.183 (0.001) 0.116 (0.064) 0.138 (0.005) 0.244 (0.000) 0.097 (0.071)
0.067 0.020 0.037 0.119 0.018
EARN = Accounting earnings; PRICE = Stock price; and SG = Sales growth.
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Table 12. Third Highest-Paid NEOs (Regression Analysis). Effective Year
EARN  (Sig.)
PRICE R2
 (Sig.)
SG R2
 (Sig.)
R2
Total cash compensation −2 0.206 (0.000) −1 0.200 (0.000) 1 0.257 (0.000) 2 0.253 (0.000) 3 0.254 (0.000)
0.198 0.202 0.292 0.245 0.272
0.118 (0.045) 0.186 (0.002) 0.206 (0.001) 0.296 (0.000) 0.437 (0.000)
0.012 0.028 0.034 0.065 0.139
0.081 (0.007) 0.057 (0.080) 0.088 (0.000) 0.167 (0.000) 0.106 (0.000)
0.035 0.015 0.053 0.165 0.067
Number of options granted −2 0.195 (0.000) −1 0.123 (0.015) 1 0.230 (0.000) 2 0.196 (0.000) 3 0.177 (0.000)
0.063 0.025 0.073 0.058 0.049
−0.128 (0.273) 0.032 (0.785) 0.129 (0.300) 0.032 (0.773) −0.081 (0.469)
0.005 0.000 0.004 0.000 0.002
0.180 (0.002) 0.125 (0.039) 0.160 (0.001) 0.210 (0.000) 0.090 (0.092)
0.059 0.025 0.052 0.089 0.016
EARN = Accounting earnings; PRICE = Stock price; and SG = Sales growth.
For both PRICE and EARN, reported values of R2 are small (ranging from 0.011 to 0.165), but generally increase over the time period examined. The coefficient on PRICE, however, increases markedly. For the third highest-paid NEO, for instance, the PRICE coefficient increased from.118 to.437 (R2 increased from 0.012 to 0.139). Unlike EARN and PRICE, the SG coefficients, while significant, did not exhibit appreciable increases; values were stable and near 0.10 in most cases. Tests of the first and second hypotheses demonstrated that executive compensation is shifting toward bonus and away from salary payments. The tests of the third hypothesis reveal that the link, albeit a modest one, between compensation and performance (as measured by net income and stock price) is strengthening. With regard to option grants, however, no link with performance is revealed by the regression analyses. While option grants have become more popular and increased in number annually during the five-year period (Fig. 2), they do not appear to be related to performance. The variables tested, especially PRICE, tend to be insignificant. This result is a direct contrast to the legislative perception that options appear de facto to meet the performance-based criteria of §162(m) (U.S. House of Representatives, 1993). However, this analysis is based on the number of options granted annually rather than a monetary valuation. An examination of the monetary value attributable to stock options may lead to different conclusions.
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Parsing Data for Pre- and Post-§162(m) Analyses An additional transformation of the data set was made so that, as was done with the first two hypotheses, the third hypothesis could be tested on the pre- and post-§162(m) years separately. Table 13 contains the results of testing the data on these two data sets. Again, the independent variable PRICE is largely insignificant; p-values range from 0.001 to 0.693, both before and after the enactment of RRA 93. SG, however, consistently increased in significance after the enactment, but the coefficient of this variable indicates only very slight increases. For the highest-paid NEO, in fact, the coefficient of SG actually decreased after the imposition of the new compensation guidelines. Table 13. Regression Analysis, Pre- and Post-§162(m). Period
Intercept 
Sig.
EARN 
Sig.
PRICE 
R2
SG
Sig.

Sig.
CEO Pre-§162(m) Post-§162(m)
Total cash compensation 12.856 0.000 0.171 12.613 0.000 0.254
0.000 0.000
0.045 0.019
0.495 0.693
0.059 0.057
0.028 0.001
0.14 0.25
CEO Pre-§162(m) Post-§162(m)
Number of options granted 10.397 0.000 0.125 10.392 0.000 0.228
0.024 0.000
−0.174 −0.242
0.212 0.024
0.074 0.083
0.163 0.035
0.04 0.07
1st NEO Pre-§162(m) Post-§162(m)
Total cash compensation 12.237 0.000 0.173 12.172 0.000 0.243
0.000 0.000
0.052 0.018
0.427 0.711
0.077 0.057
0.004 0.001
0.15 0.24
1st NEO Pre-§162(m) Post-§162(m)
Number of options granted 9.582 0.000 0.124 9.538 0.000 0.243
0.014 0.000
−0.179 −0.255
0.140 0.004
0.103 0.095
0.038 0.005
0.05 0.10
2nd NEO Pre-§162(m) Post-§162(m)
Total cash compensation 12.006 0.000 0.187 11.835 0.000 0.238
0.000 0.000
0.088 0.039
0.124 0.362
0.032 0.058
0.169 0.000
0.19 0.27
2nd NEO Pre-§162(m) Post-§162(m)
Number of options granted 9.509 0.000 0.106 9.388 0.000 0.208
0.050 0.000
−0.227 −0.287
0.056 0.001
0.107 0.115
0.028 0.000
0.05 0.10
3rd NEO Pre-§162(m) Post-§162(m)
Total cash compensation 11.977 0.000 0.191 11.670 0.000 0.245
0.000 0.000
0.067 0.032
0.247 0.431
0.013 0.048
0.579 0.001
0.19 0.30
3rd NEO Pre-§162(m) Post-§162(m)
Number of options granted 8.952 0.000 0.071 9.057 0.000 0.180
0.181 0.000
−0.081 −0.203
0.494 0.024
0.127 0.124
0.008 0.000
0.04 0.09
EARN = Accounting earnings; PRICE = Stock price; and SG = Sales growth.
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As with previous analyses, the most notable results are associated with the net income variable (EARN). Without exception, both the significance of and the value of the coefficients related to EARN increased during the post-§162(m) period. Specifically, all coefficients were significant (p-values of 0.000) in the post-§162(m) years. The values of the coefficients increased substantially in some cases. This finding provides further support of the general conclusion that the strength of the pay-performance link, especially that related to net income, increased after the enactment of RRA 93.
CONCLUSIONS, IMPLICATIONS, LIMITATIONS AND FUTURE RESEARCH This study has empirically examined the responses of 340 U.S. corporations to the Revenue Reconciliation Act of 1993 and IRC §162(m). The two primary goals of RRA 93, to apply downward pressure to compensation payments and to alter the shape of remuneration packages, are investigated. Both total cash compensation and the number of options granted annually continued to increase for the group of key executives during the five-year period examined in the current research. Continually rising compensation levels are reflections of increases in many forms of remuneration (i.e. salary, bonus, other and long-term incentive payouts), and have implications for future research. Specifically, executive compensation research that does not include all forms of remuneration may represent only a partial analysis; to fully investigate the topic, all components of compensation plans merit consideration. The evidence found is consistent with an increased reliance on bonus, or performance-based, payments by firms after the enactment of RRA 93. Further, evidence also is consistent with RRA 93’s goal of strengthening the payperformance link. While total compensation does not decrease, it does, however, appear to be more closely tied to performance in the years after the enactment of RRA 93 than it was previously. The stronger link, however, is a modest one and primarily applies to the relationship between firm net income and total cash compensation. The relationship between the number of stock options granted and performance, however, shows no real signs of strengthening during the five-year period examined. The modest nature of this conclusion has implications for ongoing policy discussions related to the deduction of executive compensation. In February of 1999 (H.R. 740), and again in 2001 (H.R. 2691), for instance, the Income Equity Act [of 1999 and 2001] was introduced in the U.S. House of Representatives. This bill was reintroduced in 2001 (H.R. 2691). This bill, if
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enacted, would apply to U.S. corporations and would further limit (in addition to §162(m)) the deduction of salary, wages and bonuses paid to any employee to 25 times the pay of the lowest compensated employee (U.S. House of Representatives, 1999). Notably, the terms of H.R. 740 do not apply to categories of other compensation or stock option grants. The goal of this particular legislation appears to be that of reducing the absolute dollar amount of salary and bonus payments. Based on the results of the current study, however, these legislative efforts (H.R. 740 and 2691) are not well placed because compensation appears to be resistant to changes in the tax law. Additional research should consider modifications to the underlying data. First, the valuation of options, which is not included in the current research, would provide considerable information regarding the overall compensation packages of the firms under investigation. Similarly, the inclusion of the fourth highest-paid NEO, an employee excluded from the present analysis, would provide additional information regarding the full effects of RRA 93. Finally, the investigation of additional performance measures in the analysis of the pay-performance link would provide additional information.
NOTES 1. As recently as April 2002, the Senate Finance Committee met to examine the issue of executive compensation (Digest, 2002). 2. The SEC’s Shareholder Proposal Rule allowed those owning $1,000 worth of stock for at least one year to submit issues for vote by the corporation’s shareholders. Upon submission, the corporation would have to circulate the shareholder’s proposal in its proxy statement unless the topic qualified for an exception. Executive pay was considered a legitimate exception to this circulation procedure. As a result, corporations could, at their discretion, ignore shareholder proposals concerning executive compensation (Levin, 1991). 3. Statistical tests of the compensation decreasing objectives were preformed and results of those tests reveal that compensation did not decrease after the imposition of §162(m). 4. The method of combining compensation amounts in years when more than one CEO was in office did not affect the results of the hypotheses tests. Statistical tests were repeated on the smaller (n = 217) group of CEOs, and the results were similar in all cases. 5. While all monetary amounts have been deflated to remove the effects of inflation, this adjustment is small. In general, the consumer price index (CPI) rose in a slight, yet consistent manner throughout the time period covered by the current research. The range of annual CPI increases was limited to 2.3–3.0%. On average, the CPI increased approximately 2.8% annually during the years currently under examination. 6. Prior to conducting the statistical tests of the first and second hypotheses, t-tests were used to assess whether or not differences exist when the pre-§162(m) years (years −2 and −1) are compared to post-§162(m) years (years 1, 2, and 3). For all executives, large t-values, which range from −7.1 to 3.9, and the corresponding levels of significance, all very near zero, indicate the means of the two periods are significantly different.
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ACKNOWLEDGMENTS This paper is based on my dissertation at Case Western Reserve University. I thank my committee, Tim Fogarty (chair), Rob Bricker, Julia Grant, and Tom Love. I also appreciate the helpful comments of two anonymous referees, workshop participants at the University of New Hampshire, the University of Pittsburgh, and the 2000 American Accounting Association Annual Meeting.
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