CONTENTS LIST OF CONTRIBUTORS
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EDITORIAL BOARD
ix
AD HOC REVIEWERS
xi
AIT STATEMENT OF PURPOSE
xiii
MAIN ARTICLES PROFESSIONAL LIABILITY SUITS AGAINST TAX ACCOUNTANTS: SOME EMPIRICAL EVIDENCE REGARDING CASE MERIT Donna D. Bobek, Richard C. Hatfield and Sandra S. Kramer
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AN EMPIRICAL ASSESSMENT OF SHIFTING THE PAYROLL TAX BURDEN IN SMALL BUSINESSES Ted D. Englebrecht and Timothy O. Bisping
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AN EMPIRICAL EXAMINATION OF INVESTOR OR DEALER STATUS IN REAL ESTATE SALES Ted D. Englebrecht and Tracy L. Bundy
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CHARITABLE GIVING AND THE SUPERDEDUCTION: AN INVESTIGATION OF TAXPAYER PHILANTHROPIC BEHAVIOR FOLLOWING THE MOVE FROM A TAX DEDUCTION TO A TAX CREDIT SYSTEM Alexander M. G. Gelardi
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HOW ENGAGEMENT LETTERS AFFECT CLIENT LOSS AND REIMBURSEMENT RISKS IN TAX PRACTICE Lynn Comer Jones, Ernest R. Larkins and Ping Zhou
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THE ALTERNATIVE MINIMUM TAX: EMPIRICAL EVIDENCE OF TAX POLICY INEQUITIES AND A RAPIDLY INCREASING MARRIAGE PENALTY John J. Masselli, Tracy J. Noga and Robert C. Ricketts
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AN EMPIRICAL INVESTIGATION OF FACTORS INFLUENCING TAX-MOTIVATED INCOME SHIFTING Toby Stock
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RESEARCH NOTES ACADEMIC TAX ARTICLES: PRODUCTIVITY AND PARTICIPATION ANALYSES 1980–2000 Paul D. Hutchison and Craig G. White
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EDUCATORS’ FORUM EXPORT INCENTIVES AFTER REPEAL OF THE EXTRATERRITORIAL INCOME EXCLUSION Ernest R. Larkins
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LIST OF CONTRIBUTORS Timothy O. Bisping
Department of Economics and Finance, Louisiana Tech University, USA
Donna D. Bobek
School of Accounting, University of Central Florida, USA
Tracy L. Bundy
School of Professional Accountancy, Louisiana Tech University, USA
Ted D. Englebrecht
School of Professional Accountancy, Louisiana Tech University, USA
Alexander M. G. Gelardi
College of Business, University of St. Thomas, St. Paul, MN, USA
Richard C. Hatfield
Department of Accounting, University of Texas at San Antonio, USA
Paul D. Hutchison
Department of Accounting, University of North Texas, USA
Lynn Comer Jones
Department of Accounting and Finance, University of North Florida, USA
Sandra S. Kramer
Fisher School of Accounting, University of Florida, USA
Ernest R. Larkins
School of Accountancy, Georgia State University, USA
John J. Masselli
Area of Accounting, Texas Tech University, USA
Tracy J. Noga
Department of Accounting, Suffolk University, USA
Robert C. Ricketts
Area of Accounting, Texas Tech University, USA
Toby Stock
School of Accountancy, Ohio University, USA vii
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Craig G. White
Area of Accounting, University of New Mexico, USA
Ping Zhou
Stan Ross Department of Accountancy, City University of New York – Baruch College, USA
EDITORIAL BOARD EDITOR Thomas M. Porcano Miami University
Kenneth Anderson University of Tennessee, USA
Suzanne M. Luttman Santa Clara University, USA
Caroline K. Craig Illinois State University, USA
Gary A. McGill University of Florida, USA
Anthony P. Curatola Drexel University, USA
Janet A. Meade University of Houston, USA
Ted D. Englebrecht Louisiana Tech University, USA
Charles E. Price Auburn University, USA
Philip J. Harmelink University of New Orleans, USA
William A. Raabe Columbus, USA Michael L. Roberts University of Alabama, USA
D. John Hasseldine University of Nottingham, England
David Ryan Temple University, USA
Peggy A. Hite Indiana University-Bloomington, USA
Dan L. Schliser East Carolina University, USA
Beth B. Kern Indiana University-South Bend, USA
Toby Stock Ohio University, USA
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AD HOC REVIEWERS James R. Hasselback Florida State University, USA
Robert C. Ricketts Texas Tech University, USA
Ernest R. Larkins Georgia State University, USA
Janet W. Tillinger Texas A&M – Corpus Christi, USA
Cherie J. O’Neil Colorado State University, USA
Patrick J. Wilkie George Mason University, USA
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ADVANCES IN TAXATION EDITORIAL POLICY AND CALL FOR PAPERS 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 also is 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 xiii
PROFESSIONAL LIABILITY SUITS AGAINST TAX ACCOUNTANTS: SOME EMPIRICAL EVIDENCE REGARDING CASE MERIT Donna D. Bobek, Richard C. Hatfield and Sandra S. Kramer ABSTRACT As with most professional service occupations, liability claims are a major concern for accounting professionals. Most of the academic research on accountants’ professional liability has focused on audit services. This study extends research on accountants’ professional liability by examining liability claims arising from the provision of tax services. In addition to a descriptive analysis, the current study explores the role of merit in tax malpractice litigation. Hypotheses are developed based on the legal construct of claim merit, which requires the presence of accountant error and damages as a result of that error for a claim to be considered meritorious. The hypotheses are tested using logistic and OLS regression of 89 actual claims filed with an insurer of tax professionals. The results suggest that the components of merit are significant in determining both the presence of compensatory payments to the client and the dollar amount of those payments, although the hypothesized interaction effect is only significant for the dollar amount of compensatory payments. Advances in Taxation Advances in Taxation, Volume 16, 3–23 Copyright © 2004 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(04)16001-8
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INTRODUCTION This study examines the relationship between merit and outcome in tax malpractice claims. Although this relationship seems intuitive, prior research focusing on accountant liability in an audit setting has been unable to find a significant link. The role of merit is of importance to accounting firms who have a vested interest in legal reform. For example, the large accounting firms have stated that unwarranted litigation (i.e. lacking merit) and coerced settlements are the “principal cause” of the profession’s liability problems (Arthur Andersen & Co. et al., 1992). Using detailed claim files from an accountant insurance company, we explore this issue in the tax accounting profession. Palmrose (1997) undertook a review of the audit malpractice literature in an effort to answer the question, “do the merits of a case matter with regards to bringing and resolving claims against auditors?” Kinney (1993) asserts that meritorious claims against independent auditors require three elements: substandard financial statements, substandard audits, and compliance with relevant legal standards (e.g. detrimental reliance on the financial statements). However, Palmrose (1997) suggests that the low probability of bringing a claim to court actually severs the theoretical tie between merits and outcome. The empirical data drawn from several studies (e.g. Dunbar et al., 1995; Palmrose, 1994) suggest that the role of merit is inconclusive (particularly with regard to outcome). This result is due in part to the fact that prior research generally does not undertake the question of merit directly, and has been unable to find an adequate proxy for claim merit. Palmrose (1997) concluded her study with a call for research that examines the role of merit in accountant malpractice claims. Although most research examining the issue of malpractice liability in the accounting profession deals with auditor liability, the issue of tax professional liability is also of concern. Several different sources have quantified the fact that tax accounting engagements result in more claims brought by clients than any other area of accounting practice (although audit claims are higher in total costs). In fact, the AICPA reports that 60% of all accountant malpractice claims in the AICPA Professional Liability Insurance program arise from tax engagements (Anderson & Wolfe, 2001). This is up from 43% ten years ago. Donnelly et al. (1999) note that the frequent enactment of tax law changes and the relatively recent inclination of the IRS and the Tax Court to hold practitioners responsible for client information has put additional pressure on small and midsize accounting firms. This pressure, they add, has led to “more frequent and more severe malpractice claims arising from tax planning and preparation” (p. 59). Although the occurrence of tax malpractice claims is quite high, the research regarding this issue has been limited.
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This study extends prior research in both auditing and tax litigation. Tax research in this area is fairly new and has yet to address the important relationship between claim merit and claim outcome. And, although some audit research has directly addressed the issue of merit (e.g. Carcello & Palmrose, 1994; Dunbar et al., 1995), audit researchers typically have a difficult time finding an adequate proxy for claim merit. We begin by developing a definition of claim merit based on case law (Anderson, 1991; Rockler vs. Glickman, 1978). Specifically, we define a meritorious case as one that contains both tax professional error and damages occurring as a result of that error. We also hypothesize that meritorious claims should be more likely to result in compensation being paid to the client, as well as larger payment amounts. We examine these hypotheses with data from the files of an insurance company (the files contain good proxies for these two components of merit). As prior audit research has suggested, it appears that a claim does not have to meet the strict legal criteria of a meritorious claim in order to result in a compensatory payment to the client. Our results suggest that the existence of either error on the part of the tax professional or damages incurred by the client is enough to result in compensatory payments. However, there is a fairly large and significant difference in the magnitude of payments for claims with both error and damages compared to all other claims, after controlling for the overall size of the claim. In fact, claims with both components of merit resulted in average compensatory payments that were more than four times larger than other claims in our sample ($62,921 vs. $15,284).1 Thus, we conclude that the effect of the components of claim merit, as suggested by case law, are a significant determinant of both the likelihood of compensatory payments being made, and the amount of those payments. The remainder of this article is organized as follows. In the next section, prior research regarding professional liability of accountants is discussed; followed by a definition of claim merit and development of the hypotheses. This is followed by a description of the variables and descriptive data regarding the sample. In the next section, results are reported and discussed. Finally, conclusions and opportunities for future research are discussed.
PRIOR RESEARCH There are two streams of research on which this study draws. First, there is some prior research that deals directly with tax accountant liability, although this research does not address the issue of claim merit. Second, there is a larger body of research regarding audit litigation. The audit environment shares some key characteristics with the tax environment. For example, both originate from
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accounting firms that may have relatively deep pockets. Second, the rate at which tax claims are brought to trial is similarly low (11% for our sample vs. 10% for Palmrose (1991)). However, there also are differences. The key difference is that tax professionals serve as paid advocates of the client, while auditors work for the shareholders and are required to be independent of the client’s managers. Further, in the current study we focus on tax professionals from small firms, while most audit research has examined Big 5 accountants. Russell (2002) presents survey results demonstrating that the median firm size of CPAs in private practice focused on tax work is just one or two professionals, while the average firm size is around four professionals.
Prior Tax Research The literature on tax practitioner liability is in the early stages and primarily descriptive in nature. Prior descriptive research has addressed issues such as: which areas of tax planning/compliance are more likely to result in malpractice claims (e.g. Anderson & Wolfe, 2001; Demery, 1995; Donnelly & Miller, 1990, 1995; Donnelly et al., 1999), and tips for avoiding malpractice claims (e.g. Anderson, 1991; Bandy, 1996; Holub, 2001; Kahan, 1999; Yancey, 1996). Areas that were repeatedly identified as problem areas include S Corp elections, complex areas such as estate tax and partnership taxation, like-kind exchanges, and filing errors (Anderson & Wolfe, 2001; Donnelly & Miller, 1995; Donnelly et al., 1999). Common tips for avoiding malpractice problems include the use of engagement letters, avoiding “problem” clients and situations (e.g. divorce), proper documentation of procedures, proper communications with the client, and adequate malpractice insurance coverage (Anderson, 1991; Bandy, 1996; Holub, 2001; Yancey, 1996). Although there has been some research considering factors that influence the decision to file a claim against a tax professional (Krawczyk & Sawyers, 1995; Schisler & Galbreath, 2000), research has not yet addressed which factors influence whether a filed claim will result in the tax professional actually making compensatory payments. Krawczyk and Sawyers (1995) report the results of an experiment that varied the nature of the engagement letter and the magnitude of the IRS assessment. As hypothesized, the magnitude of the IRS assessment was positively associated with both the likelihood of filing suit and the dollar amount requested. Further, an engagement letter that included a statement limiting the preparer’s financial liability to the amount of the fees paid had the expected effect of decreasing the dollar amount requested in the suit. However, it had the surprising effect of increasing the probability of filing a suit. Schisler and Galbreath (2000) found that relative to non-involved observers, subjects who were
Professional Liability Suits Against Tax Accountants
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placed in the perspective of the taxpayer were more likely to hold tax preparers responsible for bad outcomes, while taking credit for positive outcomes.
Prior Audit Research Palmrose (1997) reviewed the relevant audit literature in an attempt to answer the question “does merit matter” in malpractice litigation. Her motivation for the study was to provide input for the ongoing debate over legal reform and the reduction of auditor liability. For example, she cites a Statement of Position by the Big Six (Arthur Andersen & Co. et al., 1992, p. 1) which claims that “the principal causes of the accounting profession’s liability problems are unwarranted litigation and coerced settlements.” Palmrose’s ultimate conclusion was that the evidence to date was not conclusive, particularly with regard to the outcome of filed claims. Alexander (1991) provides a rationale for why merit may not be important in securities litigation. The involvement of insurance companies, officers and directors as defendants, and certain rules of law combined to make the likelihood of carrying such cases to court very small. Alexander argued that once the option of trial is virtually eliminated, the outcome of malpractice claims is no longer a function of claim merit. Although Alexander’s conclusion may seem disturbing to the accounting profession, it appears to be consistent with audit research involving the outcome of audit malpractice claims. Carcello and Palmrose (1994) and Dunbar et al. (1995) were unable to find significant results when regressing claim merit on settlement amount. In addition to the theoretical reasons why merit may not “matter enough” (Palmrose, 1997, p. 365), there also has been the issue of finding an adequate proxy for claim merit. While not satisfactorily addressing the issue of claim merit, prior research on auditor liability has identified a number of factors that were related to litigation outcomes. The first is characteristics of the auditor. Research has found that firm size, experience, and number of years on the particular engagement are significantly related to litigation outcome (Palmrose, 1988; St. Pierre & Anderson, 1984). Second, characteristics of the client, such as industry membership, financial condition, market value, variability of return, bankruptcy, and size have been related to audit litigation outcome (Lys & Watts, 1994; Palmrose, 1994; Stice, 1991). Third, research also has examined the event that triggered the error search. For example, negative financial signals from the client and the client’s industry and regulatory reviews (e.g. SEC action) have been determined to prompt the search for errors (St. Pierre & Anderson, 1984). Finally, characteristics of the audit also may influence the outcome (e.g. structure of the audit, portion of total
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revenues/independence, report type given, error type). Several of these variables (e.g. firm size, experience, client relationship) also may be related to tax malpractice litigation. While we consider these variables in our “additional analyses” section of our results, the purpose of the current study is to focus on the definition of claim merit in a tax setting and to assess its effect on the outcome of tax malpractice claims.
DEFINING MERIT IN A TAX SETTING The focus of this study is to examine the relationship between the merit of a malpractice claim and the likelihood that compensatory payments are made by the accounting firm (or their insurance provider). Accountants are held to the same standards of care as lawyers, doctors, and other professionals (Rockler vs. Glickman, 1978). Anderson (1991) details the extensive malpractice case law precedent directly related to lawyers and accountants. This case law requires both: (1) an actual breach of duty by the professional; and (2) damages to the client because of that breach of duty, before there can be a holding of malpractice.2 These two factors3 should be the hallmarks of a meritorious case and should be the distinguishing factors between the group of claims for which compensatory payments are made and the group of claims where there are no compensatory payments. Breach of duty or error(s) on the part of the tax professional include at least two broad categories. First, the tax professional may provide inaccurate planning advice or may inaccurately complete the tax return. Second, the tax professional may inappropriately file a tax return or other tax related document (e.g. elections). Although legally, the tax professional should not be liable unless he/she makes an error resulting in damages to the client, the client may incur tax related damages for reasons other than error on the part of the accountant. For example, the client may provide inaccurate or incomplete information to the tax preparer or may not completely follow the tax professional’s advice/instructions. Any resulting damages would not be due to the work of the tax professional. An error on the part of the tax accountant is only the first requirement for a meritorious malpractice claim. The client also must incur financial damages as a result of the error. Unfavorable consequences can originate with the IRS when it assesses penalties for late or procedurally deficient filings or selects the return for audit. If the return is audited, additional taxes, penalties and interest may be assessed or the IRS may determine the return is correct as filed. While additional taxes, penalties and interest assessed by a tax authority are likely to be the major source of financial damage, there certainly are other tax-related damages that can
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occur as the result of an incorrect tax return. For example, missing the required date for filing an S election could mean a firm had to file as a C corporation. If the error was found and the proper C corporation return filed, there would be no IRS penalty but the corporation would still suffer financial damages in the form of an increased tax liability. Theoretically speaking, only meritorious claims should result in compensatory payments to the client. However, prior audit research, as well as anecdotal observation, shows that there are other reasons, including the cost involved in defending a claim, the low likelihood of the case ending up in court, and the uncertainty involved in proving that a claim is not meritorious, that may lead accountants (and their insurance company) to make some form of compensatory payment even though the merits of the claim are not completely clear. Thus, we hypothesize that claims filed against tax professionals that are meritorious are more likely to result in compensatory payments by the tax professional (or their insurance company) to the client. Additionally, the compensatory payments should be, on average, larger for claims that are meritorious than for non-meritorious claims. This leads to the following two hypotheses, stated in alternative form: Hypothesis 1. Claims where both tax professional error and tax-related damages (i.e. claim merit) are present will result in a greater frequency of compensatory payments to the client than will claims where both of these characteristics are not present. Hypothesis 2. Claims where both tax professional error and tax-related damages (i.e. claim merit) are present will result in a larger dollar amount of compensatory payments to the client, than will claims where both of these characteristics are not present.
DATA An insurance firm that provides liability insurance to accountants in local and regional accounting firms with 1–100 professionals provided access to all the tax malpractice claim files that were closed during the period of January 1994 to March 1997. All cases were no longer active (dropped, settled, or litigated) by May 1998. The insured accounting firms are required to report to the insurer any situation in which the accountant thinks a claim may be filed. If a claim of malpractice is filed, the insurance company hires a tax expert to gather the facts, assess the situation, and to recommend action to the CEO of the insurance firm. The claim can be settled by the insurance company, dropped by the client, or litigated. The insurance company files included the facts as set out by the tax expert, information
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Table 1. Descriptive Data about the Claims. Claim Information Number of claims in sample Range of dates of incident Average # of months claim opened
89 1989–1996 18 months
Who identified the issue IRS Client CPA Other/don’t know
44% 29% 11% 16%
Outcome (%) Droppeda Settled Judge/Jury verdict Claim denied by Ins. Co.
44% 42% 11% 3% Financial Detail All Claims
Only Claims with Payments
Damage payments Number % of total with payments Mean payment/claim
89 48% $24,811
43
Legal expenses Number % of total with legal expenses Mean legal expense/claim
89 54% $13,700
48
$49,047
$25,116
a Includes
claims where CPA was concerned about a malpractice claim and notified the insurance company, but client never followed up.
about the accounting firm involved, and information about compensatory payments and costs paid by the insurance company.4 Tables 1 and 2 present descriptive information about the claims, the accountants and the clients. The dates the claims were reported to the insurance company range from 1989 to 1996. The average amount of time it took these claims to be closed was 18 months (considerably shorter than the 4.3 years Palmrose (1997) reported for the non-payment auditing claims). Forty-four percent of the claims were eventually dropped, 42% were settled and only 11% were the result of a judge or jury verdict. Forty-eight percent of the claimants received some amount of compensatory payment. This is similar to the percentage reported for audit claims by Palmrose (1997). For those 43 claims that resulted in compensatory
Professional Liability Suits Against Tax Accountants
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Table 2. Characteristics of Client, CPA/Firm and Claim Issue. Mean
Median
CPA and firm info Years experience of CPA Number of partners in firm Number of other (non-partner) CPA’s in firm Number of total employees in firm Percentage of billing from tax services
20.6 years 5.7 9.3 29.7 38
20 years 5 7 23 38
Client info % of claims with established clients (>3 years) % of claims with engagement letters % of claims with tax-only clients
43 54 58
Client entity type Corporation Individual Estate Other/don’t know
40% 31% 4% 25%
Claim issuea % of claims clearly about a tax issue % of claims arising from a fee or tax dispute % of claims where accountant alleged client provided erroneous information Partial list of tax issues Number of claims relating to S corps and partnerships Number of claims relating to estates and trusts Number of claims relating to pensions Number of claims that were not related to federal taxes Number of claims that involved erroneous filings a These
70 34 17
10 6 4 14 12
categories are not mutually exclusive.
payments, the average payment was $49,047. For the 54% of the claims where legal expenses were incurred, the legal expenses averaged $25,116. For the entire sample of claims, the total average cost per claim (compensatory payments and legal expense) was $38,511, and 35% of this amount was for legal expenses. The typical CPA was from a small CPA firm and had over 20 years of experience. Approximately 38% of firm billings were from tax services and there were, on average, 30 employees employed by their firm. Most of the clients in our sample were either individual or corporation tax service-only clients. Forty-three percent had been clients of the respective tax professionals for four years or more. Fifty-four percent of the claims reported the presence of an engagement letter.
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There was a wide array of issues from which the claims arose. The tax areas that were identified in the claims were similar to those noted in prior descriptive research, including S Corporations, partnerships, estate and trust issues, non-Federal income tax issues (e.g. sales tax, excise tax, payroll taxes and state income tax), and failure to properly file required tax forms. Interestingly, however, a number of claims, at least partially, arose from “non-tax” issues. For example, 34% of the claims reported either a fee dispute between the accountant and the client, or a client who was disgruntled about the amount of tax they owed.5 Fee disputes have been mentioned in prior descriptive research (e.g. Anderson, 1991; Stimpson, 2001; Yancey, 1996), and are not a new concern. Yancey (1996) notes a case that involved a fee dispute from the 1960s; and Stimpson (2001) goes so far as to recommend that accountants not sue for fees, as this may lead to an increase in the frequency of malpractice claims. The number of claims that we identify as involving fee disputes seems to confirm that advice. Finally, for 17% of the claims, the accountant alleged that the problem occurred because the client provided either erroneous or untimely information.
Variables Hypothesis 1 examines factors that influence whether or not compensatory payments are made to the client and Hypothesis 2 considers the magnitude of such payments. To test Hypothesis 1, the occurrence of compensatory payments, we use a binary dependent variable (one if compensatory payments occurred, zero otherwise). The independent variables of interest for this analysis are whether or not the tax professional committed an error in completing and/or filing the tax return and whether or not damages occurred. Both of these variables and the surrogates developed are discussed below. The first independent variable measures whether the tax professional committed an error. The insurance files contained an expert’s determination of whether there was a clear error by the accountant. In a number of cases, the accused accountant readily admitted to the insurance company investigator that he had made a mistake in completing the return. In other cases, the insurance company’s investigator determined that the accountant had made a mistake. If either the accountant or the insurance company investigator determined that a mistake was made in preparing the tax return, the variable CPA ERROR is coded one. In addition, many of the claims involved cases where the IRS assessed penalties because a tax return was filed late (or not filed at all) or filed with procedural errors such as missing signatures.6 If the filing was late or procedurally incorrect and the investigator determined that the error was the CPA’s error, this also resulted in the variable CPA ERROR being coded one. In all cases where it was not clear that the CPA
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made either an error completing or filing the return, the variable CPA ERROR is coded zero. The second characteristic necessary for a claim to have merit is that damages were incurred by the client. Case law indicates that if there are no damages that result from any act of malpractice, then no compensatory payments should be assessed against the professional. The variable TAX DAMAGES is a measure of whether the damages alleged were tax-related damages (such as interest or penalties). Increased present or future costs that resulted from the cause of action, although more difficult to accurately quantify, also were included as tax-related damages.7 Other alleged damages such as loss of time, and pain and suffering were included as zero values for this variable. The theoretical relationship is that tax/financial damages must exist for a case to have merit. Accordingly, there is no expectation about the size of the tax damage, only the existence of tax damage. Further, the data available often made it difficult to quantify the amount of tax damages (e.g. present value of future tax payments). Therefore, TAX DAMAGES is an indicator variable equal to one if there were tax-related damages and zero if there were no tax-related damages. Therefore, Hypothesis One will be tested with the following regression: Compensatory Payments = 0 + 1 (CPA ERROR) + 2 (TAX DAMAGES) + 3 (CPA ERROR × TAX DAMAGES) Hypothesis 2 considers the magnitude of compensatory payments made by the tax professional. To consider this continuous dependent variable, a control for the size of the claim is necessary since both independent variables are indicator variables. The best proxy we have for a size control variable is the amount of compensation requested by the client in the original claim (COMP REQUESTED). Hypothesis 2 is tested with the following regression: Compensatory Payments = 0 + 1 (CPA ERROR) + 2 (TAX DAMAGES) + 3 (CPA ERROR × TAX DAMAGES) + 4 (COMP REQUESTED)
RESULTS Hypothesis 1 Hypothesis 1 predicts an interaction effect between CPA ERROR and TAX DAMAGES. Specifically, Hypothesis One predicts that when the legal requirements for a meritorious claim are present (CPA ERROR and TAX DAMAGES),
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Table 3. Panel A – Logistic Regression Compensatory Paymentsa = 0 + 1 (CPA ERROR) + 2 (TAX DAMAGES) + 3 (CPA ERROR × TAX DAMAGES) Independent Variableb
Intercept CPA ERROR TAX DAMAGES CPA ERROR × TAX DAMAGES
Wald Chi-Square
p-Value (Two-Tailed)
4.883 4.903 17.329 2.710
0.027 0.027 0.000 0.10
Model statistics Chi-square = 30.349, p-value = 0.000 Cox & Snell R2 = 0.289 % correctly classified = 77.5% Panel B – Percentage of Cases with Compensatory Payments by Condition CPA Error Damages Occurred
No
Yes
No Yes
17.6%c (n = 34) 70% (n = 30)
75% (n = 4) 82.4% (n = 17)
Total
42.2% (n = 64)
80.9% (n = 21)
Total 23.7% (n = 38) 74.5% (n = 47)
a The dependent variable, Compensatory Payments, is a dichotomous variable with a value of “1” when
compensatory payments occurred due to the claim and “0” otherwise. b The independent variables are as follows: CPA Error is valued at “1” if an insurance expert determined
that there was CPA error involved and zero otherwise; Tax Damages was valued at “1” if there was any cost to the client which was tax related (e.g. interest, penalties, additional taxes), and zero otherwise. c This condition had a significantly smaller occurrence of compensatory payments (p = 0.000).
the likelihood of compensatory payments being made to the client will increase. Logistic regression was used to explore the relationship between the independent variables and the dichotomous dependent variable. The results of this logistic regression are reported in panel A of Table 3. The regression correctly classified 77.5% of the claims, and the model chi-square statistic is significant at the 0.000 level. The main effects of both independent variables are significant, suggesting that each individual characteristic of claim merit increases the probability of compensatory payments. An error on the part of the CPA (CPA ERROR) was significant at p = 0.027, while the presence of damages (TAX DAMAGES) was significant at the p < 0.001 level. Hypothesis One predicts a significant interaction effect such that the probability of compensatory payments
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occurring are the largest when both CPA error and tax damages are present. Panel A of Table 3 shows a marginally significant interaction coefficient (p = 0.10). However, the effect is difficult to interpret given the dichotomous nature of the variables. To further explore the interaction effect, we report the percentage of claims receiving compensatory payments in each of the four possible conditions in Panel B of Table 3. An examination of these percentages reveals that rather than both conditions being necessary for compensatory payments to be made (i.e. both CPA error and tax damages), either factor is sufficient. That is, if there is CPA error only, tax damages only, or both, then compensatory payments are more likely to be made. This finding is not completely consistent with Hypothesis 1’s prediction that merit (as defined by case law) is necessary for compensatory payments to be made. However, the components of merit do matter, and when neither component is present, the percentage of claims with compensatory payments is significantly lower than in the other three conditions.
Hypothesis 2 Hypothesis 2 predicts that the existence of a meritorious case will affect the magnitude of compensatory payments made. To test this proposition, we use the dollar amount of compensatory payments made as the dependent variable. To control for the size of the claim, we include the amount of the compensatory payment requested (COMP REQUESTED) in the regression.8 The results of this regression are displayed in panel A of Table 4. Again, both independent variables representing merit have significantly positive main effects (CPA ERROR and TAX DAMAGES significant at p = 0.000 and p = 0.014, respectively). The interaction, as predicted by Hypothesis 2, also was significant (p = 0.051). Panel B of Table 4 provides the mean values of compensatory payments for the four possible conditions. An examination of the cell means reveals that the dollar amount of compensatory payments is consistent with the prediction of Hypothesis 2. Further, we do a contrast test comparing the mean compensatory payment where both CPA error and tax damages existed (cell 4) with the other three conditions. This contrast test is significant (p < 0.05), suggesting that claim merit, as defined by case law, is important in determining the magnitude of the compensatory payment. Although we do not consider hypotheses regarding the total cost of a malpractice claim, it is of interest to know how much (if any) the relationship between claim merit and cost is weakened by considering the cost to investigate and defend the claim. The total cost of the claim includes not just the amount paid to the client, but also the legal costs. As noted earlier, the legal costs are significant and amount
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Table 4. Panel A – Regression Results Compensatory Paymentsa = 0 + 1 (CPA ERROR) + 2 (TAX DAMAGES) + 3 (CPA ERROR × TAX DAMAGES) + 4 (COMP REQUESTED) Independent Variableb
Intercept CPA ERROR TAX DAMAGES CPA ERROR × TAX DAMAGES COMP REQUESTED
Coefficient Value
t-Statistic ( p-Value)
51,190 48,835 55,297 48,417 0.104
5.271 (0.000) 3.977 (0.000) 2.512 (0.014) 1.984 (0.051) 8.126 (0.000)
Panel B – Average Amount of Compensatory Payments by Condition CPA Error Damages Occurred
No
Yes
No Yes
$12,794 (n = 34) $19,845 (n = 30)
$2,250 (n = 4) $62,921c (n = 17)
Total
$16,099 (n = 64)
$51,365 (n = 21)
Total $11,684 (n = 38) $35,425 (n = 47)
Note: Model R 2 = 0.539 (p-value = 0.000). a The dependent variable, Compensatory Payments, is the dollar amount of compensation paid to the client by the accountant and/or insurance carrier. b The independent variables are as follows: CPA Error is valued at “1” if an insurance expert determined that there was CPA error involved and zero otherwise; Tax Damages was valued at “1” if there was any cost to the client which was tax related (e.g. interest, penalties, additional taxes) and zero otherwise; Compensation Requested is the dollar amount of compensation originally requested by the client. c This cell was significantly larger than the other three cells (p < 0.05).
to 35% of the total cost of the claim. Results from a regression using the same independent variables used to test Hypothesis 2 with total costs as the dependent variable showed that “Compensation Requested” and “CPA Error” were the only significant variables (R 2 = 0.593). The coefficient for CPA Error was very similar to that reported in Table 4 ($48,135), while the coefficient for “Compensation Requested” increased to 0.180 (or 80% higher than in Table 4). Additionally, TAX DAMAGES and the interaction term were no longer significant. We conclude from this analysis that while merit is significantly related to the amount of compensatory payment made to the client, it would appear that the size of the compensation requested drives the amount of effort that is expended to defend the claim, and thus the total costs.
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Additional Analyses Though not the primary focus of this study, we also consider six other possible influences on malpractice claim outcome. We examined four non-merit variables suggested by prior accounting research: firm size, tax professional experience, client relationship, and engagement letter. We examined one legal issue, contributory negligence; and finally we analyzed the effect of the presence of “non-tax” issues that led to claims on the likelihood and magnitude of compensatory payments. Firm size, tax professional experience, and client relationship were suggested by prior audit research. Firm size is measured as number of employees. Experience is measured as the tax professionals’ years of experience. We use length of relationship (client tenure) as our client relationship variable.9 Due to data limitations, this variable is treated as an indicator variable.10 Prior tax research showed an influence on likelihood to sue based on the wording of the engagement letter (Krawczyk & Sawyers, 1995). Additionally, a number of commentators suggest that the use of engagement letters will reduce the likelihood and/or cost of a malpractice claim (e.g. Bandy, 1996; Stimpson, 2001; Williams, 1997). We include a variable, “engagement letter” that was coded one if the services were covered by an engagement letter, otherwise it was coded, zero. As noted earlier, a few of the accountants (17%) in our sample indicated that the reason the client incurred damages was not because the tax professional had made an error, but instead because the client had provided the accountant with erroneous information. The legal precedent surrounding contributory or comparable negligence is complex and differs somewhat by jurisdiction (Anderson, 1991). However, there is some recognition by the courts that the accountant should not be held fully responsible if the client’s negligence contributed to the accountant’s error (Steiner Corp. vs. Johnson & Higgins, 1998). Although our measure may be influenced by the involved accountant’s bias, it provides the best available measure of the quality of the client-provided information. Accordingly, the variable CLIENT BAD INFO was set to one if the accountant alleged that the client provided incomplete or inaccurate information. If no such allegation was made, the variable was set to zero. Thus, we use this variable, CLIENT BAD INFO, as an initial exploration of whether or not contributory negligence is related to the outcome of tax malpractice claims. Finally, although not explicitly suggested by prior accounting research, we also investigated the phenomena of tax malpractice claims arising from non-tax issues. We consider a variable labeled FEE/TAX DISPUTE, because as noted earlier, we observed that there were a number of claims that arose either because the client was unhappy with the fees charged by the accountant or with the amount of taxes
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he/she had to pay. This variable was coded one if there was evidence of either of these concerns; otherwise it was coded zero. We performed three analyses with these six variables. For the dichotomous variables, we performed univariate t-tests comparing the percentage of claims with compensatory payments and the dollar amount of compensatory payments at each level of the independent variable. Second, we added these six variables to the logistic regression reported in Table 3 to see if any of these variables improved the predictive ability of this model; and third, we added these six variables to the regression model reported in Table 4 to see if any of these variables were significant in explaining the dollar amount of the compensatory payment. The univariate results are reported in Table 5. The means for relationship, CLIENT BAD INFO and FEE/TAX DISPUTE were significantly different between the groups of claims (although the FEE/TAX DISPUTE difference was not significant for the dollar amount). Table 5 shows that a longer relationship is
Table 5. Additional Variables – Univariate Tests. Independent Variablea
% of Claims with Compensatory Payment
Average Dollar Amount of Compensatory Payment
Relationship < 4 years 4 years or more p-value for difference
37.2% 65.8% 0.007
$11,397 $42,215 0.02
Engagement letter Yes No p-value for difference
52% 50% 0.850
$20,308 $32,302 0.367
Client bad info Yes No p-value for difference
13.3% 56.8% 0.000
$3,214 $29,071 0.001
Fee/Tax dispute Yes No p-value for difference
29.0% 60.3% 0.004
$13,418 $30,360 0.186
a Relationship
refers to the length of the accountant/client relationship; Engagement Letter refers to the presence or absence of an engagement letter between the accountant and the client; Client Bad Info refers to whether or not the accountant alleged that the client provided incomplete or inaccurate information; and Fee/Tax Dispute refers to whether or not the claim, at least partially, arose because of a fee dispute or a client disgruntled about paying taxes.
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associated with a greater likelihood of compensatory payments. While that is in contrast to prior research which showed that errors were more likely to occur with new clients (St. Pierre & Anderson, 1984), further analysis of the data explains the result. Claims involving clients with long relationships were more likely to have resulted from an IRS Audit (71% for long relationships vs. 28% for shorter relationships), and thus more likely to be deemed to have actual damages incurred by the taxpayer (71% for long relationships vs. 43% for shorter relationships). Therefore, our tentative conclusion is not that clients who have a long tenure are more likely to sue, but instead, that claims by clients with a long tenure are more likely to be meritorious. Regarding CLIENT BAD INFO, both the percentage of claims with compensatory payments (13.3% vs. 56.8%) and the dollar amount of compensatory payments ($3,214 vs. $29,071) were significantly lower in claims where the accountant alleged that the client had provided incomplete or erroneous information. This suggests either that these claims were less likely to be meritorious, and/or that the legal concept of contributory negligence served to reduce the liability of the accountant. Similarly, when the claim involved a fee or tax dispute, it was much less likely to result in compensatory payment (29% vs. 60.3%), and although the dollar amount of the claims was lower when the FEE/TAX DISPUTE variable was “yes,” the difference was not statistically significant. This seems to imply that a number of unsuccessful claims arise, not as a result of actual error on the part of the accountant or damages, but because of general dissatisfaction on the part of the client. For the subset of claims where fees were at issue and no compensatory payments were made, the cost to settle the claims was still over $2,000 (and this amount does not include any foregone fees, which often were waived in these cases). When these variables were added to the logistic regression from Table 3, only the relationship variable significantly affected the result.11 The p-value of the relationship variable was 0.053, the Cox and Snell R2 of model improved to 0.373, and the predictive ability of the model increased to 80.9%. However, none of the additional variables were significant when they were added to the Compensatory Payment regression from Table 4. In summary, after considering a number of variables suggested by prior research, we conclude that while a few of these variables (i.e. relationship, CLIENT BAD INFO, and TAX/FEE DISPUTE) are related to claim outcome, the components of claim merit, (CPA Error and Tax Damages) appear to be the primary determinants of claim outcome. Additionally, one could argue that the pattern of influence of relationship, CLIENT BAD INFO and TAX/FEE DISPUTE is consistent with all three of these variables being additional proxies for the merit of the claim.
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Limitations This study is only a first step to understanding malpractice claims involving tax professionals. It is limited by the data set. The data set has only 89 claims from one insurer. In addition, all of the claims came from small firms, thus we were unable to test a “deep pockets” hypothesis, which is a prominent issue in auditing research. Also, with regard to the contrast test done for Hypotheses 1 and 2, small cell size and the noise of the control for size should be considered when interpreting our results.
CONCLUSIONS AND FUTURE RESEARCH Legal precedent would suggest that no client should be able to successfully sue his/her tax accountant unless there are both error on the part of the accountant and damages sustained by the client as a result of that error. However, recent audit research has been unable to find a significant link between case merit and case outcome. The results of our test of merit differ somewhat depending on whether we consider the occurrence of compensatory payments or the magnitude of compensatory payments. When considering the occurrence of compensatory payments, the pattern of results suggests that either error or damages are required to result in compensatory payments being made to the client. The hypothesized interaction effect is not significant when assessing the presence of compensatory payments. However, it does appear that merit has a significant effect on the magnitude of payments made. Compensatory payments made in claims having both CPA error and tax damages were significantly larger than payments made for other claims (more than four times larger). However, it should be noted that claims lacking either characteristic still resulted in an average compensatory payment of $12,794. While these results are mixed, we believe they do represent a positive and significant development in the study of merit in accountant malpractice. We were able to clearly specify the determinants of a meritorious malpractice claim based on legal precedent, develop adequate proxies for these determinants, and identify statistically and practically significant results. In addition, we considered a number of other possible influences on claim outcome suggested by prior research and observations from our data set. Only one of these additional variables, the length of the relationship with the client, had a significant effect on the likelihood of compensatory payments, and none of them had a significant effect on the dollar amount of the payment. Additionally, the nature of the effect is not inconsistent with our findings regarding claim merit.
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Future research is necessary to better understand the area of tax professional malpractice. Data from a larger number of claims and a wide range of accounting firm sizes would enrich the results. It is certainly possible, for example, that merit would not be such a dominant determinant of compensatory payments if the accounting firms involved had much deeper pockets. Additionally, we noted that the concept of “tax damages” is not homogenous. There is a wide variety of explicit and implicit financial costs (e.g. present value of future taxes, unnecessary transaction costs, etc.) that the client may incur when the accountant makes an error. Future research examining the make-up and potential magnitude of damages suffered by the client could be helpful to both our understanding of the effect of damages on claim outcome and to accountants in helping to improve their work product. Also, it is necessary to investigate the threshold question of why a claim is brought against a tax accountant. Audit and medical research have investigated the characteristics of situations that lead to a lawsuit as well as characteristics of professionals who are sued. Finding evidence about tax accountant litigation in this context might be helpful in reducing the number of tax claims filed.
NOTES 1. This is not merely a size effect. Claims for which both tax professional error and damages occurred had damage payments averaging 49.5% of the amount requested, compared to 19.1% for all other claims (over 2 21 times as much). 2. In addition to breach of duty and damages caused by the breach of duty, there are two other technical, although less interesting requirements. There must be an “accountantclient” relationship, and the accountant must have a duty to provide some service to the client as a result of that relationship. 3. Case law actually considers the second requirement that we mention, “damages as a result of the breach of duty” as two separate issues: damages and proximate cause. Proximate cause means that there must be a connection between the loss suffered by the client (the damages) and the accountant’s error (breach of duty). We do not try to disentangle damages and proximate cause. 4. The files included some cases (27 claims) where the accountant reported a potential claim to the insurance company but no claim was ever filed because the client did not pursue the matter. These files included less information since the insurance company never hired an expert to evaluate the situation. These claims are included with the dropped claims in the analysis. Results are not changed by removing these 27 cases from the analysis. 5. Other non-tax issues that we observed included the accountant being caught in the middle of a dispute between two parties (e.g. in a divorce), the client looking for “deep pockets,” and embezzlement by an employee of the client. 6. While data are clear as to whether the tax filing was inappropriate, there is not always a clear indication in the data whether the tax accountant error led to the improper filing or whether a taxpayer error led to the problem.
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7. For example, one claim involved accounting for an estate that was done improperly and the client sued for fees paid to a new accountant to correct the errors. Another case involved bad advice given to the client to retire early, who then lost 18 months of wages. A third example involved a rather minor error on the part of the tax professional; however, the result was a substantial delay in the client’s refund, which reduced their ability to pay off other obligations. 8. For this analysis, seven claims were omitted. Five were omitted because there was not a specific dollar request made. Two were omitted because the dollar requests were extreme outliers (e.g. a $30 million request for a claim with no actual damages). 9. In addition to the length of the relationship between a client and a tax professional, the breadth of the relationship also could be considered. We did have information about whether the tax professional provided services to the client in addition to tax services. However, length of relationship and “other services” were correlated [Pearson correlation coefficient = 0.420 (p-value = 0.000)], so we include only one of these variables in the regression (results are the same regardless of which one is used). 10. If there was evidence that the client had been with the tax professional for more than 3 years, client tenure was coded “1,” otherwise it was coded, “0.” While this is a somewhat arbitrary choice, in an audit setting, St. Pierre and Anderson (1984) defined a new client to be a client of three years or less. 11. FEE/TAX DISPUTE and CLIENT BAD INFO were marginally significant at 0.109 and 0.104, respectively, and the model performed better with their inclusion, than without them.
ACKNOWLEDGMENTS The authors are grateful to CPA Mutual Insurance for access to their files and data. The first author is grateful to the PriceWaterhouseCoopers Foundation and the UCF College of Business for financial assistance. Helpful comments from Robin Roberts, Dale Bandy, Jack Kramer, two anonymous reviewers and the editor are appreciated.
REFERENCES Alexander, J. C. (1991). Do the merits matter? A study of settlements in securities class actions. Stanford Law Review, 43(2), 497–598. Anderson, S., & Wolfe, J. (2001). Accountants’ liability: Where are claims coming from? The Ohio CPA Journal, 60(4), 21–24. Anderson, T. (1991). Tax practitioner malpractice litigation: Exposure and risk management. The Ohio CPA Journal, 50(4), 30–35. Arthur Andersen & Co., Coopers & Lybrand, Deloitte & Touche, Ernst & Young, KPMG Peat Marwick and Price Waterhouse (1992). The liability crisis in the United States: Impact on the accounting profession, a statement of position. Bandy, D. (1996). Limiting tax practice liability. The CPA Journal, 66(5), 46–50.
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Carcello, J. V., & Palmrose, Z. V. (1994). Auditor lititagion and modified reporting on bankrupt clients. Journal of Accounting Research, 32(Suppl.), 1–30. Demery, P. (1995). Horror stories from the files of professional liability insurers. The Practical Accountant, 28(11), 24–35. Donnelly, W., & Miller, G. (1990). Tax practice areas where an accountant is most likely to face malpractice claims. Taxation for Accountants, 44(3), 162–166. Donnelly, W., & Miller, G. (1995). Malpractice claims more likely in certain tax areas. Taxation for Accountants, 54(5), 285–290. Donnelly, W., O’Callaghan, S., & Walker, J. (1999). Top 10 tax claims. Journal of Accountancy, 187(2), 57–59. Dunbar, F. C., Juneja, V. M., & Martin, D. N. (1995). Shareholder litigation: Deterrent value, merit and litigants’ options. National Economic Research Associates, Inc. (NERA). Holub, S. (2001). Avoiding tax malpractice. The Tax Adviser, 32(12), 854–856. Kahan, S. (1999). When an engagement snaps. The Practical Accountant, 32(11), 71–75. Kinney, W. R. (1993). Auditors’ liability: Opportunities for research. Journal of Economics & Management Strategy, 2(3), 349–360. Krawczyk, K., & Sawyers, R. B. (1995). The effect of magnitude of IRS assessment and engagement letters on tax preparer liability. Journal of the American Taxation Association, 17(2), 71–88. Lys, T., & Watts, R. (1994). Lawsuits against auditors. Journal of Accounting Research, 32(Suppl.), 65–93. Palmrose, Z. (1988). An analysis of auditor litigation and audit service quality. The Accounting Review, 63(1), 55–73. Palmrose, Z. (1991). Trials of legal disputes involving independent auditors: Some empirical evidience. Journal of Accounting Research, 29(Suppl.), 149–186. Palmrose, Z. (1994). The joint & several vs proportionate liability debate: An empirical investigation of audit-related litigation. Stanford Journal of Law, Business & Finance, 53–72. Palmrose, Z. (1997). Audit litigation research: Do the merits matter? An assessment and directions for future research. Journal of Accounting and Public Policy, 16, 355–378. Rockler vs. Glickman 273 N. W. 2d 647. (1978, Minnesota). Russell, R. (2002). Independent practitioners make over half their earnings from tax preparation. Accounting Today, 16(Fall), 6–7. Schisler, D., & Galbreath, S. C. (2000). Responsibility for tax return outcomes: An attribution theory approach. Advances in Taxation, 12, 173–204. St. Pierre, K., & Anderson, J. A. (1984). An analysis of the factors associated with lawsuits against public accountants. The Accounting Review, 59(2), 242–263. Steiner Corp. v. Johnson & Higgins. 135 F.3d 684; (1998 U.S. Tenth Circuit Court of Appeals). Stice, J. D. (1991). Using financial and market information to identify pre-engagement factors associated with lawsuits against auditors. The Accounting Review, 66(3), 516–533. Stimpson, J. (2001). 21 tips for managing risk. Practical Accountant, 34(10), 36–41. Williams, S. (1997). The importance of engagement letters. The National Public Accountant, 42(4), 31–32. Yancey, W. (1996). Managing a tax practice to avoid malpractice claims: Learning from past disasters. The CPA Journal, 66(2), 12–17.
AN EMPIRICAL ASSESSMENT OF SHIFTING THE PAYROLL TAX BURDEN IN SMALL BUSINESSES Ted D. Englebrecht and Timothy O. Bisping ABSTRACT Prior studies on the social security tax have focused on it being regressive; a system that is detrimental to savings in the United States; a system that will bankrupt itself; and a host of economic inquiries examining labor market and product demand elasticities and the impact of the substitution effect. However, there is scant evidence on the shifting mechanisms employed by the owners of millions of small businesses in the United States. As a result, this study revisits the issue by surveying 4,431 small businesses in Arkansas, Louisiana and Mississippi (ArkLaMiss). Results indicate, in the ArkLaMiss area, that the largest share of the tax burden is borne by customers. When compared to past literature, a relatively larger portion of the incidence of payroll taxes is likely to fall on employees in the ArkLaMiss, as opposed to the burden being borne by firms and customers. Also, stronger anti-tax sentiment was noted in the ArkLaMiss as compared to prior literature. Little support was found for the proposition that firm size impacts the incidence of taxation. On the other hand, statistical analysis indicates that the industry within which a firm operates was influential in the incidence of taxation. Moreover, in the sample, the banking/financial industry passed the largest percentage of the tax on to employees, the public accounting profession passed the largest percentage on
Advances in Taxation Advances in Taxation, Volume 16, 25–54 Copyright © 2004 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(04)16002-X
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to customers, and the legal profession bore the largest share of the tax in the form of reduced profit.
INTRODUCTION In 1935, The Federal Insurance Contribution Act (commonly called the Social Security Tax) was passed. Even though the act has been in effect for almost 70 years, it is still as controversial as it was when enacted. Specifically, its critics charge that the social security system will be bankrupt by 2032 (Elias, 1998); it is the fastest growing tax, in dollar terms, in the U.S. system of taxes (Englebrecht et al., 2001); it is a regressive tax (Iyer, 1994; Pechman, 1987); it hampers savings (Barro, 1978; Feldstein, 1996); and the tax burden is passed on to either consumers (Pechman et al., 1968) or employees from businesses (Brittain, 1971; Ferrara, 1980). In regard to the first four charges, there is ample evidence to support those assertions. However, it is still uncertain as to the actual payroll tax burden (Brittain, 1972; Iyer, 1994). Although one-half of the payroll tax is paid by the employee and one-half by the employer, this is just the statutorily mandated split. That is, the actual burden may be different due to shifting mechanisms. Specifically, the employer may shift the burden in the form of higher prices to consumers and/or in the form of lower wages to employees. Consequently, it is the intent of this article to assess the payroll tax burden on small businesses. In this regard, responses were solicited from small business owners to gauge whether business managers believe the payroll tax is shifted forward, backward, or supported by business profits. The remainder of this article is organized as follows. First, an insight into the background literature is provided. This is followed by an explanation of the research design and data collection method. The third section presents the results and analysis of the study. In the final section, conclusions, limitations and suggestions for future research are provided.
BACKGROUND Payroll Taxes The Federal Insurance Contributions Act (FICA) finances three social insurance programs that most taxpayers think of as Social Security. First, the Old Age and Survivors’ Insurance (OASI) program that provides cash benefits to retired workers and their families, and to surviving dependents of deceased workers. Second,
An Empirical Assessment of Shifting the Payroll Tax Burden in Small Businesses
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the Disability Insurance (DI) program which supplies cash benefits to disabled workers and their families. Last, the Health Insurance (HI) program, popularly called Medicare, that provides for both hospital and physician reimbursements. The total FICA tax rate is currently 7.65%. This rate is broken into two components: Social Security tax (old age, survivors, and disability insurance) and Medicare tax (hospital insurance). In 2003, the Social Security tax rate was 6.2% with a base amount of $87,000 and the Medicare tax rate was 1.45% with no limit on the base amount. Also, the employer must match the employee’s portion for both Medicare and Social Security taxes. In 1937, the initial social security rate was only 1% on a base amount of $3,000. Of course, the rate and base amounts have grown since that time.
Prior Research In recent years, studies that dealt with the social security system have concentrated primarily on the benefit side of the system. As a result, little attention has been directed toward analysis of the effects of payroll taxation. Brittain (1972), Ricketts (1990), Iyer (1994), and Englebrecht et al. (2001)1 are the four most important inquiries dealing with payroll taxation that have a tangential bearing on the current study. However, only one of the studies, EHI (2001), is directly related to this study’s research questions. Each of these prior studies is summarized in turn. Brittain’s Study. The first extensive study on the effects of payroll taxes was by Brittain (1972). In addition to evaluating the equity effects of payroll taxes, Brittain’s study contained an in-depth evaluation of financing social security benefits through a regressive payroll tax. Even though the data consisted of actual individual tax returns, the study was set in the 1960s when the payroll tax rate was much lower and the underlying income tax structure was much different from what it is today. No equity measures were computed, merely the effective tax rates of various families of different sizes were provided. The horizontal equity effects of the social security taxes also were not investigated. Moreover, no effort was made to isolate the effects of changes in the payroll tax structure on small businesses. Notwithstanding its numerous deficiencies, it is considered a seminal study in the analysis of payroll taxes and over time has provided invaluable guidance in evaluating the social security system. Ricketts’ Study. Ricketts (1990) investigated the vertical and horizontal equity effects of the combined impact of payroll and income taxes for the years 1980, 1984, and 1988. The information on the tax liabilities for 1980 and 1984 was directly available, but the 1988 tax liabilities were simulated on the 1984 income distribution. Only the Suits index was employed as a measure of vertical equity,
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while the coefficient of variation was used as a measure of horizontal equity. Ricketts found that the regressive effects of social security taxes dominated the progressive effects of individual income taxes. However, no attempt was made to incorporate the effect on small businesses related to payroll tax increases. Iyer’s Study. The primary objective of Iyer’s study (1994) was to comprehensively evaluate the horizontal and vertical equity effects of the growth in payroll taxation between 1984 and 1993. To accomplish this goal, a sample of taxpayers was collected from the IRS panel of individual taxpayers for the years 1984 through 1988. Also, mean income distributions were generated from these years on which the income and payroll tax liabilities were simulated for the years 1989–1993. The findings suggested that the payroll tax was a regressive tax for the period of 1984 through 1993. In fact, the regressive effects of the payroll tax dominated the progressive effects of the income tax. In regard to horizontal equity, the results were mixed. Moreover, as Iyer (1994) pointed out, the incidence of the payroll tax burden has remained an unresolved controversy. EHI Study. This study is very different from the prior payroll tax studies. Unlike those studies, EHI focused on the issue of shifting mechanisms employed by small businesses in light of payroll tax increases. An innovation of the EHI study is that it allowed for the burden of the tax to be borne by labor, consumers, or firms, whereas past work has typically assumed the burden falls solely on labor. Responses were elicited from 1440 small business owners in the Hampton Roads area of Virginia to ascertain whether the payroll tax is shifted by passing it on to the consumer by way of increased prices, passing it on to the employee by way of reduced wages, or absorbed by the business in the form of reduced profits. The resulting sample of 182 small business owners in EHI revealed that, in general, small businesses are not likely to shift the employer’s share of the tax burden to employees. That is, the most utilized option in dealing with payroll tax increases was to increase prices for their products/services. Past work on payroll tax incidence has largely focused on the burden borne by employees, due in part to the theoretical focus in this area (it is simply a foregone conclusion in many studies), and perhaps due to data limitations. Through the use of survey data, EHI expanded on previous work by incorporating the potential burden of other groups. Additionally, the survey data gathered by EHI provided not only new data, but also data from a valuable new source, that being, the opinions of business managers. This current study extends EHI by utilizing a three state area, as opposed to the limited metropolitan area in Southeast Virginia used by EHI. Specifically, the survey is three times larger than the above study. Additionally, it expands the types of data analysis performed by EHI (2001) and uses measures of vertical equity.
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Theoretical Background As stated previously, the burden of payroll taxes may be shifted to employers or consumers rather than being borne entirely by the firm. As economists have pointed out extensively, the degree to which either of these occurs depends upon the nature of the relevant markets. In this case, two markets come into play. When determining the degree to which labor will bear the burden of a payroll tax, one must consider the nature of the labor market in which the firm is operating. Also, in determining the degree to which consumers will bear the burden of a payroll tax, one must consider the nature of the product market. According to economic theory, the degree to which firms are able to successfully pass a tax on to other parties depends on the nature of demand and supply elasticities in these markets. In terms of the labor market, if for example, the employer faces market conditions represented by a situation where the supply of labor is relatively inelastic, then the firm will find it easier to pass that tax on to employees, and, as a consequence, employees will bear a relatively larger share of the burden of the tax. However, when firms face a relatively elastic supply curve, they will find it more difficult to pass such a tax on to employees without triggering a large supply response. In turn, employees will bear a relatively smaller share of the burden of the payroll tax (Gruber, 1997). The share of a tax that is passed to consumers is analyzed in a similar fashion. To the extent that the entire burden of the tax is not shifted to employees, the question arises as to whether firms can pass this increased cost on to consumers. In general, there is consensus among economists that market elasticities are key determinants of a firm’s ability to pass such a tax on to consumers. As a result, an increase in payroll taxes will increase the cost of producing any given level of output for a firm, thereby triggering a supply response by the firm. Within the context of the market, this supply response will yield a change in the market equilibrium, the exact nature of which once again depends on the relative elasticities of supply and demand. In this case, where supply is relatively more elastic than demand, consumers will end up bearing a relatively larger share of the tax burden. On the other hand, if demand is relatively more elastic than supply, then the opposite is true. It is clear that elasticities play a key role in determining the burden of taxation. However, the extent to which the tax is actually passed on to labor, for instance, is not widely agreed upon by economists. Even though tentative conclusions reached by economists suggest that most of the tax will be passed to employees in the form of lower wages, there is no general consensus (Hamermesh, 1993). In the current study, we take a somewhat different approach and attempt to determine the opinion of firms regarding the incidence of a payroll tax. In essence, this question is equivalent to asking firms to reveal their beliefs regarding labor market and
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TED D. ENGLEBRECHT AND TIMOTHY O. BISPING
product market elasticities. If, for example, firms were to state that they felt that most of a payroll tax would be passed to employees, this would be consistent with a firm believing that the labor demand is relatively more elastic than the labor supply. Although we ask nothing specifically about elasticities in our survey, our results implicitly reveal the firm’s beliefs regarding labor market and product market elasticities.
RESEARCH METHOD Data Base In order to compile the data necessary to analyze payroll tax incidence in the case of small businesses, a survey was mailed to randomly-selected small businesses in Arkansas, Louisiana and Mississippi in the Spring of 2002. The questionnaire itself is an augmented version of the one used by EHI (2001). The use of this questionnaire provides not only the data necessary for a thorough analysis of the respondents’ perceptions of tax incidence, but it also provides an ideal situation for comparison to this past work, and the opportunity to examine the associated implications for the degree to which previous results can be generalized.
SAMPLE SELECTION AND DESCRIPTIVE MEASURES Small businesses in Arkansas, Louisiana and Mississippi receiving the questionnaire were randomly chosen from those small businesses listed in the Corporate America database (Thomson, 2001). For our purposes, a small business was defined as one with fewer than 100 employees and less than $5,000,000 in annual sales. In this tri-state region, a total of 9,557 firms met these criteria. Of these firms, 4,779 were selected to be surveyed, accounting for 50% of the population. Of the total number, 1,181 surveys were mailed to firms in Arkansas, 2,386 to Louisiana and 1,212 to Mississippi; these numbers correspond to each state’s proportion in the total population. A total of 348 surveys were returned as undeliverable (119 from Mississippi, 136 from Louisiana and 93 from Arkansas), leaving a total relevant mailing of 4,431. Of the 4,431 surveys mailed, 413 were returned in usable form, for an overall response rate of 9.32%. The response rates for Louisiana, Mississippi and Arkansas were respectively 10.58%, 7.91%, and 8.13%.2 Where possible, the characteristics of the sample were compared to the characteristics of the population, and it was found that the characteristics of
An Empirical Assessment of Shifting the Payroll Tax Burden in Small Businesses
31
the sample roughly correspond to those of the population, though Louisiana was slightly over represented. As is the case in most surveys, complete anonymity was guaranteed to all firms. An attempt was made to make the survey as concise, yet complete, as possible while avoiding any information deemed highly sensitive to the firm in order to maximize the resulting response rate. The questionnaire itself was nearly identical to that of EHI, which therefore allows for direct comparison to this research. (The questionnaire is presented in the Appendix.) However, the EHI sample covered only one metropolitan area in Virginia, whereas this current work covers the entire Arkansas-Louisiana-Mississippi area (hereafter referred to as the ArkLaMiss). The first two questions of the survey were designed to gather the opinions of firms regarding who should have to pay payroll taxes. In Part One of the survey, questions three and four deal with firms’ perceptions on whether the current payroll tax system is fair. Question five is a new question that pertains to the role of information technology in the payroll tax system. Part Two deals with how an employer would react to a one percentage point increase in the payroll tax in terms of changing product/service prices, changing employee pay or changes in profits. These questions are designed to directly measure the likelihood that the incidence of an increase in the payroll tax will fall on consumers, employees or firms. Part Three asks the firms to specifically allocate a new $1,000 payroll tax among employee pay, profit and product/service price. This question is extremely valuable in that firms are asked to provide specific dollar amounts, thereby making the incidence of the tax quantifiable. Part Four of the questionnaire is designed to gather demographic and other general information regarding firms. This information allows one to examine, for instance, whether firms bear more of the burden of a tax in one industry relative to other industries, or if perhaps the smallest firms bear the largest burden on a relative basis.
RESULTS Our results are based on an analysis of the data collected in the context of economic theory regarding tax incidence. The primary purpose here is twofold. First, while much of the theoretical work in the literature would suggest that the incidence of a tax varies with market conditions, little has been done to examine this using survey techniques. Two important aspects of these conditions available in our dataset include the industry within which a firm operates and the size of the firm. Here we examine the incidence of payroll taxes broken down according to industry and firm size in order to ascertain the impact of these market conditions. Second, a direct comparison to the EHI study provides insight into the degree to which we can generalize from our results, or the degree to which incidence of payroll taxes
32
TED D. ENGLEBRECHT AND TIMOTHY O. BISPING
Table 1. Classification by Industry. Industry
Total
Mississippi
Arkansas
Louisiana
EHI
Freq.
%
Freq.
%
Freq.
%
Freq.
%
Freq.
%
Manufacturing Banking/Financial Insurance Architectural/Engineering Legal Public accounting Construction Real estate Communications Health care Hotels/Restaurants Computer software Marketing/Advertising Public utilities Research/Development Transportation Wholesale distribution Retail trade Government – Federal Government – State Government – Local Non-Profit organization Other (service & farm) 24 hour Not reported
31 6 12 10 7 9 42 10 5 54 47 1 5 3 1 15 8 35 1 2 3 20 83 0 3
7.6 1.5 2.9 2.4 1.7 2.2 10.2 2.4 1.2 13.2 11.5 0.2 1.2 0.7 0.2 3.7 2.0 8.5 0.2 0.5 0.7 4.9 20.2 0.0 –
6 1 2 2 0 5 6 2 2 14 9 0 1 0 0 4 2 7 0 0 1 2 17 0 1
7.2 1.2 2.4 2.4 0.0 6.0 7.2 2.4 2.4 16.9 10.8 0.0 1.2 0.0 0.0 4.8 2.4 8.4 0.0 0.0 1.2 2.4 20.5 0.0 –
6 2 4 1 1 0 9 3 0 9 10 0 2 2 0 2 2 10 1 2 1 6 17 0 1
6.7 2.2 4.4 1.1 1.1 0.0 10.0 3.3 0.0 10.0 11.1 0.0 2.2 2.2 0.0 2.2 2.2 11.1 1.1 2.2 1.1 6.7 18.9 0.0 –
19 3 6 7 6 4 27 5 3 31 27 1 2 1 1 9 4 18 0 0 1 12 50 0 1
8.0 1.3 2.5 3.0 2.5 1.7 11.4 2.1 1.3 13.1 11.4 0.4 0.8 0.4 0.4 3.8 1.7 7.6 0.0 0.0 0.4 5.1 21.1 0.0 –
17 2 1 6 3 3 21 8 1 15 16 2 4 0 0 4 9 17 3 0 1 16 31 1 1
9.3 1.1 0.5 3.3 1.6 1.6 11.5 4.4 0.5 8.2 8.8 1.1 2.2 0.0 0.0 2.2 4.9 9.3 1.6 0.0 0.5 8.8 17.0 0.5 –
Total reported
410
100
83
100
90
100
237
100
181
100
may vary by region. Tables 1 through 7 provide a summary of our results in the aggregate as well as by state, along with a comparison to past research. Tables 8–10 provide more detailed statistical analysis.
Descriptive Statistics Table 1 deals with the distribution of our sample by industry. The implications of this table are substantial as the firm’s industry is one of the variables chosen to proxy for those market conditions suggested by economists to influence the incidence of taxation. In turn, any comparisons across states, or studies, will be impacted by this distribution. By examining the most prevalent industry classifications, it is apparent
An Empirical Assessment of Shifting the Payroll Tax Burden in Small Businesses
33
Table 2. Classification by Annual Revenue. Total
Arkansas
Louisiana
Mississippi
EHI
Freq.
%
Freq.
%
Freq.
%
Freq.
%
Freq.
%
Annual revenue <1 million 1 million-10 million 11 million-25 million 26 million-50 million 51 million-100 million 101 million-250 million 251 million-500 million 501 million-1 billion >1 billion Not reported
89 264 19 7 0 10 2 2 7 13
22.3 66.0 4.8 1.8 0.0 2.5 0.5 0.5 1.8 –
21 56 7 0 0 3 1 0 0 3
23.9 63.6 8.0 0.0 0.0 3.4 1.1 0.0 0.0 –
48 158 9 4 0 5 1 1 5 7
20.8 68.4 3.9 1.7 0.0 2.2 0.4 0.4 2.2 –
20 50 3 3 0 2 0 1 2 3
24.7 61.7 3.7 3.7 0.0 2.5 0.0 1.2 2.5 –
35 113 16 4 3
19.6 63.1 8.9 2.2 1.7
8 3
4.5 –
Total reported
400
100.0
88
100.0
231
100.0
81
100.0
179
100.0
Classification by number of employees Number of employees <10 11–25 26–50 >50 Not reported
36 135 158 79 5
8.8 33.1 38.7 19.4 –
5 31 30 24 1
5.6 34.4 33.3 26.7 –
23 73 106 33 3
9.8 31.1 45.1 14.0 1.3
8 31 22 22 1
9.6 37.3 26.5 26.5 –
10 44 72 56 0
5.5 24.2 39.6 30.8 –
Total
408
100.0
90
100.0
235
100.0
83
100.0
182
100.0
that a certain degree of uniformity exists. The “other services and farm” is easily the largest group in each state, as well as in the EHI study. After this category, in the ArkLaMiss sample Hotel/Restaurant, Health Care, Construction, Retail Trade and Manufacturing are the predominant industries. This differs slightly from the EHI study in that the ordering varies, even though the make-up of top six industries is equivalent. Since a slight variation exists, a closer look at the numbers reveals that the share of the largest categories are fairly consistent across states and the two studies as the difference in percentage terms is fairly small. This examination of the major categories reveals that while slight variation in industry distribution exists between samples, nonetheless, the overall distribution is reasonably consistent. This bodes well not only for a comparison of tax incidence across states but also across studies. Tables 2 and 3 deal with another potential proxy for the market conditions faced by a firm. All else equal, firm size may very well correspond to the degree of market power a firm enjoys. Although this is not a perfect proxy, it can be argued
34
TED D. ENGLEBRECHT AND TIMOTHY O. BISPING
Table 3. Who Should Pay the Payroll Tax? Who should pay the payroll tax?
Panel A Need not pay if number of employees <5 Need not pay if number of employees <10 Need not pay if number of employees <15 Need not pay if number of employees <20 Need not pay if number of employees <25 Need not pay if number of employees <30 Need not pay if number of employees <35 Need not pay if number of employees <40 Need not pay if number of employees <45 Need not pay if number of employees <60 Need not pay if number of employees <80 Need not pay if number of employees <100 Everyone must pay some payroll tax Not reported Total reported Panel B Need not pay if annual revenues <20 thousand Need not pay if annual revenues <40 Need not pay if annual revenues <60 Need not pay if annual revenues <80 Need not pay if annual revenues <100
Total
Arkansas
Freq.
%
Freq.
%
24
6.0
6
7.0
37
9.2
5
9
2.2
22
Louisiana Freq.
Mississippi
%
Freq.
%
8
3.4
10
12.0
5.8
21
9.1
11
13.3
0
0.0
9
3.9
0
0.0
5.5
5
5.8
13
5.6
4
4.8
31
7.7
5
5.8
20
8.6
6
7.2
13
3.2
3
3.5
6
2.6
4
4.8
5
1.2
1
1.2
4
1.7
0
0.0
9
2.2
0
0.0
6
2.6
3
3.6
3
0.7
1
1.2
1
0.4
1
1.2
6
1.5
1
1.2
4
1.7
1
1.2
1
0.2
1
1.2
0
0.0
0
0.0
50
12.5
16
18.6
26
11.2
8
9.6
191
47.6
42
48.8
114
49.1
35
42.2
12
–
5
–
–
1
–
401
100
86
100
232
100
83
100
16
4.0
2
2.3
7
3.1
7
8.4
5
1.3
1
1.1
1
0.4
3
3.6
9
2.3
1
1.1
7
3.1
1
1.2
3
0.8
0
0.0
3
1.3
0
0.0
46
11.6
8
9.2
28
12.3
10
12.0
6
An Empirical Assessment of Shifting the Payroll Tax Burden in Small Businesses
35
Table 3. (Continued ) Who should pay the payroll tax?
Total Freq.
Need not pay if annual revenues <150 Need not pay if annual revenues <200 Need not pay if annual revenues <300 Need not pay if annual revenues <400 Need not pay if annual revenues <500 Everyone must pay some payroll tax Not reported Total reported
Arkansas %
Freq.
%
7
1.8
1
1.1
19
4.8
3
8
2.0
0
Louisiana Freq.
Mississippi
%
Freq.
%
4
1.8
2
2.4
3.4
9
3.9
7
8.4
1
1.1
3
1.3
4
4.8
0.0
0
0.0
0
0.0
0
0.0
83
20.9
21
24.1
50
21.9
12
14.5
202
50.8
49
56.3
116
50.9
37
44.6
15
–
4
–
10
–
1
–
398
100
87
100
228
100
83
100
that at the very least the probability that a firm is able to influence market prices increases with the firm’s size. The size distribution of firms as measured by the number of employees of the firm and the sales volume of the firm thus becomes an important variable to consider when making cross-study/state comparisons. As reported in Table 2, in the ArkLaMiss, 41.9% of the firms responding had 25 or fewer employees. Of those states in the ArkLaMiss, Mississippi appears to have the largest percentage of small firms. In Table 2, firm size also is measured according to sales revenue. These results are generally consistent with those when firm size is measured according to the total number of employees. The consistency of these descriptive statistics is relevant for at least two reasons. First, our primary focus is the examination of the impact of payroll taxes in the ArkLaMiss, so to the extent that the states in the region are homogenous, direct comparisons are more reliable. Secondly, it facilitates comparisons with other studies.
Perceptions about the Payroll Tax in the ArkLaMiss Attitudes of firms regarding who should have to pay payroll taxes are presented in Table 3. Small businesses were asked their opinions on the relationship between firm size and whether or not a firm should have to pay the tax. The responses show a relatively strong sentiment against the tax in general, especially for the smallest businesses. In the ArkLaMiss, 30.6% of the firms responding felt that firms with
36
TED D. ENGLEBRECHT AND TIMOTHY O. BISPING
Table 4. Is the Social Security Tax System Fair? Responses
Frequency
Percentage
Strongly disagree (with above statement) Disagree Undecided Agree Strongly agree Not reported
99 122 70 105 13 4
24.1 29.8 17.1 25.7 3.2 –
Total reported
409
100
Arkansas Strongly disagree (with above statement) Disagree Undecided Agree Strongly agree Not reported
25 21 14 28 1 2
28.1 23.6 15.7 31.5 1.1 –
Total reported
89
100
Louisiana Strongly disagree (with above statement) Disagree Undecided Agree Strongly agree Not reported
57 76 42 56 7 0
23.9 31.9 17.6 23.5 2.9 –
Total reported
238
100
Mississippi Strongly disagree (with above statement) Disagree Undecided Agree Strongly agree Not reported
17 25 14 21 5 2
20.7 30.5 17.1 25.6 6.1 –
Total reported
82
100
Note: Responses to the statement “Overall the social security system is fair.”
fewer than 25 employees should not pay any payroll taxes. This sentiment was strongest in Mississippi. Only 47.6% of respondents reported that everyone must pay some payroll tax. These results are closely mirrored when firm size is measured by annual sales rather than number of employees.
An Empirical Assessment of Shifting the Payroll Tax Burden in Small Businesses
37
Table 5. Actions Regarding Employees Prompted by an Increase in Payroll Tax. Reaction
Reduce employees pay by >1% Reduce employees pay by exactly 1% Reduce employees pay by <1% No change in employees pay Increase employees pay by <1% Increase employees pay by exactly 1% Increase employees pay by >1% Arkansas Reduce employees pay by >1% Reduce employees pay by exactly 1% Reduce employees pay by <1% No change in employees pay Increase employees pay by <1% Increase employees pay by exactly 1% Increase employees pay by >1% Louisiana Reduce employees pay by >1% Reduce employees pay by exactly 1% Reduce employees pay by <1% No change in employees pay Increase employees pay by <1%
Total Frequency Very Unlikely
Unlikely
Undecided
Likely
Very Likely
Not Reported
Total
126
136
38
25
38
50
413
109
129
33
46
47
49
413
115
142
42
27
12
75
413
42
44
29
101
152
45
413
174
117
29
15
5
73
413
180
115
31
11
4
72
413
186
109
29
12
5
72
413
25
32
6
4
8
16
91
22
27
5
9
15
13
91
24
27
12
6
3
19
91
8
14
7
19
31
12
91
32
27
10
1
1
20
91
33
28
8
0
1
21
91
35
24
8
2
1
21
91
75
74
27
15
24
23
238
61
75
23
28
26
25
238
65
86
26
14
7
40
238
27
20
15
57
89
30
238
105
69
14
9
4
37
238
38
TED D. ENGLEBRECHT AND TIMOTHY O. BISPING
Table 5. (Continued ) Reaction
Increase employees pay by exactly 1% Increase employees pay by >1% Mississippi Reduce employees pay by >1% Reduce employees pay by exactly 1% Reduce employees pay by <1% No change in employees pay Increase employees pay by <1% Increase employees pay by exactly 1% Increase employees pay by >1%
Total Frequency Very Unlikely
Unlikely
Undecided
Likely
111
66
17
7
113
65
15
26
30
26
Very Likely
Not Reported
Total
2
35
238
7
3
35
238
5
6
6
11
84
27
5
9
6
11
84
26
28
4
8
2
16
84
7
10
3
25
32
7
84
36
21
5
5
1
16
84
36
21
6
3
2
16
84
38
20
6
3
1
16
84
Note: Responses to a hypothetical increase of 1% in the current payroll tax.
Attitudes on the fairness of the payroll tax are presented in Table 4. Here we find that 53.9% of respondents disagree with the statement that the payroll tax system is fair, and the strongest sentiment is expressed in Louisiana.3 Of course this sentiment may be reflective of a business’ ability to pass the tax on to others, and may even impact the manner in which a firm chooses to pass the tax on to others. We perform tests of equality of means regarding the burden passed to employees, customers, and profits according to the firm’s response to question 4 concerning fairness of the payroll tax system as perceived by the firm. We find statistically significant variation in both the mean burden of the tax placed on employees and firms in relation to perceived fairness of the system. No statistical difference was found for the same relationship in terms of the burden borne by customers.4 One clear component of this relationship is that firms who feel that the system is not fair tend to pass a substantially larger portion of the tax on to employees. There is no clear pattern for this in terms of profit’s share. The exact nature of this relationship is not readily apparent in the data and may prove a useful avenue for further research.
An Empirical Assessment of Shifting the Payroll Tax Burden in Small Businesses
39
Table 6. Actions Regarding Customers Promoted by an Increase in Payroll Tax. Reaction
Total Frequency Very Unlikely Undecided Likely Very Not Total Unlikely Likely Reported
Reduce product/service price by >1% Reduce product/service price by exactly 1% Reduce product/service price by <1% No change in product/service price Increase product/service price by <1% Increase product/service price by exactly 1% Increase product/service price by >1% Arkansas Reduce product/service price by >1% Reduce product/service price by exactly 1% Reduce product/service price by <1% No change in product/service price Increase product/service price by <1% Increase product/service price by exactly 1% Increase product/service price by >1% Louisiana Reduce product/service price by >1% Reduce product/service price by exactly 1% Reduce product/service price by <1% No change in product/service price Increase product/service price by <1%
188
109
19
11
9
77
413
188
110
20
12
3
80
413
191
110
17
11
2
82
413
81
85
44
60
72
71
413
79
109
47
79
23
76
413
61
72
46
95
71
68
413
70
92
45
68
78
60
413
37
24
4
3
2
21
91
38
23
5
3
0
22
91
38
25
4
2
0
22
91
17
18
7
13
21
15
91
18
25
10
14
4
20
91
14
16
10
18
16
17
91
14
23
8
11
15
20
91
118
58
11
6
1
44
238
117
61
11
5
1
43
238
119
60
9
6
1
43
238
49
52
25
33
39
40
238
47
59
29
48
17
38
238
40
TED D. ENGLEBRECHT AND TIMOTHY O. BISPING
Table 6. (Continued ) Reaction
Total Frequency Very Unlikely Undecided Likely Very Not Total Unlikely Likely Reported
Increase product/service price by exactly 1% Increase product/service price by >1% Mississippi Reduce product/service price by >1% Reduce product/service price by exactly 1% Reduce product/service price by <1% No change in product/service price Increase product/service price by <1% Increase product/service price by exactly 1% Increase product/service price by >1%
33
40
26
57
42
40
238
41
43
26
48
50
30
238
34
26
4
2
2
16
84
33
26
4
4
2
15
84
34
25
4
3
1
17
84
15
15
12
14
12
16
84
14
25
8
17
2
18
84
14
16
10
20
13
11
84
15
26
10
9
13
11
84
Note: Responses to a hypothetical increase of 1% in the current payroll tax.
Effect of Payroll Taxes on Employers, Employees, & Consumers Tables 5–7 provide evidence on employers’ responses to an increase in the payroll tax in terms of its effect on employees’ pay, product/service prices, and profits. Table 5 demonstrates that many firms clearly intend to pass some of the tax on to employees by way of lower wages. In the ArkLaMiss, 17.4% stated that they were likely or very likely to reduce employee pay by more than 1% when faced with a 1% increase in the payroll tax,5 25.5% felt that they were likely or very likely to reduce pay by 1%, while another 11.5% said that they would reduce pay by less than 1%.6 These percentages are reasonably consistent throughout the ArkLaMiss. It is clear that the nature of the labor market elasticities in the ArkLaMiss, as perceived by firms in the region, are conducive to passing a substantial portion of the tax on to employees. Table 6 shows the likelihood that a firm will pass some of the tax on to consumers in the form of higher prices. In the wake of a 1% increase in the payroll
An Empirical Assessment of Shifting the Payroll Tax Burden in Small Businesses
41
Table 7. Effect on Profit Prompted by an Increase in Payroll Tax. Reaction
Total Frequency Very Unlikely Undecided Likely Very Not Total Unlikely Likely Reported
Profit decrease by >1% Profit decrease by exactly 1% Profit decrease by <1% No change in profit Profit increase by <1% Profit increase by exactly 1% Profit increase by >1% Arkansas Profit decrease by >1% Profit decrease by exactly 1% Profit decrease by <1% No change in profit Profit increase by <1% Profit increase by exactly 1% Profit increase by >1% Louisiana Profit decrease by >1% Profit decrease by exactly 1% Profit decrease by <1% No change in profit Profit increase by <1% Profit increase by exactly 1% Profit increase by >1% Mississippi Profit decrease by >1% Profit decrease by exactly 1% Profit decrease by <1% No change in profit Profit increase by <1% Profit increase by exactly 1% Profit increase by >1%
70 70
86 91
36 48
68 74
96 43
57 87
413 413
75 97 157 162 167
100 88 107 104 101
46 46 37 35 35
78 52 10 11 9
32 52 12 8 10
82 78 90 93 91
413 413 413 413 413
16 17
24 18
7 8
8 20
16 7
20 21
91 91
17 21 33 36
24 12 21 20
8 12 10 9
16 13 2 1
9 13 1 1
17 20 24 24
91 91 91 91
35
21
8
2
1
24
91
46 45
42 56
21 25
46 37
56 26
27 49
238 238
44 56 94 96
58 57 65 64
26 24 16 16
46 27 7 6
19 29 9 5
45 45 47 51
238 238 238 238
101
59
18
5
6
49
238
8 8
20 17
8 15
14 14
24 10
10 20
84 84
13 20 30 30
19 20 21 20
12 9 11 10
17 12 1 4
4 10 2 2
19 13 19 18
84 84 84 84
31
21
9
2
3
18
84
Note: Responses to a hypothetical increase of 1% in the current payroll tax.
42
TED D. ENGLEBRECHT AND TIMOTHY O. BISPING
tax, 41.4% of the firms in the ArkLaMiss felt that they would be likely or very likely to increase product/service price by more than 1%. For the same increase in payroll taxes, 48.1% of the firms noted that they would increases prices by exactly 1%, whereas 30.3% suggested that they would be likely or very likely to increase prices by less than 1%. These numbers are fairly consistent across the region, with the highest likelihood of a price increase existing in Louisiana. These results imply that product market elasticities may be conducive to passing the tax on to consumers in the ArkLaMiss as well. If a firm believes that it cannot pass the entire burden of the tax on to consumers or employees, then the tax effectively becomes an added expense to the firm, reducing profits. Table 7, therefore, deals with the share of the tax burden borne by firms in the form of lower profits. The firms were asked how profits would respond to a 1% increase in the payroll tax. In the ArkLaMiss, 46.1% of the firms felt that profit would likely or very likely decrease by more than 1%, 35.9% felt that it would decrease by exactly 1%, and 33.2% noted that it would decrease by less than 1%. These numbers are fairly consistent across the region. When examined within the theoretical context of payroll tax incidence, this result is particularly interesting. That is, it is clear that although labor and product market elasticities, as perceived by firms, allow a substantial portion of the burden to be passed to employees and consumers, this tax is not without cost to the firm. While profits may indeed fall due to scale effects, it is quite possible that firms are not able to pass the entire burden of the tax to some combination of employees and consumers, and, as a consequence, market conditions force the firm to accept lower profits in the wake of a payroll tax increase.
Shifting Mechanism In the current survey, firms also were asked to divide a $1,000 new payroll tax among profits, employee pay, and product/service price. The results presented in Table 8 suggest that firms in the ArkLaMiss may very well pass at least some of the tax on to consumers and employees, as well as bearing some of the burden themselves. The average incidence by group is as follows: employees bear $220 of the burden, customers bear $554, and firms bear $224 by way of lower profits. Also, 10% of the firms said that the entire tax burden would manifest itself in the form of lower profits; 7.1% felt that they would pass the entire burden on to employees, and 30.6% stated that they would pass the entire burden on to consumers. This again emphasizes that the burden of payroll taxes, as perceived by business managers, is not borne entirely by labor. In fact, on average, managers believe that over half of the burden is borne by consumers. These results were fairly evenly distributed across the ArkLaMiss.
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Table 8. Mean Incidence of $1,000 Increase in Payroll Tax by Industry (Industries with Five or More Responses). Employees
Customers
Firms
Ranked by employee share Banking/Financial Real estate Manufacturing Transportation Non-profit Other Health care Legal Hotels/Restaurants Retail trade Architectural/Engineering Communications Marketing/Advertising Insurance Public accounting Wholesale distribution Construction
$500 $358 $298 $296 $254 $246 $239 $214 $206 $197 $180 $170 $150 $136 $135 $125 $82
$300 $258 $552 $542 $418 $582 $532 $129 $553 $548 $575 $670 $610 $455 $823 $519 $732
$200 $383 $150 $162 $328 $172 $229 $657 $241 $231 $245 $160 $240 $409 $42 $356 $185
Ranked by customer share Public accounting Construction Communications Marketing/Advertising Other Architectural/Engineering Hotels/Restaurants Manufacturing Retail trade Transportation Health care Wholesale distribution Insurance Non-profit Banking/Financial Real estate Legal
$135 $82 $170 $150 $246 $180 $206 $298 $197 $296 $239 $125 $136 $254 $500 $358 $214
$823 $732 $670 $610 $582 $575 $553 $552 $548 $542 $532 $519 $455 $418 $300 $258 $129
$42 $185 $160 $240 $172 $245 $241 $150 $231 $162 $229 $356 $409 $328 $200 $383 $657
Ranked by firms share Legal Insurance Real estate Wholesale distribution Non-profit
$214 $136 $358 $125 $254
$129 $455 $258 $519 $418
$657 $409 $383 $356 $328
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Table 8. (Continued ) Employees
Customers
Firms
$180 $206 $150 $197 $239 $500 $82 $246 $296 $170 $298 $135
$575 $553 $610 $548 $532 $300 $732 $582 $542 $670 $552 $823
$245 $241 $240 $231 $229 $200 $185 $172 $162 $160 $150 $42
Mean incidence: All firms
$220
$554
$224
p-Value (difference in means across industries)
0.32
0.00
0.05
Architectural/Engineering Hotels/Restaurants Marketing/Advertising Retail trade Health care Banking/Financial Construction Other Transportation Communications Manufacturing Public accounting
ANALYSIS The differences among reported results quite possibly are due to those items previously mentioned as determinants of tax incidence. For example, both labor and product market elasticities may vary substantially across industries. To the extent that this is the case, one would expect this to be reflected by the manner in which firms in these industries state that they would pass on the tax. Firms of different size may face varying degrees of competition, implying substantially different conditions in both the product and labor markets. To the extent that this is true, one would anticipate variation in tax incidence by firm size. To determine the potential relevance of our proxies for variations in market conditions (industry and firm size), Tables 8–10 examine the impact of industry and firm size on the allocation of this $1,000 tax. At first glance, Table 8 appears to reveal that the mean tax burden on each group varies significantly by industry. The banking/financial industry has the highest mean share of the tax borne by employees; whereas public accounting has the highest share borne by customers; and the legal industry has the highest share borne by profits. It is crucial to note that once again a substantial portion of the burden is borne by consumers, and the degree to which firms believe they can pass a new payroll tax on to consumers varies considerably by industry. For example, in the legal and banking industries firms believe that less than 30% of the burden can be passed to consumers, but
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Table 9. Mean Incidence of $1000 Tax by Firm Size. Employees
Customers
Firms
By sales volume <1 Million 1–10 Million 11–25 Million 26–50 Million 101–250 Million >250 Million
$255 $207 $181 $400 $198 $97
$527 $572 $457 $450 $403 $656
$218 $217 $362 $150 $398 $247
p-Value (difference in mean by firm size)
0.44
0.36
0.41
By number of employees <10 11–25 26–50 >50
$270 $240 $208 $185
$464 $561 $574 $554
$266 $199 $218 $261
p-Value (difference in mean by firm size)
0.44
0.49
0.50
Incidence: All firms
$220
$554
$224
in public accounting, consumers are thought to bear over 80%. It indeed appears that the incidence of the tax may depend upon the industry in question, and this conclusion is verified by a simple test of equality for means in the case of customer and profit burden share. While there does appear to be some variation in tax Table 10. Distribution of Tax Burden by Firm Size. % of Sample
% of Total Profit Burden Paid
By sales revenue <1 Million 1–10 Million 11–25 Million 26–50 Million 101–250 Million 251–500 Million 501Million-1 Billion >1 Billion
22.2 66.0 4.8 1.8 2.5 0.5 0.5 1.8
20.5 63.8 7.0 1.0 4.5 0.7 0.9 1.4
By number of employees <10 11–25 26–50 >50
8.8 33.1 38.7 19.4
10.2 29.4 37.1 23.2
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incidence by firm size in Table 9, any pattern is difficult to discern, and the p-value for the test of the difference in mean incidence does not support the notion.
Distributive Measures Table 10 contains additional information regarding firm size. Since larger firms with more market share may find it easier to pass the impact of a tax on to customers and employees, we implement a measure of vertical equity similar in structure to Suits’ S in order to examine the share of the overall tax borne by firms in each size category, relative to their overall share of all firms in the sample.7 Suits’ S, which is similar to a Gini coefficient, is designed to determine the degree to which a tax burden is distributed equally among certain groups.8 While the true measure of tax base would be the firm’s payroll, due to the lack of data on firm payrolls, we employ firm size as measured by the number of employees, as a proxy. Due to the nature of our data, respondent firms already are grouped by size from their responses to questions two and three on Part 4 of the questionnaire. Therefore, we first calculate each group’s share of the total sample of firms. Next, we sum the total tax burden (in the form of lower profits) for all firms in each group and calculate that group’s share of the total tax burden experienced by all firms in the sample. Each group’s share of the total tax burden then is compared to that group’s share of the total sample of firms. If the ratio of each group’s share of the total sample to each group’s share of the total tax burden is not equal to one, then the burden of the tax is not evenly distributed across firm sizes. We find little in the way of a discernable pattern in regards to the relationship between tax burden and firm size. Firms with fewer than 10 employees make up 8.8% of all firms in the sample, and yet they pay 10.2% of the total profit burden. Firms with 11–25 employees and those with 26–50 employees each pay a share of the profit burden that is lower than the overall share of the sample firms. However, a simple inverse relationship between size and profit burden does not prevail as the largest group (those with more than 50 employees) actually pays a share of the total profit burden that is greater than their share of the sample. This result is largely mirrored when firm size is measured by total revenue. Even though the distribution of the profit burden is not necessarily uniform, we find little evidence of a consistent relationship between firm size and profit burden. Additional insight can be gained from these results when considered within the relevant theoretical framework. First, in terms of firm size, it should be noted that this study focuses on small businesses, and it may be that the results are simply driven by lack of substantial variation in firm size. The alternative explanation would be that large and small firms experience similar labor and product market
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conditions. This explanation is not intuitively palatable. However, we do find that the industry within which a firm operates may impact tax incidence. Given that empirical research in economics has established that market elasticities vary substantially among industries, our result is consistent with both theoretical and empirical economics (Baye et al., 1992).
SUMMARY AND CONCLUSIONS An expansion of the existing literature regarding the survey work on the incidence of payroll taxes on small businesses is presented in this study. The only noted past survey research on the issue was administered to a single metropolitan area resulting in a relatively small sample. The purposes of this study are to expand upon the types of data analysis performed in previous research while interpreting these results within a theoretical framework, and to examine the degree to which past research can be generalized by surveying a larger, three state area. Our results show that, in the ArkLaMiss, customers bear most of the burden of a new $1,000 payroll tax, with a nearly even split between employees and firms. Little support is found for the notion that firm size impacts the incidence of taxation, though all firms sampled were classified as small businesses. The industry within which a firm operates was found to impact the incidence of taxation; a finding that was confirmed by statistical analysis. Moreover, the banking/financial industry passed the largest percentage of the tax on to employees; the public accounting industry passed the largest percentage on the customers; and the legal industry bore the largest share of the burden in the form of reduced profit. When compared to EHI, we find that differences between the two studies (and, therefore, possibly the two regions) do exist. In contrast to the EHI study, a larger portion of the incidence is likely to fall on employees in the ArkLaMiss, as opposed to the burden being borne by firms in the form of lower profits and consumers in the form of higher prices. Stronger anti-tax sentiment also is found to exist in the ArkLaMiss when compared to the Hampton Roads area of Virginia. However, in both studies it is apparent that the burden of a payroll tax is not borne entirely by labor, and in fact, may be borne by customers and business firms.
Limitations and Further Research While this study is a step forward in the understanding of payroll tax incidence, it is not without limitations, and the potential for valuable further research remains. The survey instrument itself is nearly identical to that of EHI. Consequently,
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it may suffer from any weakness pointed out in that work. Most notable is the potentially limiting responses available to the respondents in terms of their anticipated reaction to a new tax (lowering employee pay, raising prices, or lowering profit). Additionally, while the sample size and the geographic area studied in the survey are substantially larger than any past research on the topic, it is apparent that regional differences may exist, especially where differences in industry structure are found. Therefore, studies with even broader coverage could provide additional insight into the determinants of payroll tax incidence.
NOTES 1. Englebrecht et al. (2001) will hereinafter be EHI (2001). 2. While this response rate is less than ideal, for the sake of comparability and confidentiality, we strictly follow the method of EHI including the policy of not mailing follow-up surveys. This in turn yielded rates that are reasonably consistent with past research. Additionally, informal checks for non-response bias supported the integrity of the sample. 3. Notably, we also find that 17.9% of all respondents believe that the fair rate is 0, though we do not present the results here for the sake of brevity. 4. The results of these tests are available from the authors upon request. 5. Reducing wages by more than one percent in response to a one percentage-point increase in payroll tax is not irrational because a one percentage-point increase in the payroll tax amounts to more than a 13 percent increase in the tax rate. 6. Percentages discussed regarding Tables 5–7 are calculated as: ((Total number responding to a question in a particular manner/Total number responding to the question) ×100). For example, in Table 5, the percent stating that would “likely” or “very likely” reduce employees pay by >1% = ((25 + 38)/363) × 100) = 17.4%. 7. Here each firm is taxed an equal amount, regardless of firm size. Therefore, if the size of the firm does not matter, then the percent of the total tax paid by each group should equal its share of the sample of firms. 8. Strictly speaking, Suits’ S would be calculated by first grouping firms according to the size of their tax base (payroll) and comparing each group’s share of the total tax base to its share of total payroll tax burden paid (in the form of lower profits). This method will approximate Suits’ S to the extent that firm payroll increases proportionally with firm size. For further discussion of Suits’ S and related measures see Whicker et al. (2001).
ACKNOWLEDGMENTS This research was supported by a grant from The Center for Entrepreneurship and Information Technology at Louisiana Tech University. The authors wish to gratefully acknowledge the helpful comments of the editor and two anonymous reviewers.
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REFERENCES Barro, R. J. (1978). The impact of social security on private savings: Evidence from the U.S. time series. Washington, DC: American Enterprise Institute. Baye, M. R., Jansen, D. W., & Lee, J. W. (1992). Advertising effects in complete demand systems. Applied Economics, 24, 1087–1096. Brittain, J. A. (1971). The incidence of social security payroll taxes. American Economic Review (March), 110–125. Brittain, J. A. (1972). The payroll tax for social security. Washington, DC: Brookings Institution. Elias, D. (1998). Privatizing social security. Chief Executive (November), 82–85. Englebrecht, T. D., Henry, L. J., & Iyer, G. S. (2001). Payroll tax incidence on small businesses: An empirical investigation of shifting the payroll tax burden. Journal of Small Business Strategy, 12(2), 82–95. Feldstein, M. (1996). Social security and savings: New time series evidence. National Tax Journal, 49(2), 151–164. Ferrara, P. J. (1980). Social security: The inherent contradiction. Cato Institute Studies in Public Policy, San Francisco, CA. Gruber, J. (1997, Part 2). The incidence of payroll taxation: Evidence From Chile. Journal of Labor Economics, 15(3), 74–77. Hamermesh, D. S. (1993). Labor demand. Princeton University Press, 166–173. Iyer, G. S. (1994). An empirical analysis of the equity effects of payroll taxation and taxation of social security benefits. Unpublished doctoral dissertation, Georgia State University. Pechman, J. A. (1987). Federal tax policy. Washington, DC: Brookings Institution. Pechman, J. A., Aaron, H. J., & Taussig, M. K. (1968). Social security: Perspectives for reform (Chapter 8). Washington, DC: Brookings Institution. Ricketts, R. C. (1990). Social security growth vs. income tax reform: An analysis of progressivity and horizontal equity in the Federal Tax System in the 1980s. The Journal of the American Tax Association (Spring), 34–50. Thomson (2001, December). Corporate America. (States of Arkansas, Louisiana, and Mississippi). Knight-Ridder Information. Whicker, M. L., Julnes, P., & Williams, D. W. (2001). Making tax policy: A variance ratio approach to measuring tax incidence. Journal of Public Budgeting, Accounting & Financial Management (Spring), 83–102.
APPENDIX: SOCIAL SECURITY TAX QUESTIONNAIRE PART 1. These questions ask about your feelings towards the social security (payroll) tax. Please circle any one among the choices provided to indicate your response. (1) A business should not have to pay any social security tax if the number of employees is less than: 5
10
15
20
25
30
35
40
45
60
80
100
Do Not Agree
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(2) A business should not have to pay any social security tax if the annual revenues of the business is less than (in thousands of dollars): Less than 20 40 60 80 100 150 200 300 400 500 Do Not Agree (3) The fairest rate of social security tax for a business (excluding the Medicare portion) is: (Circle anywhere on the line to indicate your response.)
(4) Overall the social security tax system is fair. (1) Strongly Disagree
(2) Disagree
(3) Undecided
(4) Agree
(5) Strongly Agree
(5) Overall the efficiency of the social security tax system is aided by information technology. (1) Strongly Disagree
(2) Disagree
(3) Undecided
(4) Agree
(5) Strongly Agree
PART 2. These questions ask your likely reactions to an INCREASE in the social security tax rate. Assume that the employer’s portion of the social security tax rate is increased from 6.2 to 7.2% (one-percentage point). Your reaction to the increase will be (please check your response). A. Regarding Employees Very Likely 1. To reduce employees’ pay by more than one percentage point 2. To reduce employees’ pay by exactly one percentage point 3. To reduce employees’ pay by less than one percentage point 4. No change to employees’ pay
Likely
Undecided
Unlikely
Very Unlikely
An Empirical Assessment of Shifting the Payroll Tax Burden in Small Businesses
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5. To increase employees’ pay by less than one percentage point 6. To increase employees’ pay by exactly one percentage point 7. To increase employees’ pay by more than one percentage point Still assuming that the employer’s portion of the social security tax rate is increased from 6.2 to 7.2%. Your reaction to the increase will be: B. Regarding the Price of Products and Services
Very Likely 1. To reduce product/ service price by more than one percentage point 2. To reduce product/ service price by exactly one percentage point 3. To reduce product/ service price by less than one percentage point 4. No change to product/service price 5. To increase product/ service price by less than one percentage point
Likely
Undecided
Unlikely
Very Unlikely
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TED D. ENGLEBRECHT AND TIMOTHY O. BISPING
6. To increase product/ service price by exactly one percentage point 7. To increase product/ service price by more than one percentage point Still assuming that the employer’s portion of the social security tax rate is increased from 6.2 to 7.2%. Your reaction to the increase will be: C. Regarding your Profits Very Likely
Likely
Undecided
Unlikely
Very Unlikely
1. Profit will be reduced by more than one percentage point 2. Profit will be reduced by exactly one percentage point 3. Profit will be reduced by less than one percentage point 4. No change to profit 5. Profit will increase by less than one percentage point 6. Profit will increase by exactly one percentage point 7. Profit will increase by more than one percentage point PART 3. The next question is very important because it asks you how you will apportion an increase in the social security tax between employees’ wages, prices charged to customers and your profit.
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Assume that an increase in the social security tax rate has resulted in a $1000 increase in your social security tax bill. Decide how much of it you will shift to your employees by way of lower wages, how much you will shift to customers by way of higher prices, and finally how much of it you will bear yourself by way of lower profits. The total should add up to $1000. Amount (in $) Employees Customers Your profit Total
$1,000
PART 4. Demographics and General Information This questionnaire is confidential. The following items are not intended to identify you, but instead, they help us better understand your responses. For example, we might look at the responses to see if businesses of a particular size tend to answer questions similarly or businesses in a particular industry tend to answer questions similarly. (1) What is the industry classification of your company? (Check one only). (1) Manufacturing (2) Banking/Financial (3) Insurance (4) Architectural/Engineering (5) Legal (6) Public accounting (7) Construction (8) Real estate (9) Communications (10) Health care (11) Hotels/Restaurants (12) Computer software (13) Marketing/Advertising (14) Public utilities (15) Research/Development (16) Transportation (17) Wholesale distribution
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(18) Retail trade (19) Government-federal (20) Government-state (21) Government-local (22) Non-profit organization (00) Other specify (2) How many employees are at this location? (1) Less than 10 (2) 11–25 (3) 26–50 (4) More than 50 (3) What is the company’s approximate annual revenue per year? (Check one only) (1) Less than $1 million (2) $1 million–$10 million (3) $11 million–$25 million (4) $26 million–$50 million (5) $51 million–$100 million (6) $101 million–$250 million (7) $251 million–$500 million (8) $501 million–$1 billion (9) Greater than $1 billion Please circle your choice in questions 4 and 5. (4) To what degree does change in information technology influence your company’s operation? (1) No impact
(2) Some impact
(3) Medium impact
(4) Strong impact
(5) Greatest impact
(5) To what degree do payroll taxes, impact your ability to grow and/or pursue entrepreneurial activities? (1) No impact
(2) Some impact
(3) Medium impact
(4) Strong impact
(5) Greatest impact
AN EMPIRICAL EXAMINATION OF INVESTOR OR DEALER STATUS IN REAL ESTATE SALES Ted D. Englebrecht and Tracy L. Bundy ABSTRACT The importance of determining whether the seller of real estate is a dealer or investor is of major significance in terms of the income tax consequences of each characterization. That is, an investor may be entitled to capital gain treatment (at a 15% tax rate) on the sale of real estate, whereas a dealer may be subject to ordinary tax treatment (at a 35% tax rate in 2003), based on the particular circumstances. On the other hand, a dealer may be entitled to the benefit of ordinary loss treatment; in contrast, an investor could be limited to a $3,000 capital loss for the year. Naturally, a judicial decision reclassifying a taxpayer from dealer to investor or vice versa can result in costly additions to his or her tax liability. This study investigates the issue of investor or dealer status in taxation by examining decisions of the Tax Court and U.S. District Courts from 1970 to 2000. Specifically, we build limited-dependent and qualitative variables models (i.e. logistic and probit regression models, and a discriminant analysis model) from the variables delineated in the landmark Winthrop case. Analyzing cases which utilized these factors resulted in a final data set of 87 judicial decisions yielding a total of 96 observations.
Advances in Taxation Advances in Taxation, Volume 16, 55–72 Copyright © 2004 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(04)16003-1
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The final model from each method retains the same five significant predictor variables. The Hosmer and Lemeshow’s Chi-Square statistics for the probit and logit models are 3.5036 (p-value = 0.6229) and 5.7173 (p-value = 0.3347), respectively, both of which indicate a good fit. These models each have a proportional R 2p of 86.5%. The discriminant function, with the same 5 predictors, has a classification accuracy rate of 85.4%. Furthermore, we test all models over a holdout sample of 10 decisions, and predict the outcome of all 10 holdout cases, with no ambivalence, for an accuracy rate of 100%.
INTRODUCTION The characterization of gain or loss on disposal of real estate is an issue often litigated. The problem originates in the Internal Revenue Code (I.R.C.).1 Specifically, §1221 defines a capital asset in terms of what it is not, and it is this negative definition which has been at the root of extensive litigation. For the purpose of this article, the relevant language in §1221 is the exclusion of property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. In addition, §1221 excludes real property used in a trade or business. However, §1231 provides capital gain treatment for such property, subject to the recapture of depreciation allowances.2 §1231 utilizes the language of §1221 to exclude property held primarily for sale to customers in the ordinary course of business. Because of the definitional deficiency in §1221, the judiciary was forced to develop its own guidelines for determining whether the gain or loss from the disposition of real property is capital or ordinary. In U.S. vs. Winthrop (417 F.2d 905, 1969), the Fifth Circuit identified a seven-factor test to assist in resolving this question, which is now used in virtually all cases involving characterizations of this type. The court was quick to caution, as have many since, that each situation must be decided in view of all its relevant particulars, not merely on a strict application of the factors, none of which is to be considered determinative in and of itself. These seven factors have been vigorously discussed and analyzed in the years since their judicial inception; nonetheless, a paucity of quantitative analysis exists on the question of whether a taxpayer is an investor or a dealer in a given situation. Accordingly, our objective is to develop a model to identify those factors of primary importance that can be used to predict with reasonable accuracy the outcome of litigation related to a taxpayer’s status as either an investor or a dealer.
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The remainder of this article is organized as follows. First, a brief discussion of each factor is presented, along with comprehensive examples that illustrate the impact of a change in classification from investor to dealer. This is followed by an overview of prior research. The third section provides an explanation of the research design and data collection; the fourth presents the results. In the final section, we discuss conclusions and limitations of the study.
BACKGROUND There is a wealth of published material dissecting the seven factors set forth by the Circuit Court in Winthrop. The following list does not include detailed discussions of the purpose behind each factor; most are self-explanatory. However, enough controversy surrounds the first criterion that a brief delineation is warranted. (1) The nature and purpose of the acquisition and holding of the property. This is by far the most troublesome of the tests from the taxpayer’s perspective. It is inherently subjective because it requires a court to make a determination regarding intent, and many times this can only be adjudged based on the taxpayer’s own testimony. His/her position is benefited when the acquisition is of a passive nature (e.g. through an inheritance or bequest, Goggans & Englebrecht, 1982); however, the courts have consistently recognized that a change in purpose from the time of acquisition is entirely possible and do take such changes into account when deciding these issues. Ascertaining the purpose, at the time of sale, is the ultimate objective; specifically, whether the property was held for sale to customers in the ordinary course of business. The remaining factors are somewhat less subjective and easier to quantify than the taxpayer’s purpose. They include: (2) (3) (4) (5) (6) (7)
Extensive efforts by the taxpayer to sell the property. Significant number, extent, continuity, and substantiality of sales. Extensive subdivision, development, and improvements. Use of a business office for sales activities. High degree of control or supervision over selling representatives. Large amount of time and effort habitually devoted by the taxpayer to sales activities.
It should be noted that each of these factors is stated in the same direction. That is, an affirmative response to any particular factor always lends support to a decision of dealer status, and a negative response always lends support to a decision of investor status. As mentioned earlier, each case must be considered individually
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Fig. 1. Investor vs. Dealer: Gain Situation.
An Empirical Examination of Investor or Dealer Status in Real Estate Sales
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within the context of its own unique circumstances and the presence or absence of any specific factor is not necessarily determinative. In addition, it is important to realize that neither a decision of dealer status nor investor status can be absolutely defined as a taxpayer win. Investor status affords the transaction capital treatment; however, for a sale in which the taxpayer incurs a loss, it is easily recognized that classification as an investor is most decidedly not a victory as only $3,000 per year can be used to offset ordinary income.3
Fig. 2. Investor vs. Dealer: Loss Situation.
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Conversely, for a sale in which the taxpayer experiences a gain, dealer status requires the recognition of ordinary income with marginal tax rates potentially as high as 35%. In this study, 91 of 96 (94.8%) decisions involve gains; therefore, investor status is the desired outcome. The possibility of a Type I error for these taxpayers is clearly much more detrimental in terms of potential interest and penalties. On the other hand, for the loss situation in which a taxpayer is falsely assigned investor status, the damage arises from higher taxable income rather than interest or penalties.
EFFECTS OF CLASSIFICATION STATUS – EXAMPLES The following scenario is used to illustrate the effect of classification as investor or dealer under both a gain and a loss situation: Lee Reynolds is a partner in a large accounting firm, and until recently, owned several pieces of real estate. Lee’s partnership income in 2003 amounted to $325,000; he and his wife file a joint return and have no other dependents. In order to avoid unnecessary complexity, the ramifications of self-employment taxes are ignored (see Figs 1 and 2).
PRIOR RESEARCH Although there has been much commentary on this topic, little empirical research has been published. Oatsvall (1978) offers the most comprehensive study, in which discriminant analysis was used to develop a classificatory model based on two groups, cases with gains determined to be capital and those with ordinary income; losses were excluded. The fifteen factors utilized, presented in Table 1, were those outlined by the U.S. Tax Court in Klarkowski, TCM 1965-328, along with several others suggested by prior research (Rubin, 1967; Simmons & O’Hara, 1968). The final sample consisted of 78 usable cases, from 1966 to 1977, excluding those that contained “split decisions”4 or losses. Oatsvall’s final three-variable model, represented by the discriminant function, Y = −0.55834X 2 − 0.76118X 3 − 0.69036X 4 + 0.07420 (p. 103), correctly classified 75 of 78 cases, or 96.15%, where X2 is purpose for which the property was held, X3 is change in circumstances affecting intent, and X4 is extent of improvements to the property.
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Table 1. Oatvall’s Original 15 Independent Variables. • Purpose for which acquired • Purpose for which helda • Change in intent due to circumstances outside taxpayer’s controla • Improvements to propertya • Frequent and continuous sales • Average number of sales for the years in question • Substantial time and effort devoted to sales • Taxpayer involvement in a real estate business • Taxpayer licensed as a real estate agent or broker • Advertising or other promotion of property • Taxpayer approached by the buyer • Listed for sale with broker or agent over whom taxpayer had control • Average holding period • Percent of income derived from real estate sales for the years in question • Amount of gain from transaction in question a Denoted
variables included in the final discriminant model.
Oatsvall did not, however, utilize a holdout sample, and her 96.15% accuracy rate pertains to the cases used to build the model. Furthermore, she offers no justification for the use of the Klarkowski case, which was a Tax Court memorandum decision. Winthrop (1969) was decided by the Fifth Circuit Court of Appeals, and as such clearly carried more weight. It also set forth a more parsimonious set of factors than did the Tax Court case. Much of the remaining published research in this area has relied upon frequency distribution analysis, attempting to identify the most important factors, or those that are most heavily weighted by jurists in deciding these cases. In general, these studies have reached similar conclusions, typically naming intent (i.e. the purpose for which the property was held) as the critical factor, followed closely by the number and frequency of sales and the extent of development to the property (Flesher & Wallace, 1983; Hardin & Stocks, 1996; Taylor, 1980; Weithorn, 1956). In addition, there have been many technical and practical articles examining individual or groups of cases in order to more clearly define each factor and to aid practitioners in tax planning (e.g. Fellows, 2000; Hamill, 1994; Iden, 1984; Limberg, 1984; Williford, 1994).
DATA AND RESEARCH METHOD We select cases from U.S. District Courts, the U.S. Tax Court, and the U.S. Court of Federal Claims5 for the period 1970 through 2000 based upon whether the
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TED D. ENGLEBRECHT AND TRACY L. BUNDY
Fig. 3. Decision Trends over Time.
court utilized the seven-factor test from Winthrop in deciding the appropriate characterization for a gain or loss on the disposal of real estate. Figure 3 reveals the incidence of decisions over the 31-year time span, as well as the trend line for the total volume of cases heard. We eliminated cases heard before juries since the published records contain only instructions to the jury and the final verdict. The ten cases analyzed by Englebrecht and Logsdon (2001) were set aside as a holdout sample with which to test our model. The final data set consisted of 87 cases, six of which contained two or more distinct sale transactions separately addressed and decided by the court, yielding a total of 96 observations (see Appendix for a complete listing). We coded the dependent variable according to the decision reached: 1 to indicate a taxpayer status of investor or 0 for taxpayer status of dealer. The seven factors of Winthrop are the independent variables, and were initially coded 1, 0, or missing. A “0” reflects an affirmative response to the factor, indicative of dealer status, and a “1” reflects a negative response, supporting investor status (Fig. 4). To limit potential bias in coding, we handled missing variables conservatively. That is, when a specific factor was not cited in a case, it was treated as if found to support dealer status, and coded as a “0.” Given that 91 of the 96 observations involved gains, clearly a decision of investor status is most favorable to the taxpayer. Due to conservatism, we chose to make no inferences, even in those cases where the facts made it relatively clear. This most often occurred with respect to the use of an office for selling activities. For example, if the taxpayer were an individual with limited transactions, then it would in all likelihood be safe to conclude that a business office was not used. This is a rather simplistic example; therefore, given the difficulties of reading between the lines in many of the cases and the possibility
An Empirical Examination of Investor or Dealer Status in Real Estate Sales
63
Fig. 4. Frequency of Observed Values by Factor.
of erroneous conclusions, we have chosen to err on the side of caution and code all such instances as “Yes” (i.e. supporting dealer status). The only exception to this is the situation in which the judge made a sweeping comment regarding a total lack of sales efforts. A comment of this nature resulted in several factors being coded as “No” (i.e. supporting investor status) even though they were not specifically mentioned, namely, variables 2 (substantial effort to sell), 5 (use of a business office), 6 (supervision or control of agent), and 7 (extensive time and effort). The procedures employed in this article were logistic and probit regressions and discriminant analysis. We chose these methods due to the character of the data. That is, the dependent variable and the seven independent variables (the factors) all have only two possible values. The use of an ordinary least squares model would result in violations of several necessary assumptions, and further, would likely result in predicted probabilities outside the 0–1 range, making interpretation difficult at best.
RESULTS AND ANALYSIS We initially perform each method using all seven factors. However, the first of the predictor variables, the purpose for which the property was held, proves to be nearly perfectly correlated with the response (R = 97.9%). This correlation is to be expected when it is considered objectively. In fact, a solid argument could be made that this factor is not a predictor variable at all, but rather is really the dependent variable. A positive (negative) response to the question, “Was the property held for sale to customers in the ordinary course of business?” in effect also forces an outcome of dealer (investor). With that information known, though, we would then expect to find a perfect correlation between the response and this
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factor. Such is not the case, with two of the 96 observations violating this pattern. Individual examination of the two cases at issue reveals that both taxpayers claimed to have purchased and held their properties with the intent to improve or develop then sell. However, in Knudsen, TCM 1980-216, development was blocked by the city in which the property was located and the taxpayer simply chose not to attempt to litigate the matter. In Flint, TCM 1991-405, the taxpayer desired dealer status due to a loss on the property, but in fact had never had any similar business dealings. The correlation between the response variable and the first predictor variable produces a quasicomplete separation of data points; consequently, the maximum likelihood estimates cannot be calculated for the regressions. Our investigation into the problem and the subsequent conclusions reached regarding the “Held for Sale” variable, as discussed above, prompt its removal as an independent variable.
Logit Model The final logistic model includes an intercept term, and incorporates five of the six independent variables: Substantial Effort to Sell, Number and Extent of Sales, Subdivision and Development, Control of Selling Representative, and Taxpayer’s Time and Effort. The fit of the model is good with an overall Chi-square statistic of 73.815 and a proportional R 2p of 86.5%. Hosmer and Lemeshow’s Chi-Square statistic of 5.7173 also indicates a reasonably good fit. Applying this model to the raw data of the holdout sample, then taking the antilog of the model’s predicted outcomes yields the distinct probability of a finding of investor status and is represented by the equation: Predicted Probability =
1 1 + e−(3.5507+1.6853X 1 +2.6417X 2 +1.2645X 3 −1.5053X 4 +2.5862X 5 )
(1)
where X1 is substantial effort to sell; X2 is number, extent, continuity, and substantiality of sales; X3 is subdivision, development, and improvements; X4 is control over selling representative; and X5 is extensive time and effort of taxpayer. This process generates the predicted probability of a finding of investor status and the associated probability for each of the cases in the holdout sample. The model correctly predicts the outcome of all ten of the holdout cases, with no ambivalence, for an accuracy rate of 100%. Only one of the cases has less than an extremely strong predicted outcome (probability of a decision of investor status = 0.0923), yet it could by no means be considered marginal.
An Empirical Examination of Investor or Dealer Status in Real Estate Sales
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Probit Model The final probit model includes an intercept term and also incorporates five of the six independent variables: Substantial Efforts to Sell, Number and Extent of Sales, Subdivision and Development, Control of Selling Representative, and Extensive Time & Effort by Taxpayer. The Hosmer and Lemeshow’s Chi-Square statistic of 3.5036 indicates a good fit, as do the overall Chi-square statistic of 74.079 and the proportional R 2p of 86.5% (Table 2). Applying the probit model to the holdout sample gives the probability of a finding of investor status and is represented by the equation: Predicted Probability = (−2.0386 + 0.9676X 1 + 1.4750X 2 + 0.6753X 3 − 0.8917X 4 + 1.5132X 5 )
(2)
where is the cumulative normal probability function; X1 is substantial effort to sell; X2 is number, extent, continuity, and substantiality of sales; X3 is subdivision, development, and improvements; X4 is control over selling representative; and X5 is extensive time and effort of taxpayer. This model also correctly predicts the outcome of all ten of the holdout cases. As with the logit model, only one of the cases has less than a very strong predicted outcome (probability of investor status = 0.0864), yet is still a very clear prediction. Not only are the predicted outcomes the same across both models, but also the probabilities assigned by each are strikingly close. Table 3 contains both models’ predicted probability of a decision of investor status for each of the 10 cases in the holdout sample along with the actual outcome Table 2. Model Results. Variable
Intercept Selling effort Number of sales Subdivision and development Control of agent Time and effort Overall chi-square Hosmer & Lemeshow’s chi-square
Panel A: Logit
Panel B: Probit
Panel C: Discr. Analysis
Value
p-Value
Value
p-Value
Value
p-Value
−3.5507 1.6853 2.6417 1.2645
0.0000 0.0425 0.0003 0.0927
−2.0386 0.9676 1.4750 0.6753
0.000 0.0435 0.0001 0.1149
– −2.0139 −3.3041 −1.7393
– 0.0000 0.0000 0.0000
−1.5053 2.5862 73.815 5.7173
0.0992 0.0051 0.0000 0.3347
−0.8917 1.5132 74.079 3.5036
0.0769 0.0038 0.0000 0.6229
1.4407 −3.6829
0.0032 0.0000
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Table 3. The Probability Models. Logit Model
Baker (1998) Blythe (1999) Bramblett (1992) Dunwoody (1992) Hancock (1999) Lemmons (1997) Little (1993) Paullus (1996) Tabbi (1995) Zurcher (1997)
Actual Decision
Predicted Decision
Predicted Probability of Investor Status
Investor Investor Investor Dealer Dealer Dealer Dealer Investor Dealer Investor
0.9665 0.9903 0.9903 0.0279 0.0928 0.0279 0.0279 0.9903 0.0279 0.9903
Investor Investor Investor Dealer Dealer Dealer Dealer Investor Dealer Investor
Probit Model Predicted Probability of Investor Status
Predicted Decision
0.9724 0.9952 0.9952 0.0207 0.0864 0.0207 0.0207 0.9952 0.0207 0.9952
Investor Investor Investor Dealer Dealer Dealer Dealer Investor Dealer Investor
of the case. The probabilities generated by the probit model are slightly stronger than those from the logit model, with no significant changes between models (see Table 3). Discriminant Analysis Model As with the logit and probit models, the question of whether the first predictor variable is, in fact, a response variable, causes us to remove it from consideration. The final model includes the same five variables retained in the regression equations: Substantial Effort to Sell (p-value = 0.0000); Number and Extent of Sales (p-value = 0.0000); Subdivision and Development (p-value = 0.0000); Control of Selling Representative (p-value = 0.0032); and Taxpayer’s Time and Effort (p-value = 0.0000). Table 4 shows that applied to the original sample, the function has a classification accuracy rate of 85.4%. Table 4. Discriminant Function Classification Performance (Original Sample). Predicted
Total
Investor
Dealer
Actual Investor Dealer
35 6
8 47
43 53
Total
41
55
85.4%
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Table 5. Comparison of Significant Variables. Oatsvall (1978) (Significant Variables)
Englebrecht & Bundy (Significant Variables)
Purpose for which held Change in intent outside taxpayer’s control Improvements to propertya
Substantial effort to sell Number, extent, and continuity of sales Subdivision and developmenta Control of selling agent Taxpayer’s time and effort
a Only
one common variable is significant in both studies.
The final discriminant function, represented by the equation: Yˆ = −2.0139X 1 − 3.3041X 2 − 1.7393X 3 + 1.4407X 4 − 3.6829X 5
(3)
then is applied to the holdout sample, achieving 100% predictive accuracy with respect to the 10 holdout cases. Despite this result, caution is called for when using discriminant analysis. A major assumption of this method is that the independent variables are multivariate normally distributed, which obviously is not the case (Eisenbeis, 1977; McLeay, 1986). The violation of this assumption leads to inconsistent parameter estimates. Logistic regression, on the other hand, does not assume a normal distribution and is preferred in this situation (Maddala, 1991; Simonoff, 1998). Conversely, when the predictor variables are normally distributed, then discriminant analysis is preferred due to its greater efficiency (Maddala, 1991). Also, it should be noted that most discriminant analysis studies use a linear classification rule. That is only optimal if the restriction of equal group covariance matrices is satisfied (Lennox, 1999). Moreover, a multitude of bankruptcy studies have shown this condition of equal group covariance matrices does not hold (Hamer, 1983). The factors selected by all three of our models diverge considerably from those derived by Oatsvall. In part, this can be explained by the parsimonious test devised by the Fifth Circuit in Winthrop as opposed to the somewhat redundant factors included by Oatsvall from Klarkowski and other research. Additionally, Oatsvall’s use of discriminant analysis and her removal of all loss transactions could be responsible. For a summary of the significant variables from both Oatsvall and the current study, see Table 5.
CONCLUSIONS AND LIMITATIONS This study is the first to compare the results of different statistical models in predicting the outcomes of real estate “investor versus dealer” court cases. Also, it is
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the first to employ logistic and probit regressions to address the issue of the characterization of gains and losses on real estate transactions. Oatsvall (1978) discusses the appropriateness of the probit method but does not provide results from the procedure. The three-variable discriminant function developed in that study had an accuracy rate of 96.15%, while our five-variable logistic regression equation achieved an accuracy rate of 100%, as did our five-variable probit regression equation and our discriminant function. The models identify the five factors from Winthrop that most significantly and consistently affect the outcome of litigation. These factors are quite different than those depicted in prior research. Specifically, only the “improvements” variable is significant in both studies. Consequently, this information should be useful to taxpayers and practitioners in obtaining favorable administrative or legal relief in the investor versus dealer dilemma. A potential limitation of this study could arise in the coding of the independent variables. Although in most cases the court records are clear-cut and unambiguous, room still exists in some decisions for erroneous conclusions to be drawn. The language used by judges in interpreting the facts of the cases and in drafting their opinions varies widely, and at times is quite convoluted. Naturally, room exists for misinterpretation of a judge’s true meaning. However, because we utilize multiple coders who reach a consensus on all the assigned coding, we feel that this potential problem has either been eliminated or greatly minimized. Other restrictions include our small holdout sample. However, the strong results suggest that our results should be generalizable.
NOTES 1. Unless otherwise noted, all references to the Internal Revenue Code are to the Internal Revenue Code of 1986, as amended. 2. §§ 1245, 1250, and 291. 3. After netting against capital gains from other sources. 4. The term, “split decision,” is used by Oatsvall to describe cases in which multiple transactions were accorded different outcomes. 5. Prior to October 29, 1992, this court was known as the U.S. Claims Court; and prior to October 1, 1982, as the U.S. Court of Claims.
REFERENCES Eisenbeis, R. A. (1977). Pitfalls in the application of discriminant analysis in business, finance, and economics. Journal of Finance, 32, 875–890.
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Englebrecht, T. D., & Logsdon, S. (2001). Investors vs. dealers in the 1990s. Journal of Real Estate Taxation, 28, 398–405. Fellows, J. A. (2000). When is real estate a capital asset? And when is it not? A reply from the tax court. Real Estate Law Journal, 29, 43–52. Flesher, T., & Wallace, W. (1983). When capital gains can be obtained upon the sale of subdivided real estate. Taxation for Accountants, 31, 98–102. Goggans, T. P., & Englebrecht, T. D. (1982). Investors vs. dealers: Tax implications of investor vs. dealer status in real estate. Journal of Real Estate Taxation, 9, 169–179. Hamer, M. M. (1983). Failure prediction: Sensitivity of classification accuracy to alternative statistical methods and variable sets. Journal of Accounting and Public Policy, 2, 289–307. Hamill, J. R. (1994). Capital gains for the casual subdivider: Can section 1237 be used as a safe harbor in the post-RRA 1993 environment? Journal of Real Estate Taxation, 21, 253–263. Hardin, J. R., & Stocks, M. H. (1996). When is a taxpayer a real estate dealer? Real Estate Issues, 21, 33–37. Iden, B. F. (1984). The dealer problem: Capital gains and the real estate investor. Real Estate Law Journal, 13, 99–121. Lennox, C. (1999). Identifying failing companies: A reevaluation of the Logit, Probit and DA approaches. Journal of Economics and Business, 51, 347–364. Limberg, S. T. (1984). Bradshaw provides support and guidelines for capital gains in condominium conversions. Journal of Real Estate Taxation, 11, 328–346. Maddala, G. S. (1991). A perspective on the use of limited-dependent and qualitative variables models in accounting research. The Accounting Review, 66, 788–807. McLeay, S. (1986). Student’s t and the distribution of financial ratios. Journal of Business Finance and Accounting, 13, 209–222. Oatsvall, R. J. (1978). Capital gain/ordinary income treatment of real estate sales. Doctoral dissertation, The University of South Carolina, Columbia. Simonoff, J. S. (1998). Logistic regression, categorical predictors, and goodness-of-fit: It depends on who you ask. The American Statistician, 52, 10–14. Taylor, R. L. (1980). Dealers and investors in real estate: Distinguishing between investors and dealers in real estate transactions. Journal of Real Estate Taxation, 7. Weithorn, S. (1956). Subdivisions of real estate – ‘dealer’ v. ‘investor’ problem. Tax Law Review, 11. Williford, J. S. (1994). Purpose for which real property is acquired and held affects the tax consequences on its sale. Journal of Real Estate Taxation, 22, 56–72.
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APPENDIX: CASES USED Case Name
Ackermann Adam Adams Armstrong Atkins Au
Case #
TCM 1976-299 60 TC 996 (1973) TCM 1978-152 TCM 1980-548 40 AFTR 2d 77-5839 53 AFTR 2d 84-999 (Cl.Ct.) Biedenharn 31 AFTR 2d 73-956 Biedenharn 37 AFTR 2d 76-679 Bramblett 69 AFTR 2d 92-1344 Briggs TCM 2000-380 Broadhead TCM 1972-195 Brodnax TCM 1970-164 Buono 74 TC 187 (1980) Bush TCM 1977-75 Byram 52 AFTR 2d 83-5142 Cairo 34 AFTR 2d 74-5703 Casalina 60 TC 694 (1973) Case 46 AFTR 2d 80-5981 CivicCenter 42 AFTR 2d 78-5861 Climate TCM 1974-206 Cottle 89 TC 467 (1987) Crosswhite 40 AFTR 2d 77-5620 Daugherty 78 TC 623 (1982) Dean TCM 1975-137 Drage 42 AFTR 2d 78-5869 Drozda TCM 1984-19 Edwards TCM 1974-120 Edwards2 TCM 1974-120 Edwards3 TCM 1974-120 Erfurth TCM 1987-232 Fabiani TCM 1973-203 Ferguson TCM 1987-257 Flint TCM 1991-405 Fraley TCM 1993-304 Frasher TCM 1973-268 Frick TCM 1972-71 Gangi TCM 1987-561 Gartrell 45 AFTR 2d 80-1206 Gibson TCM 1981-240 Graves 63 AFTR 2d 89-692
Held for Effort Number Devel Office Agent Time & Sale Control Effort 1 0 0 1 0 0
1 0 0 1 0 0
1 0 1 1 0 0
1 0 0 1 0 0
n/a 0 0 n/a 0 n/a
n/a 0 n/a 1 0 0
1 0 0 1 0 0
0 1 0 1 1 0 0 1 0 1 0 0 1 0 0 0 1 0 0 1 0 0 1 0 0 1 1 0 1 0 0 0 1 1
0 1 0 n/a 0 0 0 1 0 n/a 0 0 1 0 0 0 0 0 0 n/a 0 0 0 0 0 1 0 0 n/a 0 0 0 1 n/a
0 1 0 n/a 1 0 0 0 0 1 0 0 0 1 0 1 1 1 0 1 0 0 1 1 0 1 0 0 1 0 1 0 1 1
1 1 0 1 n/a 0 0 1 0 1 0 0 1 1 0 0 0 0 0 1 0 0 1 0 0 1 1 0 1 0 0 0 1 0
0 1 0 n/a n/a n/a n/a n/a 0 n/a n/a n/a n/a n/a n/a 0 n/a n/a n/a n/a 0 0 0 1 0 n/a n/a n/a n/a n/a 1 n/a 0 n/a
0 1 0 n/a n/a 0 n/a n/a 0 n/a n/a n/a n/a 0 n/a 0 0 0 0 n/a 0 0 0 1 0 1 0 0 n/a n/a 1 0 0 n/a
0 0 0 n/a n/a 0 n/a 1 0 n/a 0 0 n/a 0 0 0 0 0 0 n/a 0 0 0 0 0 n/a n/a 0 1 0 0 0 1 n/a
An Empirical Examination of Investor or Dealer Status in Real Estate Sales
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APPENDIX (Continued ) Case Name
Hamilton Hansche Harder Harper Harris Hay Haynsworth
Case #
TCM 1974-93 TCM 1970-342 TCM 1990-371 TCM 1976-58 TCM 1983-774 TCM 1992-409 47 AFTR 2d 81-1443 (Ct.Cl.) Haynsworth2 47 AFTR 2d 81-1443 (Ct.Cl.) Hicks TCM 1978-373 Houston 44 AFTR 2d 79-6074 Howell 57 TC 546 (1972) Huey 34 AFTR 2d 74-6065 (Ct.Cl.) Jarret TCM 1993-516 Jenkins TCM 1970-53 Jersey 35 AFTR 2d 75-1157 Juleo 32 AFTR 2d 73-5275 Knudsen TCM 1980-216 Lewellen TCM 1981-581 Lomas 45 AFTR 2d 80-1499 Lomas2 45 AFTR 2d 80-1499 Maddux 54 TC 1278 (1970) Major TCM 1981-361 McManus 65 TC 197 Meyers TCM 1971-268 Myers 29 AFTR 2d 72-1289 Newman TCM 1982-61 Nicewander TCM 1975-234 Nicewander2 TCM 1975-234 Norris TCM 1986-151 Parker 53 AFTR 2d 83-349 Parmer TCM 1971-320 Pasadena TCM 1975-237 Philhall 37 AFTR 2d 76-445 Planned TCM 1980-555 Pritchett 63 TC 149 (1974) Pritchett2 63 TC 149 (1974) Pritchett3 63 TC 149 (1974) Pritchett4 63 TC 149 (1974) Redwood 68 TC 960 (1977)
Held for Effort Number Devel Office Agent Time & Sale Control Effort 0 1 1 1 1 0 1
0 1 1 n/a 0 n/a 0
0 0 1 1 1 0 1
1 1 1 n/a 0 1 0
n/a 0 1 n/a n/a n/a 0
n/a 0 1 n/a 0 n/a 0
0 0 1 n/a n/a n/a 1
0
0
0
0
0
0
0
0 1 0 0
0 0 0 0
0 1 0 0
0 1 0 0
n/a n/a n/a n/a
0 0 n/a n/a
0 0 0 0
1 0 0 1 1 1 0 0 0 1 1 1 1 0 1 0 1 1 0 0 1 0 0 0 0 0 0
1 0 0 0 0 0 0 1 0 1 1 1 n/a 0 n/a 0 1 0 0 1 1 0 0 0 0 0 1
0 1 0 0 0 1 0 0 0 1 0 1 1 0 1 1 1 1 0 0 1 1 0 0 0 0 n/a
1 0 0 0 1 1 0 0 0 1 1 0 1 0 n/a 0 1 0 n/a 1 1 1 0 0 0 0 0
n/a n/a 0 n/a n/a 0 n/a 0 n/a n/a n/a n/a 0 0 n/a n/a n/a 0 n/a n/a n/a 0 0 0 0 0 n/a
0 0 0 0 n/a 0 n/a 0 n/a n/a 1 n/a n/a 0 n/a n/a n/a 0 n/a 0 n/a 0 0 0 0 0 n/a
1 0 0 0 n/a 1 0 0 0 n/a 1 1 1 0 n/a 0 1 0 0 0 1 0 0 0 0 0 0
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APPENDIX (Continued ) Case Name
Case #
Redwood Rymer Sanders Sanford Sapphire Suburban Taylor Terry Toledo Tollis Tollis2 Turner Urick VanBibber Walsh Westchester Williams
TCM 1985-332 TCM 1986-534 51 AFTR 2d 83-1104 TCM 1986-404 TCM 1973-23 45 AFTR 2d 80-1263 TCM 1973-82 TCM 1984-442 TCM 1976-366 TCM 1993-63 TCM 1993-63 TCM 1974-264 TCM 1983-60 TCM 1985-344 TCM 1994-293 63 TC 198 (1974) 53 AFTR 2d 84-884
Held for Effort Number Devel Office Agent Time & Sale Control Effort 0 0 1 1 1 1 0 0 0 1 0 1 1 1 1 1 0
1 n/a 1 n/a 1 0 0 0 0 n/a 0 n/a 1 1 0 0 0
n/a 0 1 1 n/a 1 0 0 0 1 1 1 1 1 1 0 1
0 0 1 0 1 0 0 0 0 0 0 1 1 1 0 1 0
n/a n/a 0 n/a n/a 0 0 0 0 n/a n/a n/a n/a 1 n/a n/a 0
n/a n/a 1 n/a 0 0 0 0 0 n/a n/a n/a 1 0 n/a n/a 0
0 n/a 1 n/a n/a 0 0 0 0 n/a n/a 1 1 1 0 n/a 0
CHARITABLE GIVING AND THE SUPERDEDUCTION: AN INVESTIGATION OF TAXPAYER PHILANTHROPIC BEHAVIOR FOLLOWING THE MOVE FROM A TAX DEDUCTION TO A TAX CREDIT SYSTEM Alexander M. G. Gelardi ABSTRACT Governments often encourage charitable giving through the tax system, by a deduction or tax credit. In 1988, Canada moved from a deduction system to a tax credit system. The tax credit for donations above $250 was calculated at the highest tax rate, even if the taxpayer was at the lowest tax rate. This gives what can be called a “superdeduction.” At the same time, the top rate of tax was reduced. Thus, the cost of giving was reduced for the lower taxpayers and increased for the higher-income taxpayers. The article reports whether taxpayer behavior changed from 1986 (pre reform) to 1988 and 1992 (post reform). The analysis also investigates the influence of inflation on the charitable donations. The percentage of
Advances in Taxation Advances in Taxation, Volume 16, 73–93 Copyright © 2004 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(04)16004-3
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taxpayers giving over $250 was analysed for both all the taxpayers and those consistently in the low and high tax brackets. The lower-income taxpayers were found to reduce their giving, contrary to expectations. The middle-income taxpayers, in general, increased their giving, which was expected and so took advantage of the superdeduction. The results of the moderate high-income taxpayers were mixed. Taxpayers who had very high incomes decreased their giving, as was expected.
INTRODUCTION Many individuals are philanthropic. They donate portions of their income to a variety of social, educational, religious, and cultural organizations. Charitable giving reduces the pressure on governments to participate in similar activities. The resulting easing of their financial burdens motivates governments to encourage private charitable giving. They usually accomplish this through the income tax system. Governments generally use one of two methods to simulate such giving: tax deductions or tax credits. In either case, the cost of giving is reduced. Usually in a tax deduction system, the cost of a donation is reduced by the marginal tax rate of the donor, whereas in the case of the tax credit system, the cost of donation usually is reduced by a standard factor for all taxpayers. Canada used to have a tax deduction system, but moved to a tax credit system in 1988.1 This article looks at taxpayers’ behavioral changes as a result of this move. Although this article looks at the Canadian experience, the policy implications are universal. The results of this research would be of interest to policy makers in the United States and other countries that currently have a tax deduction system and may wish to change to a tax credit system. The United States uses a deduction system, but the benefits are only available to taxpayers who itemize their deductions. In 2001, President Bush originally proposed to permit taxpayers who do not itemize their deductions to deduct their charitable donations. However, this provision seems to have been withdrawn early on in Congress.2 Also, there has been some discussion as to whether the U.S. should move to a tax credit system (Adams, 1997; Ombwatch, 1997). If the tax reduction proposal had included a provision for a tax credit for all taxpayers, this provision may have survived in Congress. Although currently there is no U.S. federal tax credit for charitable giving, several states do have such tax credits, albeit against state tax only.3 When the Canadian income tax system underwent a major reform between 1987 and 1988, one of the changes affected how charitable donations are treated
Charitable Giving and the Superdeduction
75
by the Income Tax Act. Prior to 1988, an individual could deduct amounts made as contributions to registered charities in arriving at taxable income (subject to certain limits). This gave the economic effect that the cost of the donation to the taxpayer depended on his marginal tax rate. The after-tax cost of a charitable donation for a taxpayer who was in the lowest tax bracket was greater than that for a taxpayer in the highest tax bracket. After 1987, an individual received a tax credit for charitable donations (again, subject to the same limits). The tax credit was based on the lowest federal tax rate for the first $250 of donations and at the highest federal tax rate for the balance. This resulted in the cost of making charitable donations being the same for all taxpayers, regardless of the individual’s marginal tax rate. Tax reform also reduced the number of tax brackets and lowered the top federal rates starting in 1988. This had an indirect effect on the cost of charitable giving. The net cost of making charitable donations increased for taxpayers in the highest tax brackets, and decreased for taxpayers in the lower tax brackets (for donations above $250). In fact, for taxpayers in a tax bracket below the highest tax bracket, the effect of the tax credit (for donations above $250) is greater than the effect of a deduction. This added benefit is known as the superdeduction. This article examines the effect of these tax changes on taxpayers’ charitable giving. As stated above, the cost of donations was altered by the changes in the law. The cost of giving for lower-income taxpayers was reduced. One would expect that donations, particularly for amounts over $250, would be increased by this group. On the other hand, the cost of philanthropy increased for the higher-income group of taxpayers, leading one to expect that charitable giving would decrease for this group. The article is organized as follows: the literature review, outlined in the next section, is followed by an explanation of the tax legislation for charitable donations. The article continues with some hypotheses and an outline of the database and methodology used; the results of the analysis are, then, presented. The article ends with a summary discussion and conclusions.
LITERATURE REVIEW Many studies have analysed how tax rates affect taxpayers’ willingness to make charitable donations. Most look at United States data (see Broman, 1989; Clotfelter, 1985, for thorough reviews of the literature). Many of the older studies found that there was substantial cost elasticity of giving. Some studies carried out in the United States and Canada have found that charitable donations have a price elasticity of between −1 and −2.5 (Feenburg, 1981; Feldstein & Clotfelter, 1976; Kitchen &
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ALEXANDER M. G. GELARDI
Dalton, 1990; Kitchen, 1992). However, price elasticities of these models have been found to be poor predictors (Christian et al., 1990). Other studies have estimated price elasticities to be much lower, between 0 and −1 (Auden et al., 2000; Barrett et al., 1997; Broman, 1989; Clotfelter, 1980; Ricketts & Westfall, 1993). Many of these latter researchers used panel data in their studies. Dunbar and Phillips (1997) found that for non-itemizers between 1985 and 1986, where the price of giving decreased, the amount of donations increased. In fact, the elasticity of giving was estimated as −3.356. Duquette (1999) also looked at the price elasticity of donations by taxpayers who did not itemize their deductions. He found that such giving was price sensitive. However, the degree of elasticity, once provisions were fully phased-in, was less than that of the giving of taxpayers who did itemize their deductions. The study found that in neither 1985 and 1986 (the years studied) were the elasticities significantly different from −1. In a study of charitable donations from 1979 to 1990, Auden et al. (1992) predicted that the level of donations would fall as the cost of giving increased. They used an estimate of changes in contributions based on a regression from cross-sectional data and compared this to actual giving obtained from panel data. They found that the higher-income taxpayers did decrease their donations, but not as much as the regression had predicted. The authors concluded that although the higher-income taxpayers gave less, this seemed to be due to fewer donations of relatively large amounts, and not a general average decrease. However, the authors also found that very large donations (over $1,000,000) increased. Ricketts and Westfall (1993) found that lower-income taxpayers had a positive price elasticity (meaning that as the price increases so do the donations), whereas high-income taxpayers had a marginally negative elasticity. This difference can be partially explained by suggestions that lower-income taxpayers tend to give to religious organizations and higher-income taxpayers tend to give to cultural and educational organizations (Auden et al., 2000; Clotfelter, 1992; Feldstein, 1975). This would indicate that one might expect that giving to religious organizations is less elastic than to cultural organizations, due to the nature of the recipient charity. Barrett et al. (1997) examined middle-income taxpayers, and thus had a more homogenous group. They looked at a dynamic model for long-term effect. Overall, the authors found that taxes affect both the timing and amount of charitable giving over the long term. Auden et al. (2000) looked at the philanthropic behavior of the wealthy. The authors analysed the tax benefits, the types of institution to which the wealthy tend to give and the patterns displayed by the wealthy in their giving. The price elasticities of giving were calculated for the periods spanning the (U.S.) Economic Recovery Act of 1981 and the (U.S.) Tax Reform Act of 1986. These elasticities were −0.51 and −0.95 respectively, less than the traditional ones. The authors
Charitable Giving and the Superdeduction
77
speculated that “the charitable inclination of donors were aroused by the tax acts themselves and the publicity surrounding their possibly deleterious effect on contributions, causing donors to give more than otherwise they might have” (p. 417).
TAX LAW RELATING TO CHARITABLE DONATIONS IN CANADA Canada underwent a major tax reform in 1987.4 One of the main changes involved the move from a system with a great number of tax deductions to one in which many of those deductions were transformed into tax credits, the rationale being that the benefit from those credits would be equal among taxpayers and not subject to the individual’s marginal tax rate. The general rule was that the tax credit was calculated at the lowest federal tax rate. Thus, every taxpayer received the same benefit. For example, a pre-reform deduction for $1,000 would provide a $160 benefit to taxpayers with a 16% federal marginal rate, whereas taxpayers with a 34% federal marginal rate would receive a $340 benefit. Provincial taxes would have magnified the difference. However, since the lowest tax rate became 17%, a post-reform base amount of $1,000 would be translated into a tax credit of $170 for all taxpayers. The effect of the change from deductions to tax credits was augmented by changes to the tax rate structure. The number of tax brackets was reduced from ten to three. The highest federal tax rate was reduced from 34 to 29%. The effect of this reduction on higher rate taxpayers was greater than it seems, since provincial tax was based on federal tax. The combined top tax rates in 1986 were 42.7–59.9%, depending in which province the taxpayer resided. The combined top tax rates in 1988 and 1992 were 44.9–51.1% and 46.7–51.6%, respectively.5 The lowering of the top marginal rate from 1986 to 1988 benefited the higher-income taxpayers (those taxpayers in groups 8–10, see Table 1). This benefit was diminished by 1992, mainly due to the provinces increasing their taxes. The reduction in the number of tax brackets resulted in an increase in the marginal tax rates for many of the lower-income taxpayers. This increase was made larger by 1992, again, due to the provinces increasing their take. Tax reform also affected the treatment of charitable donations. Prior to 1988, a taxpayer could deduct his donations from income in arriving at taxable income. There was a general overall limitation on the amount a taxpayer could deduct for charitable donations. This limitation was generally 20% of income for tax purposes.6 After 1987, this limit was maintained. Charitable donations are the one exception to normal rule that the tax credit is calculated on the lowest tax
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ALEXANDER M. G. GELARDI
Table 1. Total Income: Actual, Const$, MTR, N by Deciles. 1986 Mean 1. Total Inc-actual Total Inc-Const88 MarTax N 2. Total Inc-actual Total Inc-Const88 MarTax N 3. Total Inc-actual Total Inc-Const88 MarTax N 4. Total Inc-actual Total Inc-Const88 MarTax N 5. Total Inc-actual Total Inc-Const88 MarTax N 6. Total Inc-actual Total Inc-Const88 MarTax N 7. Total Inc-actual Total Inc-Const88 MarTax N 8. Total Inc-actual Total Inc-Const88 MarTax N 9. Total Inc-actual Total Inc-Const88 MarTax N 10. Total Inc-actual Total Inc-Const88 MarTax N
13,231 14,378 32.12 2,190 21,044 22,869 31.91 2,186 27,231 29,886 32.96 2,185 33,660 36,579 36.44 2,188 39,821 43,274 37.82 2,184 47,137 51,224 39.12 2,189 57,442 62,422 40.93 2,198 81,774 88,864 45.18 2,185 153,851 167,189 50.11 2,195 504,119 547,827 51.63 2,196
1988 S.D. 2,684 2,917 16.77 1,978 2,149 8.42 1,865 2,026 5.71 1,688 1,835 5.45 1,815 1,973 6.25 2,428 2,639 6.97 3,839 4,172 7.01 12,196 13,254 8.44 36,312 39,461 9.18 484,772 526,801 9.53
Mean 15,820 15,820 34.17 2,659 24,269 24,269 30.18 2,660 31,100 31,100 35.90 2,653 37,758 37,758 38.76 2,654 44,793 44,793 40.16 2,653 53,306 53,306 40.62 2,668 68,066 68,066 41.41 2,667 129,177 129,177 44.20 2,662 289,514 289,514 45.76 2,651 781,746 781,746 45.49 2,657
1992 S.D. 3,350 3,350 15.08 1,971 1,971 6.71 1,913 1,913 7.88 1,965 1,965 8.06 2,132 2,132 7.78 2,873 2,873 6.50 6,413 6,413 5.88 33,972 33,972 5.27 47,568 47,568 4.73 652,811 652,811 5.95
Mean 17,851 15,173 35.00 2,862 27,888 23,705 34.54 2,848 35,406 30,095 40.90 2,835 43,148 36,676 41.07 2,852 51,603 43,862 41.60 2,851 61,717 52,460 42.56 2,848 77,764 66,100 43.65 2,857 122,882 104,449 46.51 2,865 260,364 221,310 47.92 2,858 710,619 604,026 47.32 2,856
S.D. 3,615 3,073 16.94 2,375 1,810 9.84 2,129 1,810 9.36 2,852 1,945 8.95 2,572 2,187 7.69 3,340 2,839 7.19 6,531 5,551 6.93 24,208 20,577 5.67 54,281 46,139 5.30 609,869 518,389 6.64
Note: Total Inc-actual = Total income actual $; MarTax = Marginal tax rate; N = number of observations; Total Inc-Const88 = Total income in 1988 dollars; S.D. = Standard deviation.
Charitable Giving and the Superdeduction
79
rate. For the first $250 of donations, the tax credit is at the lowest federal tax rate.7 For the balance of donations (above $250), the tax credit is at the highest federal tax rate, even if the taxpayer’s marginal federal rate is lower.8 This feature is popularly known as a “superdeduction” as a non-highest marginal rate taxpayer is better off with this tax credit than he would have been with a deduction. Thus, a lower-income taxpayer had his cost of giving substantially reduced for amounts more than $250. In contrast, the high-income taxpayer had his cost of giving increased, due to the reduction in tax rates. This change affected the cost of giving. Prior to the reform, the cost of giving was 1 – MTR (marginal tax rate). The cost of giving in 1986 is based on the marginal tax rate shown in Table 1. In 1988 and 1992, the cost of giving was not dependent on the marginal tax rate. For those taxpayers giving less than $250, the marginal cost of giving was about 73% in 1988 and about 72% in 1992; for those taxpayers giving more than $250, the marginal cost of giving was about 54% in 1988 and 53% in 1992.9 For example, the after-tax cost for a taxpayer in the first decile making a charitable donation of $200 would be $136 ($200 × [1 − 0.3212]) pre-reform and $146 ($200 × 0.73) post-reform, a small increase. If that taxpayer made a contribution of $1,000, the pre-reform cost of giving would be $679 ($1,000 × 0.6788) and the post-reform cost of giving would be $588 ($250 × 0.73 + $750 × 0.54), a relatively large decrease. The after-tax cost for a taxpayer in the sixth decile making a charitable donation of $200 would be $121 ($200 × [1 − 0.3912]) pre-reform and $146 (200 × 0.73) post-reform, an increase of about 20%. If that taxpayer made a contribution of $1,000, the pre-reform cost of giving would be $609 ($1,000 × 0.6088) and the post-reform cost of giving would be $588 ($250 × 0.73 + $750 × 0.54), a small decrease. The after-tax cost for a taxpayer in the tenth decile making a charitable donation of $200 would be $97 ($200 × [1 − 0.5136]) pre-reform and $146 (200 × 0.73) post-reform, an increase of about 50%. If that taxpayer made a contribution of $1,000, the pre-reform cost of giving would be $484 ($1,000 × 0.4837) and the post-reform cost of giving would be $588 ($250 × 0.73 + $750 × 0.54), an increase of about 21%. The average donation of a taxpayer in the tenth decile was about $6,500. This would have had a pre-reform cost of giving of $3,144 ($6,500 × 0.4837) and a post-reform cost of giving of $3,558 ($250 × 0.73 + $6,250 × 0.54), as increase of about 13%. Thus, the cost of giving increased for lower- and middle-income taxpayers, if modest amounts were given and decreased as the amounts given increased.10 The very High-income taxpayers had increases in their cost of giving for all amounts given, though the relative increase became smaller as the amount of donations became larger.
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ALEXANDER M. G. GELARDI
The Canadian tax system is based on individual taxation, wherein spouses are taxed separately. However, one taxpayer is permitted to claim all the charitable donations made by both spouses. Thus, in the pre-reform tax system (the deduction system) it behoved the higher marginal rate spouse to claim all the charitable giving in one tax return. Similarly, in the post-reform system (the tax credit system), it behoves one spouse to claim all the charitable donations as only one amount below $250 would be granted the tax credit at the lower rate.11
HYPOTHESES The literature review shows that many prior studies found that there was a negative elasticity for charitable giving. Other studies showed that there was little negative elasticity or even a positive one (Ricketts & Westfall, 1993) or showed that elasticities were poor predictors of charitable giving (Christian et al., 1990). Thus, there is some doubt as to the adjustments made in philanthropic behavior by taxpayers when their tax cost changes. Taking into account the findings of the majority of the studies, the expectation is that lower-income taxpayers who could benefit from the “superdeduction” starting in 1987, would increase their charitable giving. This leads to the first hypothesis: H1. Lower-income taxpayers would increase their charitable giving after tax reform of 1987. Higher-income taxpayers had a reduction in marginal tax rate. Since the credit for charitable donations made after tax reform is based on the lowest tax rate (for amounts given under $250) or the highest tax rate (for amounts given over $250), the taxpayers in the highest income groups would have suffered an increase in their cost of giving. Prior research (including Auden et al., 1992) indicate that donations should decrease as the cost of giving increases. Thus the second hypothesis is: H2. Higher-income taxpayers would decrease their charitable giving after tax reform of 1987. From the examples shown above, it can be seen that the law after tax reform made the after-tax cost of giving for amounts over $250 substantially lower than the after-tax cost of giving for donations of $250 or less. The expectation would be that more taxpayers would increase their giving to over $250 to take advantage of this benefit. The third hypothesis is: H3. The percentage of taxpayers giving more than $250 in charitable donations would increase after tax reform of 1987.
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81
RESEARCH METHOD The database used was the Social Policy Simulation Database and Model (SPSD/M), which is produced by Statistics Canada. The database was constructed from four microdata sources to permit the calculation of all taxes and government transfers. These four microdata sources were: (a) Survey of Consumer Finance (SCF); (b) Personal Income Tax Returns (Green Book); (c) Unemployment Insurance History Data; and (d) Family Expenditure Data. Statistics Canada merged the microdata sources to produce the SPSD/M (Statistics Canada, 1992). The result is that individuals in the SPSD/M database are statistically representative of the Canadian population (Bordt et al., 1990). No group is over-represented or under-represented. The database contains information on approximately 200,000 individuals representing about 27 million Canadians. One of the problems with the statistical matching of different databases is that if variables used in a regression are from different underlying databases then the assumption of conditional independence may not be satisfied (Macnaughton, 1992). Thus, the analysis of the elasticity of charitable donation by regression was not carried out. Analysis of the data was executed by non-parametric techniques, using the Mann-Whitney statistic. As indicated above, the SPSD/M is a cross-sectional database. In order to have some insight into taxpayer behavior, one needs to look at different years. Ideally, one can use panel data where the same taxpayer is followed over a number of years. However, this type of database is not available in Canada. For an alternative, one can use similar cross-sectional databased on different years. In their study of charitable donations from 1979 to1990, Auden et al. (1992) used both panel data and cross-sectional data. They found that the general patterns of the cross-sectional analysis and the panel analysis were similar. This study uses SPSD/M databases with 1986, 1988 and 1992 base years. Thus, although it is not possible to follow the same taxpayer over the years across tax reform to ascertain behavioral changes, one is able to analyse trends among similarly situated taxpayers for the years before and after tax reform. The 1992 database was added to analyse whether changes observed in behavior were long lasting or if there was a delay in reaction. Since this research is designed to analyse those taxpayers who already had committed themselves to making donations, the analysis was carried out on taxpayers who had at least $1 of charitable donations. So that the various income groups could be analysed separately, the taxpayers were arranged into ten equal groups (deciles) based on total income. Using ten groups permits one to see trends more easily than using a smaller number of groups. These deciles can be further catagorised into three income groups – the low-income group (deciles one and
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ALEXANDER M. G. GELARDI
two), the middle-income group (deciles three to six) and the high-income group (deciles seven to ten). For a variety of reasons, some taxpayers are extremely generous, well beyond any expectation from their income. Therefore, to remove these extreme outliers in each group, any taxpayer whose charitable contribution was greater than four standard deviations from the group mean was excluded.12 Table 1 shows the means of the amount of income, both in actual amounts received and in constant (1988) dollars, of taxpayers in each decile. The Table also shows the mean marginal tax rates and the number of observations in each decile. Income, both actual and in constant dollars, increased from 1986 to 1988 for each decile. From 1988 to 1992, the picture is somewhat different. Actual income decreases for the higher-income groups (8–10); the income in constant dollar terms decreases for all income groups. Marginal tax rates increased from 1986 to 1988 for some groups (1, 3–7) and decreased for other groups (2, 8–10). Other than group 2, the marginal rate decreases were in the highest income groups. From 1988 to 1992, the marginal tax rates increased for all deciles.
RESULTS The research question required one to ascertain whether taxpayers changed their charitable giving behavior from 1986 (pre reform) to 1988 (post reform), and whether any change was sustained into 1992. As seen from the law section above, the critical amount of donations where the benefit to the lower-income taxpayers was maximized was $250. The data were analysed from a number of perspectives. The actual charitable donation made gives some insight, but has the drawback that an increase in income could distort the picture. Another perspective would be to look at constant dollar donations and income. A third, and perhaps stronger analysis, is to look at the percentage of giving to after-tax income. This article gives the results of all three analyses.
Analysis of the Means of the Actual Charitable Donations Made First, the analysis on the means of charitable donations as reported in the taxpayer’s returns was carried out. As seen in Table 2, seven of the deciles showed a significant increase in the level of charitable donation from 1986 to 1988 at the
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83
Table 2. Actual $ Charitable Donations by Decile and Year. 1986
1 2 3 4 5 6 7 8 9 10
1988
1992
Mean
S.D.
Mean
S.D.
Mean
S.D.
290 320 403 376 392 483 668 894 1,814 6,473
412 493 635 648 650 814 1,158 1,403 2,592 14,062
284 385 422 475 480 555 739 1,555 2,730 6,827
432 626 652 752 831 920 1,267 2,253 3,877 14,154
318 417 439 500 521 589 712 11,300 3,019 7,261
458 667 701 829 886 970 1,189 2,133 4,510 15,262
1986 vs. 1988
1986 vs. 1992
1988 vs. 1992
*
*
*
*
**
**
**
*
*
*
*
*
*
*
*
*
*
*
* *
*
(*) *
Note: Actual = Chartiable donations in actual dollars; S.D. = Standard deviation. ∗ Significant at 0.05 level. ∗∗ Significant at 0.10 level.
95% significance level (Mann-Whitney) and a further group showed a significant increase at the 90% significance level. The lowest and the highest deciles did not show any significant change over the tax reform period. Table 2 also provides an indication of whether the changes were sustained into 1992. The comparison of the amount of charitable donations from 1986 to 1992 is shown. In this case, taxpayers in nine of the deciles showed significant changes in their charitable giving at the 95% level and the remaining decile (decile 4) was significant at the 90% level. Deciles 1 and 2 reflect the lowest tax rate taxpayers and deciles 7–10 reflect the highest tax rate taxpayers. Deciles 3–6 have the moderate-level taxpayers. The expected increase in charitable giving from 1986 to 1988, for the low marginal tax rate persons, was seen only in decile 2, whereas there was no change in decile 1. Thus, H1 is rejected, all lower-income taxpayers did not immediately increase their charitable giving after the 1987 tax reform . There were, however, significant increases from 1986 to 1992 in all deciles. This time lag may be due to the lower-income taxpayers taking longer to realize the benefits of the post-reform regime or could be due to the effects of inflation, as indicated in the next section. Contrary to expectations, the taxpayers in the highest deciles (7–9) showed increases in charitable giving. Decile 10 had an increase from 1986 to 1992. Thus, H2 is rejected, all higher-income taxpayers (other than those in decile 10) increased, rather than decreased, their charitable giving immediately after tax reform.
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ALEXANDER M. G. GELARDI
Analysis of the Means in Constant Dollars of the Charitable Donations Made The previous analysis looked at the charitable donations made, in terms of the actual amount given. As the data are from a period spread over six years, inflation increases might have distorted the picture. To ascertain whether this was indeed the case, the data were recomputed into constant 1988 dollars.13 The results are shown in Table 3. Table 3 shows that five of the deciles show a significant increase at the 95% level from 1986 to 1988, while the first decile has a decrease at the 90% significance level. The third, sixth, seventh, and tenth deciles have no significant differences. The increase was sustained only for the eighth and ninth deciles. Four of the deciles show significant decreases in the constant dollar charitable donation. The expected increase for the low-income deciles only occurred in decile 2, though this was not sustained into 1992. Decile 1 had a significant decrease (at the 90% level), which was deeper in 1992 (significant at the 95% level). Again, the expected decrease in giving by the higher-income taxpayers (H2) was not observed. Of the four high-income deciles, two ( deciles 8 and 9) had significant increases, that were sustained into 1992. Deciles 7 and 10 had no significant change from 1986 to 1988, but, interestingly, both had significant decreases going into 1992. Thus, there is only limited support for the predictions of hypothesis H2, in the longer term.
Table 3. Constant $ Charitable Donations by Decile and Year. 1986
1 2 3 4 5 6 7 8 9 10
1988
1992
Mean
S.D.
Mean
S.D.
Mean
S.D.
315 347 438 409 426 524 726 971 1,971 7,034
449 536 690 704 707 885 1,258 1,524 2,816 16,368
284 385 422 475 480 555 739 1,555 2,730 6,827
432 626 652 752 831 920 1,267 2,253 3,877 14,154
270 355 373 425 443 500 605 1,105 2,566 6,172
390 667 595 705 753 825 1,011 1,813 3,834 12,973
1986 vs. 1988
1986 vs. 1992
(**)
(*)
1988 vs. 1992
*
(**) (*)
*
(*) (*)
*
(*) (*) (*)
(*)
*
**
(*)
*
* (*)
Note: Const $88 = Chartiable donations in constant 1988 dollars; S.D. = Standard deviation. ∗ Significant at 0.05 level. ∗∗ Significant at 0.10 level.
(**)
Charitable Giving and the Superdeduction
85
In fact, eight of the deciles showed significant decreases from 1988 to 1992 on an inflation adjusted basis. This result may be explained, in part, by the fact many taxpayers tend to give similar amounts from year to year.14 Analysis of the Percentage of Charitable Donations as a Percentage of After-tax Income The analysis in the prior section takes into account the possible relationship of inflation by looking at constant dollar charitable donations. However, this does not take into account the possibility that incomes were not increased by a value equal to inflation (see Table 1). In fact, this Table shows that incomes increased relatively from 1986 to 1988 but declined (in every decile) from 1988 to 1992. Furthermore, any increase in charitable donations may be a result of an increase in income, notwithstanding the anecdotal evidence (see Note 14) to the contrary. As a result of these observations, the data were analysed also to examine whether the change in the law affected the relative amount of charitable donations made with respect to after-tax income. In arriving at after-tax income the tax payable was recalculated as if no charitable donation had been made. The results of this analysis are shown in Table 4. The results show that two deciles had significant increases in the percentage of income given to charity from 1986 to 1988. Taxpayers in deciles 4, being in the Table 4. Charitable Donations as a Percentage of After-Tax Income by Decile and Year. 1986
1 2 3 4 5 6 7 8 9 10
1988
1992
Mean
S.D.
Mean
S.D.
Mean
S.D.
2.38 1.71 1.69 1.33 1.20 1.26 1.46 1.40 1.58 1.83
3.52 2.58 2.59 2.23 1.95 2.07 2.46 2.11 2.00 2.77
1.90 1.75 1.57 1.51 1.30 1.30 1.38 1.60 1.40 1.39
2.62 2.74 2.34 2.60 2.18 2.10 2.27 2.45 1.90 2.52
1.92 1.66 1.43 1.38 1.25 1.22 1.19 1.44 1.71 1.64
2.61 2.55 2.21 2.20 2.06 1.93 1.89 2.20 2.38 2.63
1986 vs. 1988
1986 vs. 1992
(*)
(*)
1988 vs. 1992
(*) *
(*)
(*) *
(*)
(*) (*)
(*) *
(*)
*
Note: Percentage of After-Tax Income – Charitable Donations/After-tax income (ignores the tax deduction/credit for donations) as a percentage; S.D. = Standard deviation. ∗ Significant at 0.05 level.
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ALEXANDER M. G. GELARDI
middle-income range, were not expected to change their behavior substantially. This result is contrary to expectations. Decile 8 also had a significant increase, and was contrary to expectations. Taxpayers in three other groups (deciles 1, 9 and 10) showed significant decreases in the percentage of income given to charity. The result from decile 1, which was sustained into 1992, is contrary to expectations. Thus, there is no support for Hypothesis H1. The results from deciles 9 and 10 do follow expectations, that the higher-income taxpayer would give less to charity. Also, decile 3 and 7 showed significant decreases from 1986 to 1992. The result of decile 3 is contrary to expectations, whereas that of decile 7 supported expectations. Overall, it appears that the higher-income taxpayers were giving a smaller percentage of their after-tax income to charity. Thus, there is some support for the predictions of Hypothesis H2.
Analysis of the Number of Taxpayers Making Donations of Greater than $250 The above analysis details how taxpayers’ average donations were affected by the change in the law. However, as the revised law benefited those taxpayers in the medium or low tax groups who gave more than $250 to charities, it is useful to ascertain whether the new law affected the percentage of taxpayers who contributed more than that threshold amount. Table 5 shows that approximately half the groups had significantly different percentages of taxpayers donating more than $250 in 1988 compared to 1986. Since the tax credit for contributions over $250 is substantially higher than for those below, Hypothesis H3 predicted that the percentage of donation over $250 would increase. Deciles 1 and 10 had significant decreases from 1986 to 1988. This is contrary to expectations. It is interesting to note that both, however, did recover by 1992, but did not show any increase from 1986 to 1992. The taxpayers in these deciles may have taken longer to realize the benefits of the greater giving. Increases in the percentage of giving over $250 from 1986 to 1988 are observed in deciles 4, 8 and 9. Two other deciles, 2 and 5, show increases from 1986 to 1988. Of the lower and middle-income groups, only the taxpayers in deciles 3 and 6 did not have any significant change in their giving patterns. Of the higher-income groups, only those taxpayer in decile 7 showed no significant change in their donations. Only four of the six low to middle-income groups showed the expected increase in giving over $250 from 1986 to 1992 (the other two remained constant). The four higher-income groups did show the expected behavior. In each case, the percentage
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87
Table 5. Percentage of Charitable Donations over $250 by Decile and Year. 1986
1 2 3 4 5 6 7 8 9 10
1988
1992
Mean
S.D.
Mean
S.D.
Mean
S.D.
35.71 35.35 38.03 35.92 37.18 41.39 47.04 60.14 81.41 93.49
52.07 52.18 51.44 52.32 51.66 50.74 50.08 51.03 61.09 74.32
33.02 35.30 39.65 39.37 36.90 41.64 49.19 71.60 87.92 91.34
52.95 52.20 51.07 51.13 51.74 50.69 49.99 54.90 67.28 71.87
35.85 39.08 38.91 40.15 39.81 43.36 47.53 65.31 87.51 93.00
52.04 51.20 51.24 51.93 51.04 50.43 50.05 52.39 66.93 74.48
1986 vs. 1988
1986 vs. 1992
(*)
* *
*
1988 vs. 1992
*
* **
*
*
*
(*)
*
*
(*)
*
Note: Percentage over $250 = Percentage of taxpayers making donations over $250; S.D. = Standard deviation. ∗ Significant at 0.05 level. ∗∗ Significant at 0.10 level.
of taxpayers giving over $250 in donations from 1986 to1992 either stayed the same or increased. The predictions of Hypothesis H3 were mainly supported.
Tax Changes Due to the Move from a Deduction to a Tax Credit System As seen above, one of the main changes following the 1987 tax reform was that the marginal benefit of making donations over $250 compared to donations under $250 was substantially greater. To be able to obtain some insight into taxpayers’ behavior on the change from the deduction system to the tax credit system only, the data were analysed by observing only those taxpayers who were in the same marginal tax group in each of the three years. Under the tax deduction system, the marginal tax rate was important in determining the tax cost of charitable giving; the marginal tax rate is irrelevant under the tax credit system. The expectation would follow Hypothesis H3, that even where the marginal rates are similar, taxpayers would increase their donations to above $250, to take advantage of this threshold benefit. For the taxpayers with the lowest marginal tax rate, one would expect that the percentage of taxpayers giving more than $250 to increase, because these taxpayers would benefit from the superdeduction. The change in the law reduced the benefit of charitable giving for the higher marginal rate taxpayers who gave less than $250 (the benefit was now based on
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the lowest tax rate rather than their actual marginal tax rate). Although the highest marginal tax rate was reduced, taxpayers in the highest marginal tax rates would still obtain a greater benefit for donations over $250 than for donations under that amount. Thus, taxpayers in the highest marginal tax rates would be expected to increase their giving to more than $250. Taxpayers who had the lowest marginal tax rates and the highest marginal tax rates were used to analyse this behavior decile had taxpayers in the lowest marginal tax rates and other taxpayers in the highest marginal tax rates.15 In this analysis, the number of groups were reduce to quintiles, so that there would be at least 100 observations in each group. Each group was made up of two deciles. Table 6 reports the results of this analysis. Table 6. Percentage of Charitable Donations over $250 by Group, MTR and Year. Decile/Group
1986 Mean (N)
S.D.
1988 Mean (N)
S.D.
1992 Mean (N)
Panel A: Marginal tax <28%: percentage over $250 1–2 37.5 48.4 36.1 48.0 38.7 1,242 1,665 1,254 3–4 52.8 50.0 43.9 49.7 46.4 269 691 375 5–6 64.2 48.1 39.7 49.0 42.9 123 406 326 7–8 68.9 46.5 59.1 49.3 66.7 103 137 114 9–10 84.1 36.6 94.3 23.3 93.4 164 105 122 Panel B: Marginal tax <42%: percentage over $250 1–2 41.9 49.4 41.3 49.3 39.4 465 492 960 3–4 19.7 39.8 34.3 47.5 36.8 402 1,389 2,596 5–6 30.1 45.9 36.1 48.1 37.9 1,073 1,973 2,806 7–8 51.2 50.0 64.0 48.0 58.5 2,221 3,234 3,800 9–10 86.2 34.5 89.14 31.1 90.3 3,715 4,649 5,034
S.D.
1986 vs. 1988
1986 vs. 1992
1988 vs. 1992
48.7 50.0
(*)
49.6
(*)
(*)
47.3 *
*
48.2
*
*
48.5
*
*
49.3
*
*
29.6
*
*
24.9
48.9
(*)
Note: MTR = Marginal tax rate; S.D. = Standard deviation; N = Number of observation in cell. ∗ Significant at 0.05 level.
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Panel A of Table 6 contains information for taxpayers whose marginal tax rate was under 28% each year. There was no significant change in the percentage of taxpayers who gave more than $250 in charitable donations for taxpayers in the lowest quintile (deciles 1and 2). There were significant decreases for taxpayers in the second and third quintiles (covering deciles 3 to 6). Both of these results were contrary to the a priori expectations. Taxpayers in the highest quintile (deciles 9–10) showed a significant increase in the percentage giving over $250 to charity. Taxpayers in this group were the only ones to take advantage of the benefit of the change in the tax rules. Panel B of Table 6 shows the analysis of the taxpayers who had a marginal rate of over 42% in each year. The results show that the percentage of taxpayers giving over $250 increased significantly in all the quintiles other than the lowest quintile. This follows the a priori expectations, that, to keep much of the benefit, higher-income taxpayers who had not given over $250 in 1986 were more likely to do so after tax reform. Overall, taxpayers who were taxed consistently at the lowest marginal tax rates changed their behavior in a manner that did not follow the predictions; however, those taxpayers who were taxed consistently at the highest marginal tax rates changed their behavior in a manner that was predicted by H3.
SUMMARY DISCUSSION AND CONCLUSION The tax changes that occurred in the tax reform of 1987 affected the tax cost of charitable giving. The move from a deduction system to a tax credit system was a major change in tax philosophy. Furthermore, permitting all taxpayers who gave more than $250 in donations to receive the tax credit at the highest federal tax rate gave low-income taxpayers a greater reduction of taxation than the pre-reform system would have done. This is called the superdeduction. Initial results show that taxpayers increased their actual charitable giving from 1986 to 1988 for all deciles other that the first and tenth deciles. There were significant increases in the level of donations from 1986 to 1992 for taxpayers in all deciles. Relative results, taking into account inflation, percentage of after-tax income or percentage of donations over $250, showed a somewhat less certain picture. Comparing the results shown in Tables 2–4, it seems that an increase in income has a corresponding increase in charitable giving, but to a much smaller degree. This may be due to taxpayers giving similar amounts from year to year, as anecdotal evidence suggests. In the low income groups (deciles 1 and 2), the taxpayers in decile 1 generally had relative decreases in giving. This was contrary to the a priori expectations,
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which was that they would increase their giving to take advantage of the superdeduction. This result does lend some support to the findings of Ricketts and Westfall (1993). The taxpayers in decile 2 increased their charitable giving amounts even when the figures were adjusted for inflation. This is in line with the predictions. The results, however, for the percentage of after-tax income or the percentage of giving over $250 did not show any significant increase. Perhaps only those low-income taxpayers who had relatively higher-income increased their charitable giving, but not as much as would have been expected. Some middle-income taxpayers took the opportunity to increase their donations and thus benefited from the new law. The taxpayers in the two middle deciles (deciles 4 and 5) of this income area significantly increased their donations from 1986 to 1988, when adjusted for inflation and also increased the percentage of giving to after-tax income. These increases, however, were not sustained into 1992. This result does not support the findings of Ricketts and Westfall (1993). The percentage of taxpayers in decile 4 who gave more than $250 also increased significantly from 1986 to 1988, and this increase was sustained in 1992. In the high-income deciles, only taxpayers in the tenth decile followed the a priori prediction that they would decrease their donations. The taxpayers in the middle two deciles of this group (deciles 8 and 9) increased their giving generally, though taxpayers in the ninth decile decreased their contributions as a percentage of after-tax income. Overall, except for the taxpayers in decile 10, the results do not support a pure tax cost argument explaining philanthropy, which would have predicted results opposite to those obtained. Analysis also was carried out to ascertain the changes in philanthropic behavior due to the change from the deduction system to the tax credit system. The implications from the above is that the tax cost of giving does not appear to be an element in the decision whether or how much to give to charity. However, the crossing of the threshold of the superdeduction may well play an important role. Those taxpayers with lower marginal tax rates in the three years had mixed results. Taxpayers in the middle quintiles (covering deciles 3–6) showed a decrease in the percentage giving over $250, whereas taxpayers in the top quintile (deciles 9 and 10) showed increases. The results for taxpayers who were in the highest marginal tax rates in the three years were consistent. A greater percentage of these taxpayers (other than those taxpayers in the first quintile) gave more than $250 in 1988 and 1992 than in 1986. This indicates that the threshold for the increased tax credit is more important to higher marginal tax rate taxpayers than to lower marginal tax rate taxpayers. Policymakers should regard the results of this research as indicating that the move from a tax deduction system to a tax credit system gives unexpected results. This is especially true if the change is accompanied with a lowering of marginal
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tax rates. The usual economic argument that tax costs drive philanthropy may not be valid in this case, especially where there is a definite threshold between the levels of tax credit given. Overall, the results of this research indicate that some factor (or factors) other than tax cost is (are) important to taxpayers with respect to their decision regarding charitable giving. Further research should be carried out to determine the nature of these factors and their individual and combined effects on charitable giving.
NOTES 1. The United Kingdom uses a modified deduction system, whereby a taxpayer’s donation (by covenant or “gift aid”) is treated as having basic rate deducted; eligible taxpayers may claim a credit for higher rate tax. This makes it equivalent to a deduction system, where the relief depends on the taxpayer’s tax rate. 2. Washington Post: 30th May 2000. 3. Montana has had a credit since 1997. Indiana permits a credit of 50% of a gift up to a maximum credit of $200. Oregon is currently debating Oregon Tax Credit bill. The billwould permit a 105% tax credit, which would be carried over if not used. (House Bill 3342 Sponsored by Representative Hopson – 71st Oregon Legislative Assembly – 2001 Regular Session). 4. The income tax provisions of the tax reform took effect from 1988. Information regarding tax reform was made public in the Tax Reform White Paper, dated 18th June 1987. The bill effecting the legislation was C-139, which became the Act, S.C. 1988, c.55. Royal Assent was granted on 13th September, 1988. 5. Due to clawback of benefits, the actual “marginal tax” rate could be much higher. Many benefits were targeted to taxpayers had low incomes, thus as incomes rose some benefits were reduced or eliminated. 6. This limitations continued into the post-reform tax credit regime. The amount on which the credit was computed was restricted to 20% of income for tax purposes. This limitation was increased in 1996 to 50% and again in 1997 to 75%. 7. The threshold of $250 was reduced to $200 in 1994. 8. Since provincial tax was a percentage of the federal tax after tax credits, the benefit to the taxpayer was increased by the lowering of the combined taxes payable. 9. The exact cost of giving varied slightly from these figures depending on the province of residence of the taxpayer. For taxpayers giving less than $250, the marginal tax benefit of giving was 17% (deduction at the lowest federal rate) plus the provincial tax (including surtaxes) of about 10%. Thus, the marginal cost of giving was 73% (1-MTR). Similarly, for taxpayers giving more than $250, the marginal benefit of giving was 29% (deduction at the highest federal tax rate) plus provincial tax of about 17%. Thus, the marginal cost of giving was 54%. 10. A taxpayer in the first decile giving $348 would have about the same after-tax cost of giving: pre-reform $236 ($348 × 0.6788) and post-reform $235 ($250 × 0.73 + $98 × 0.54). A taxpayer in the sixth decile making a donation of $700 would have the same after-tax cost of giving: pre-reform $426 ($700 × 0.6088) and post-reform $426 ($250 × 0.73 + $450 × 0.54).
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11. If both spouses were to claim their own charitable donations, each spouse would have a tax credit on the donations up to $250 calculated at the lower rate. 12. The analysis also was carried out on the full set of observations. There was very little difference in the results. Certainly, the conclusions would not have changed. 13. Inflation was taken as the changes in Consumer Price Index of Canada in July of the relevant years (Statistics Canada, 2002 – Table 4). 14. There is anecdotal evidence that taxpayers tend to give similar amount from one year to the next. Recently, the author has heard two clerics bemoan the fact that many in their congregations have not changed their weekly “plate” giving in over ten years! 15. Taxpayers with low total income could be in the highest marginal tax rates due to clawback of benefits. Taxpayers with high total income could be in the lowest marginal tax rates due to large deductions or losses carried over from other years. Taking into account provincial taxes as well as federal taxes, the lowest marginal rates were taken as below 28% and the highest rates were taken as over 42%.
ACKNOWLEDGMENTS The author would like to thank the participants of the workshops at Simon Fraser University and Wilfred Laurier University, the anonymous reviewers and especially the editor, Tom Procano, for helpful comments on earlier versions of the paper. The author also thanks the Institute of Chartered Accountants in British Columbia for its generous funding assistance.
REFERENCES Adams, S. (1997). Can a charity tax credit help the poor. The American Prospect (pp. 10, 45). Auden, G., Cilke, J., & Randolph, W. (1992). The effects of tax reform on charitable contributions. National Tax Journal, XLV(3), 267–290. Auden, G., Clotfelter, C., & Schmalbeck, R. (2000). Taxes and philanthropy among the wealthy. In: J. Slemrod (Ed.), Does Atlas Shrug? Cambridge, Mass.: Harvard University Press. Barrett, K. S., McGurik, A. M., & Steinberg, R. (1997). Further evidence of the dynamic impact of taxes on charitable giving. National Tax Journal, L(2), 321–334. Bordt, M., Cameron, G. T., Gribble, S. F., Murphy, B. B., Rowe, G. F., & Wolfson, M. C. (1990). The social policy simulation database and model: An integrated tool for tax/transfer policy analysis. Canadian Tax Journal, 38(January), 48–65. Broman, A. J. (1989). Statutory tax reform and charitable contributions: Evidence from a recent period of reform. Journal of the American Taxation Association, 11(1), 7–21. Christian, C. W., Boatsman, J. R., & Reneau, J. H. (1990). The interpretation of econometric estimates of the tax incentive to engage in philanthropy. The Journal of the American Taxation Association, 11(2), 7–16. Clotfelter, C. (1980). Tax incentives for charitable giving: Evidence from a panel of taxpayers. Journal of Public Economics (June), 319–340. Clotfelter, C. (1985). Federal tax policy and charitable giving. Chicago: University of Chicago Press.
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Clotfelter, C. (1992). The impact of tax reform on charitable giving: A 1989 perspective. In: J. Slemrod (Ed.), Taxes Matter? Cambridge, Mass.: MIT Press. Dunbar, A. E., & Phillips, J. (1997). The effect of tax policy on charitable contributions: The case of nonitemizing taxpayers. The Journal of the American Taxation Association (Suppl.), 1–20. Duquette, C. M. (1999). Is charitable giving by nonitemizers responsive to tax incentives: New evidence. National Tax Journal, LII(2), 195–206. Feenburg, D. (1981). Are tax price models really identified: The case of charitable contributions. National Tax Journal, XXXV, 629–633. Feldstein, M. (1975). The income tax and charitable contributions: Part 2 – the impact on religious, educational, and other organizations. National Tax Journal, XXXVIII(2), 209–226. Feldstein, M., & Clotfelter, C. (1976). Tax incentives and charitable contributions in the United States. Journal of Public Economics (January/February), 1–26. Kitchen, H. (1992). Determinants of charitable donations in Canada: a comparison over time. Applied Economics, 24, 709–713. Kitchen, H., & Dalton, R. (1990). Determinants of charitable donations by families in Canada: A regional analysis. Applied Economics, 22, 285–299. Macnaughton, A. (1992). Canadian income tax data. In: R. P. Crum (Ed.), A Guide to Tax Research Databases. Sarasota, FL: American Accounting Association. Ombwatch (1997). Charity tax credit delayed as community renewal debate focuses on vouchers. http://www.ombwatch.org/npadv/1997/acra1017.html Ricketts, R. C., & Westfall, P. H. (1993). New evidence on the price elasticity of charitable contributions. The Journal of the American Taxation Association, 15(Fall), 1–25. Statistics Canada (1992). SPSD/M reference manual: Database creation guide. Ottawa, ON: Statistics Canada. Statistics Canada (2002). Catalogue 62-001. Ottawa. ON: Statistics Canada.
HOW ENGAGEMENT LETTERS AFFECT CLIENT LOSS AND REIMBURSEMENT RISKS IN TAX PRACTICE Lynn Comer Jones, Ernest R. Larkins and Ping Zhou ABSTRACT In a supplemental analysis, Krawczyk and Sawyers (1995) (K&S) found evidence that variations in engagement letter language affect the likelihood that taxpayers hold CPAs “responsible” for additional tax assessments, a broad measure of risk. We extend the K&S analysis by examining the effect of engagement letters on a larger set of precisely-defined tax practice risks. Our factor analysis identifies two risk constructs relating to client loss and reimbursement. MANCOVA shows that engagement letters reduce the likelihood of incurring both categories of risks. Also, some evidence suggests that higher-income participants are greater tax practice risks, and subjects with external loci of control represent higher client loss and reimbursement risks. Finally, we find that engagement letters reduce the percentage of professional fees subjects request as reimbursements following an unfavorable IRS audit and that prior legal suits, gender, age, and income level also may affect the fee reimbursement requested.
Advances in Taxation Advances in Taxation, Volume 16, 95–122 Copyright © 2004 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(04)16005-5
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INTRODUCTION Reinstein and Bayou (1999, p. 10) and Williams (1997, p. 31) observe that the number and magnitude of legal claims in accounting practices have increased. Scutellaro and Muirhead (2000, p. 890), Kahan (1998a, p. 49), Stevens (2000, p. 39), and Yancey (1996) indicate that tax practice accounts for about half of all accounting claims filed and approximately one-fourth of dollars paid on malpractice insurance policies. The costs of defending against these claims, as well as the costs of settlement (whether in court or out of court), are often high. Williams (1997, p. 31) estimates that the average legal claim costs accounting firms between 250 and 300 billable hours. Bandy (1996, p. 46) observes that the cost of malpractice insurance is approximately 10% of total expenses in the typical accounting practice. However, risks associated with dissatisfied clients can extend beyond defense costs and legal liability claims. For example, clients may be more likely to request reimbursements. We refer to requests for reimbursement and the possibility of legal suit as “reimbursement risks.” Further, clients may be less likely to provide positive recommendations and more likely to change tax advisers following an unfavorable IRS audit. We label these tendencies as “client loss risks.” Thus, dissatisfied clients may involve costs that are not reflected in legal risk measures. We collectively refer to a tax professional’s exposure to client loss and reimbursement risks as “tax practice risks.”1 Managing tax practice risks is important for tax professionals and the insurance industry that, to varying degrees, share such risks. The American Institute of Certified Public Accountants (AICPA) and insurance underwriters recommend the use of engagement letters to reduce exposure to legal liability (Demery, 1997; Murray, 1992; Reinstein & Bayou, 1999). Engagement letters clarify services that tax professionals agree to render clients and are commonly thought to reduce demands for reimbursement (e.g. see Reinstein & Bayou, 1999). Prior research has not specifically examined the impact of engagement letters on non-litigation risks even though tax professionals receive exposure to such risks more frequently than litigation risks.2 The economic losses to tax practitioners associated with non-litigation risks may be difficult to quantify, but such difficulty does not lead to the conclusion that non-litigation risks are negligible. It is important for tax practitioners to be aware of and manage these risks too. This research extends Krawczyk and Sawyers (1995) (K&S), the only prior study involving tax engagement letters and makes four contributions. First, we test the effect of using an engagement letter vs. using no engagement letter on client loss and reimbursement risks. Second, we examine additional and more specific risk measures than K&S and conduct a factor analysis to identify two risk
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constructs. Third, we consider the impact of several factors on tax practice risk that K&S did not, such as locus of control and income levels. Fourth, we control for a possible scaling effect and examine whether a larger engagement magnitude might be related to an increased likelihood of tax practice risk or a proportionately higher reimbursement request. In this study, we examine the effect of engagement letters on: (a) the likelihood of client loss and reimbursement risks; and (b) the percentages of additional tax, interest, and professional fees that clients request as reimbursements. We find that using engagement letters reduces the likelihood of realizing both forms of tax practice risks. These results suggest that tax professionals can use engagement letters to reduce a broad spectrum of risks through reducing client expectation gaps. We also find that using engagement letters reduces the percentage of professional fees clients request as reimbursements, but we do not find a similar effect for the percentage of additional tax and interest clients request as reimbursements. This result suggests that clients view professional fees differently from additional tax and interest. MANCOVA indicates that tax practice risks are greater for higher-income taxpayers, suggesting that these individuals may experience greater expectation gaps than lower-income taxpayers. Further, we find evidence that participants with external loci of control represent greater client loss and reimbursement risks. Our study proceeds as follows. The second section summarizes the only prior study to examine the effect of tax engagement letters on tax practice risks and presents our hypotheses. The third section describes the experiment, the fourth section reports our results, and the final section offers concluding remarks and suggests avenues for future research.
HYPOTHESES In this section, we develop hypotheses based on client-adviser expectation gaps and consumer attribution theory. We present hypotheses about the effects of engagement letters and engagement magnitude on tax professionals’ tax practice risks when clients receive unfavorable IRS audit results. We base our analysis on a two-stage framework of a client’s decision-making process. In the first stage, the client decides whether to hold the tax professional responsible for the unfavorable audit results. In the second stage, the client determines how much (if any) to seek from the tax professional as a reimbursement. We state two sets of hypotheses based on these two stages. The first set predicts the effects of engagement letters and engagement magnitude on the likelihood of incurring tax practice risks. Assuming that the client decides to seek
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reimbursement from the tax professional following an unfavorable IRS audit (i.e. the amount sought is greater than zero), the second set of hypotheses predicts the effects of engagement letters and magnitude on the percentages clients request as reimbursements.
Engagement Letter Christensen (1992) discovers several gaps between tax services clients expect and tax services they actually receive. Generally, her findings suggest that client expectations are higher than tax professionals realize, often leading to client dissatisfaction. Higher levels of client dissatisfaction suggest higher tax practice risks. The professional literature asserts the commonly-held belief that routine and consistent use of tax engagement letters is one means to reduce the expectation gap between clients and tax professionals (e.g. see Holl & Colby, 2001, p. 34; Kahan, 2001, p. 35; Karys, 1998; Reinstein & Bayou, 1999; Stimpson, 1999, p. 32; Wolosky, 1998, pp. 45–4). At the same time, much anecdotal evidence exists that practitioners often do not send engagement letters for various reasons, relying instead on oral understandings and agreements (e.g. see Demery, 1997, p. 40; Kahan, 1998b, p. 48; Stimpson, 2000, p. 54; Wolfe & Anderson, 2001; Wolosky, 1998, p. 45). Tax engagement letters generally clarify the service tax professionals render for clients and the IRS audit risks in following any advice rendered. As a means of clarification, engagement letters are thought to narrow the expectation gap between clients and tax professionals and, thus, reduce tax practice risks. Conversely, the absence of an engagement letter may provide clients with convenient excuses to hold tax professionals responsible after unfavorable IRS audits. Folkes (1984) presents survey and experimental evidence supporting the application of attribution theory to consumer complaining behavior. In this context, attribution theory posits that product or service failure is not the sole determinant of consumer complaints. Behavioral reactions also depend on perceived reasons products or services do not meet expectations. When consumers attribute product or service failure to the provider, Folkes finds consumers more likely to express their dissatisfaction by speaking negatively to others about the company and demanding refunds. Conversely, consumers attributing product or service failures to other factors are less likely to react negatively toward the provider. To the extent engagement letters narrow expectation gaps or shift the focus of responsibility more toward clients, one might expect that clients not receiving tax engagement letters are more likely to attribute responsibility for negative audit results to their tax advisers vis-`a-vis clients receiving engagement letters.
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Similarly, Jorgensen (1996) finds consumer reaction to company-related mistakes is positively related to their perceptions of the company’s responsibility for the incident. Company communications can ameliorate consumers’ negative reactions when consumers perceive that the company could not reasonably prevent or control the unfortunate incident. Using structural equation modeling, Jorgensen finds that company responsibility is positively associated with consumers’ negative emotions, and negative emotions are positively associated with punitive actions consumers intend to take toward the company (e.g. making future purchases from a competitor). In the present context, these results suggest that using engagement letters may lessen taxpayers’ perceptions of tax professionals’ responsibility for negative IRS audit results and, thus, reduce tax practice risks. As the only prior research studying tax engagement letters, K&S examined the effect of altering an engagement letter’s language on broad measures of tax practice risk. They conducted an experiment using 117 members of seven service and civic clubs. Subjects received two fact scenarios in which CPAs advised them to claim tax deductions that the IRS later audited and disallowed, resulting in additional tax assessments. K&S randomly assigned subjects to receive one of four engagement letters with the fact scenarios – three containing different legal liability disclaimers and one without disclaimers – and to one of two IRS assessments (large and small). Thus, K&S manipulated explanatory variables between subjects, while the fact scenario acted as a within-subject variable. Participants answered the following questions: (1) What is the likelihood that you would hold the CPA responsible for the adverse IRS determination? (2) Would you bring suit against the CPA or otherwise request them to reimburse you for any of the additional taxes assessed by the IRS in this situation? (3) If you answered “Yes” to question 2, what amount would you request from the CPA? When examining all responses, K&S did not find that variations in engagement letter language affected the likelihood of holding CPAs responsible for the additional taxes assessed. However, when K&S conducted a supplemental analysis with only subjects experiencing large IRS assessments, they found evidence that more explicit disclaimers of legal liability did reduce the likelihood of assigning responsibility to CPAs. They did not find that more explicit disclaimers reduced the percentage of subjects who would sue the CPA or otherwise request a reimbursement. However, in one of two fact scenarios, their results suggest that more explicit risk disclaimers in engagement letters reduce expected legal claims. We extend the K&S analysis by examining the impact on risk when a client receives an engagement letter vs. when an engagement letter is not received,3
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considering other factors that may affect tax practice risk such as clients’ loci of control,4 and defining and analyzing more specific dimensions of K&S’s broad measures of tax practice risk. For example, their question 1 asked subjects whether they would “hold the CPA responsible.” The specific way in which subjects might hold CPAs responsible can vary from switching tax advisers (or not recommending the CPA to others) to requesting reimbursement to bringing legal suit. Similarly, their question 2 asked each subject whether they would “bring suit against the CPA or otherwise request them to reimburse you for any of the additional taxes.” This measure encompasses both litigation and non-litigation measures of tax practice risks, does not consider the risk related to reimbursing interest charges and professional fees, and does not include risks related to client loss. Thus, we hypothesize (in alternative form) that: H1a. Engagement letters reduce the likelihood of incurring client loss and reimbursement risks in tax practice. The earlier discussion suggests that engagement letters may reduce the likelihood that clients hold tax professionals responsible for unfavorable IRS audits. Based on the same theory, we also expect that engagement letters reduce the percentage reimbursements clients seek from tax professionals. K&S examined only reimbursements for the additional tax assessed and expressed the reimbursement in dollars. We believe a client’s perception of economic loss associated with an unfavorable IRS audit also may extend to professional fees and interest charges on the additional tax. Thus, we extend K&S’s analysis by segregating a client’s requested reimbursement into three parts – additional tax, interest, and professional fee. To avoid scaling effects, we express each measure as a percentage of the maximum that clients can request. For example, if the professional fee is $1,000 and the client requests $600 as a reimbursement, we use 60% ($600/$1,000) as our dependent variable measure. Thus, we predict: H1b. Engagement letters reduce the percentage of additional tax, interest, and tax advice fee clients request as reimbursements.
Engagement Magnitude Another possible factor affecting tax practice risk after an unfavorable IRS audit is engagement magnitude, which we characterize as the total size of the additional tax assessment, interest charge, and professional fee. Following an unfavorable IRS audit, a client experiences an economic loss. The larger the engagement magnitude is, the greater the economic loss. When the taxpayer depends on a tax adviser, one
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possible source for recouping the economic loss is the adviser. St. Pierre and Anderson (1984) find a positive relationship between the size of a clients’ losses and client propensity to sue accounting firms, suggesting that the expected recovery from the adviser is greater the larger the engagement. Thus, we expect engagement magnitude to have a positive relationship with the likelihood of incurring tax practice risks. Nonetheless, K&S did not find that the magnitude of additional tax the IRS assesses is positively associated with the likelihood of holding tax preparers responsible. The conflicting result between St. Pierre and Anderson (1984) and K&S (1995) is one motivation for manipulating magnitude in this study. K&S may not have found a magnitude effect because of the range over which they manipulated this variable. Specifically, they presented subjects with fact scenarios involving assessment magnitudes of either $700 or $3,500. After considering court-related expenses, some participants may have perceived these amounts as too small to pursue. In our manipulation, participants received cases involving additional taxes of $10,000 or $50,000. Also, we examine the effect of engagement magnitude (K&S examined assessment magnitude) on specific forms of tax practice risks (K&S used a broader measure of holding the “CPA responsible”). Thus, we hypothesize (in alternative form) that: H2a. Engagement magnitude is positively associated with the likelihood of incurring client loss and reimbursement risks in tax practice. K&S find a strong positive relationship between magnitude and the dollar amount of additional tax clients request in a lawsuit (their research question 3). However, this relationship may have resulted from a scaling effect. To avoid scaling effects, we divide the dollar amount requests for additional tax, interest, and professional fee by the totals of each (as in H1b). Thus, we examine whether the percentage of tax, interest, and fee that clients request as reimbursements is higher for larger engagements. Following K&S, we predict: H2b. Engagement magnitude is positively associated with the percentage of additional tax, interest, and tax advice fee clients request as reimbursements.
EXPERIMENT Participants In the present study, 162 MBA students attending a southeastern public university participated.5 We use two types of monetary inducements to motivate conscientious participation. First, $1 is attached to each experimental instrument.
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Second, a drawing is held among all participants for a $100 prize. Only subjects correctly answering two questions related to the experimental task are eligible for the drawing.6 Demographic information appears in Panel A of Table 1. Almost 30% of the participants (46 out of 162) paid someone to prepare their most recent tax return; about two-thirds of these 46 individuals used a CPA.7 Of those who hired a tax preparer, 43% received an engagement letter (20 of 46). The fact that 57% of our participants used tax return preparers that did not send an engagement letter is consistent with anecdotal evidence discussed earlier. Of those receiving engagement letters, 75% (16 out of 20) were required to return a signed copy to their preparer. Only 6% of the participants underwent an IRS audit, and 6% had been involved in a previous legal suit (other than for divorce, separation, or child custody). Sixty-four percent of participants were male, 77% were under 31 years of age, and 70% were Caucasian. In our sample, only three (1.9%) participants did not indicate a filing status on their most recent tax returns, suggesting that almost all subjects pay income taxes. Fifteen percent of the respondents had family gross income of $25,000 or less, while 30% had income between $25,000 and $50,000. In comparison, the IRS reports that 51% of taxpayers have adjusted gross incomes (AGIs) of $25,000 or less, 25% have AGIs above $25,000 but not more than $50,000, and 24% have AGIs of $50,000 or more (Campbell & Parisi, 1999, p. 25). Thus, the sample’s income distribution appears to be higher than that of the taxpaying public, though not necessarily different from individuals using tax preparers. Approximately 60% of the subjects file joint tax returns. Panel B of Table 1 provides information about subjects’ effort levels in completing the questionnaire, the understandability of the experimental task, and the clarity of instructions and terms. We used a five-point Likert scale to measure responses to the debriefing questions, where a 5 indicated high effort, high understanding of the task, and clear instructions and terms. Generally, subjects indicated that they did their best in responding to the questionnaire (mean 4.69 Table 1. Demographic Information and Debriefing Items. Panel A: Demographic Information (n = 162)
Tax return preparer CPA Attorney Other None
Number
Percentage
31 1 14 116
19.14 0.62 8.64 71.60
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Table 1. (Continued ) Panel A: Demographic Information (n = 162) Number
Percentage
Engagement letter Received but not required to sign Received and required to sign None received No tax return preparer Missing IRS audit Filed legal suit Male
4 16 25 116 1 9 9 104
2.47 9.88 15.43 71.60 0.62 5.56 5.56 64.20
Age 30 or less 31–50 Above 50
125 37 0
77.16 22.84 0.00
Race African-American Asian Caucasian Other Missing
14 24 113 10 1
8.64 14.81 69.75 6.18 0.62
Gross income $25,000 or less $25,001–$50,000 $50,001–$75,000 $75,001–$100,000 Above $100,000 Missing
24 49 51 16 16 6
14.81 30.25 31.48 9.88 9.88 3.70
Filing status Single Joint Other Missing
54 98 7 3
33.33 60.50 4.32 1.85
Mean
Median
Stan. Dev.
5.00 5.00 5.00 4.00 5.00
0.82 0.84 0.84 0.96 0.76
Panel B: Debriefing Items (n = 162)
Best effort Clear meaning Understand case Interesting task Clear instructions
4.69 4.38 4.46 3.59 4.60
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and median 5.00). The wording in the questionnaire was clear (mean 4.38 and median 5.00), the case facts were understood (mean 4.46 and median 5.00), and the survey instructions were clear (mean 4.60 and median 5.00). Using Rotter’s (1966) general expectancy construct of personality, we measured each participant’s internal-external (I-E) locus of control. Since externals view events or occurrences as outside their control, they tend to assign blame or responsibility for unfavorable events or outcomes (e.g. IRS assessments) to powerful others (e.g. CPAs). Davis and Davis (1972) demonstrated that the differences between internals and externals are more pronounced when outcomes are unfavorable (e.g. additional tax and interest is due following an IRS audit). Similarly, Stones (1983) discovered that externals are more likely to attribute responsibility for failures to others when threatened. Phares et al. (1971) found that externals attribute blame to other individuals more often than internals. The Rotter I-E scale enjoys widespread use and general reliability and validity (Lefcourt, 1991, pp. 420–425). However, experimental time constraints prompted us to reduce Rotter’s original battery of 23 items to Ferguson’s (1993) six-item personal control dimension plus three filler items. One expects that the six items measure the same theoretical construct. Cronbach’s (1987) coefficient alpha for the six factors is 0.618 in our study, suggesting internal-consistency reliability. I-E locus of control indicates the extent to which participants attribute unfavorable outcomes to external factors (e.g. a CPA who provides tax advice). Externals (internals) generally obtain high (low) I-E scores. Thus, tax practice risks may be greater for clients with high I-E scores (i.e. externals).
Design and Procedures All participants read a case in which the hypothetical taxpayer plants a peach tree orchard on his property and sells peaches from a roadside stand. The tax issue is whether the activities of growing and selling peaches constitute a trade or business or a hobby.8 If treated as a trade or business, the activity’s net loss is deductible. Otherwise, I. R. C. § 183 disallows the net loss. The taxpayer, based on the tax professional’s advice, takes the tax return position that the net loss is deductible. The IRS later audits and disallows the deduction, assessing the taxpayer additional tax and interest. The experiment uses a 2 × 2 between-subject design and manipulates the presence of an engagement letter (LETTER) and the engagement magnitude (MAG). Regarding LETTER, the case includes either no engagement letter or an engagement letter explaining the respective responsibilities of the parties, audit risks, and the relevant factors under the law.9 Regarding MAG, we manipulate
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the engagement magnitude on two levels. For the larger magnitude, the tax advice saves the client $50,000, and the client pays the tax adviser a $5,000 fee. As a result of the subsequent IRS audit, the client pays additional tax of $50,000 plus interest of $11,500. For the smaller magnitude, we divided all dollar amounts by five (i.e. $10,000 savings, $1,000 fee, and $2,300 interest).10 We randomly assigned participants to one of four categories: letter with small magnitude, letter with large magnitude, no letter with small magnitude, and no letter with large magnitude. Each participant received an experimental instrument consisting of a case and a questionnaire. (The Appendix contains a sample instrument.) The questionnaire has three parts. In Part 1, participants provide several measures of tax practice risk (as discussed in more detail below) and demographic information about themselves. Part 2 consists of Ferguson’s (1993) internal-external (I-E) personal control instrument, which we use to measure participants’ loci of control (discussed earlier). Part 3 assesses how well subjects understand the tasks and whether instructions are clear, among other things. The experiment takes about 15 minutes.
Dependent Variables Part 1 of the questionnaire collects nine measures of the dependent variable, tax practice risk, which we divide into two groups: likelihood measures and percentages that participants request as reimbursements. The first group measures the likelihood of incurring six tax practice risks: not recommending the tax professional to others (NOTREC); switching to another professional the next time the client needs tax advice (SWITCH); requesting a reimbursement from the tax professional for additional tax the IRS assesses (REIMBtax ), interest associated with the additional tax (REIMBint ), the tax advice fee (REIMBfee ); and the risk of legal action (LEGAL). We measure these likelihood variables along a 7-point Likert scale, where 7 represents the highest risk, and 1 indicates the lowest risk.11 We performed an exploratory factor analysis on our first group of likelihood measures and determined that the six measures load on two constructs. Table 2 shows that NOTREC and SWITCH load heavily on one factor while the remaining likelihood measures load on a second factor. We describe these two constructs as client loss risk and reimbursement risk, respectively. In the second group, our dependent variables measure the percentages that participants request as reimbursements following the unfavorable IRS audit, represented as PERCtax , PERCint , and PERCfee .12 To illustrate, consider a participant receiving a small engagement magnitude case (i.e. tax advice fee of
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Table 2. Varimax Common Factor Analysis on Likelihood Measures of Tax Practice Risk. Variables
Factor 1
Factor 2
REIMBint REIMBtax REIMBfee LEGAL SWITCH NOTREC Eigenvalue Proportion of total eigenvalues
0.832 0.647 0.643 0.615 0.199 0.272 2.842 85.23%
0.105 0.175 0.313 0.317 0.861 0.818 0.827 24.79%
Note: Factor loadings higher than 0.500 appear in bold. Variables defined: NOTREC = Likelihood subject does not recommend CPA to others; SWITCH = Likelihood subject switches to a different CPA; REIMB = Likelihood subject requests reimbursement from CPA for tax, interest, or fee; LEGAL = Likelihood subject begins legal action against CPA.
$1,000) and indicating that she would ask the tax professional to reimburse her for $700 of the tax advice fee. For this participant, PERCfee equals 70%.
RESULTS Likelihood of Incurring Tax Practice Risks Table 3 presents descriptive statistics for the likelihood of incurring tax practice risks when a client follows a tax professional’s advice but receives an unfavorable IRS audit result. Overall means for NOTREC and SWITCH are 5.98 and 6.06, respectively, suggesting the likelihood of incurring client loss risks is high. Overall means for reimbursement risk measures (REIMBtax , REIMBint , and REIMBfee ), are 3.67, 4.69, and 5.30, respectively, suggesting that taxpayers are most likely to request reimbursement for their tax advice fee and least likely to request reimbursement for their additional tax. The other reimbursement risk measure, LEGAL, is 4.67, which is lower than those of all other risk measures except for REIMBtax . Two-tailed t-tests show that all differences between the means of client loss risks (NOTREC and SWITCH) and reimbursement risks (REIMBtax , REIMBint , REIMBfee , and LEGAL) are significant at the 0.0001 level, confirming that the mean of each client loss risk is significantly higher than that of each reimbursement risk when negative tax audits occur. H1a predicts that engagement letters reduce the likelihood of incurring tax practice risks and involves six measures of the likelihood (dependent variables).
NOTREC
Small magnitude Large magnitude Combined magnitudes Overall
SWITCH
REIMBtax
REIMBint
REIMBfee
LEGAL
Letter
No Letter
Letter
No Letter
Letter
No Letter
Letter
No Letter
Letter
No Letter
Letter
No Letter
5.73 (49) 5.61 (31) 5.69 (80)
6.35 (48) 6.12 (34) 6.26 (82)
5.96 (49) 5.90 (31) 5.94 (80)
6.21 (48) 6.15 (34) 6.18 (82)
3.27 (49) 3.00 (31) 3.16 (80)
4.15 (48) 4.20 (34) 4.17 (82)
4.10 (49) 3.52 (31) 3.88 (80)
5.75 (48) 5.12 (34) 5.49 (82)
4.90 (49) 4.68 (31) 4.81 (80)
6.02 (48) 5.44 (34) 5.78 (82)
4.06 (49) 3.70 (31) 3.92 (80)
5.35 (48) 5.44 (34) 5.39 (82)
5.98 (162)
6.06 (162)
3.67 (162)
4.69 (162)
5.30 (162)
How Engagement Letters Affect Client Loss
Table 3. Likelihood Descriptive Statistics [Mean (n)].
4.67 (162)
Note: Variables defined: NOTREC = Likelihood subject does not recommend CPA to others; SWITCH = Likelihood subject switches to a different CPA; REIMB = Likelihood subject requests reimbursement from CPA for additional tax, interest, or professional fee; LEGAL = Likelihood subject begins legal action against CPA.
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H2a predicts that the engagement magnitude is positively associated with the likelihood of incurring tax practice risks and also involves six dependent variables. The correlations among dependent variables range as high as 0.814, and all correlations are significant at the 0.01 level (unreported). Thus, to mitigate the effect of an inflated type I error, we test H1a and H2a using MANCOVA. Panel A in Table 4 reports MANCOVA results using all six dependent variables. Based on the exploratory factor analysis, we also report MANCOVA results in Panel B using two factor scores for each participant, one each for client loss and reimbursement risk. Under both models, LETTER is very significant (p < 0.001). Thus, the MANCOVA strongly supports H1a, suggesting that using engagement letters reduces the likelihood of incurring a broad spectrum of tax practice risks. However, our results do not support H2a since MAG is not significant in either model. Thus, we find no evidence that larger economic losses (i.e. larger engagement magnitudes) increase the likelihood of either client loss or reimbursement risks. K&S also found no evidence of a magnitude effect for tax assessments of $700 and $3,500. Our results are consistent with K&S over a broader range of tax assessments ($10,000 and $50,000) and for more specific measures of tax practice risk. Though consistent with K&S, the H2a results differ from the findings of St. Pierre and Anderson (1984). However, less than 10% of the cases St. Pierre and Anderson examined involved tax engagements; about 80% involved audit engagements and write-up work. To the extent St. Pierre and Anderson’s cases differ in magnitude or perceived injustice from tax-related engagements, the positive relationship between magnitude and risk might not hold. For example, Bandy (1996, p. 46) observes that suits from audit failures generally involve larger dollar amounts than tax-related controversies. Ceteris paribus, perhaps dollar magnitudes must be larger than those we examine before clients feel that the effort justifies the expected return from bringing legal action. Since St. Pierre and Anderson examined only cases actually reaching court, their sample involved fairly large magnitudes where parties perceived that expected litigation returns exceeded costs. Cases involving smaller dollar amounts did not reach the courts and, thus, did not appear in their sample. Also, drawing on the distributive justice literature (Deutsch, 1985), perhaps injured parties perceive greater injustice from a failed financial statement audit than they do when an IRS audit simply reveals a client’s “true” tax liability in a closed-facts scenario. Similarly, injured parties may perceive more accountant responsibility from financial statement audits failing to reveal alleged errors than they do from aggressive positions accountants take on tax returns. Of the covariates appearing in the MANCOVA, locus of control is marginally significant in the Panel A model (p = 0.075), but not in the factor score model in
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Table 4. Mancova Tests of H1a and H2a: Likelihood of Incurring Tax Practice Risks. F Stat
P-Value
Panel A: Dependent variables: NOTREC, SWITCH, REIMtax , REIMint , REIMfee , LEGAL Main effects LETTER 7.529 0.000 MAG 1.475 0.191 Interaction LETTER × MAG
0.590
0.738
Covariates Used paid preparer Filed legal suit Audited by IRS Gender Age Locus of control Income level
0.199 1.178 1.344 0.999 0.850 1.966 1.729
0.977 0.322 0.242 0.429 0.533 0.075 0.119
Panel B: Dependent variables: factor scores for client loss and reimbursement risks Main effects LETTER 17.031 0.000 MAG 2.318 0.102 Interaction LETTER × MAG
0.287
0.751
Covariates Used paid preparer Filed legal suit Audited by IRS Gender Age Locus of control Income level
0.090 2.347 1.480 1.407 1.019 2.032 3.576
0.914 0.099 0.231 0.248 0.364 0.135 0.031
Note: Variables defined: NOTREC = Likelihood subject does not recommend CPA to others; SWITCH = Likelihood subject switches to a different CPA; REIMB = Likelihood subject requests reimbursement from CPA for tax, interest, or fee; LEGAL = Likelihood subject begins legal action against CPA; LETTER = 1 if subject receives engagement letter and 0 otherwise; MAG = 1 if engagement magnitude is large and 0 otherwise.
Panel B (p = 0.135). Thus, some evidence exists that subjects with external loci of control are greater tax practice risks than other participants. Also, the income level of the participants appears related to tax practice risks in Panel B. Specifically, participants with higher incomes represent higher tax practice risks following an
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adverse IRS audit (p = 0.031).13 However, this same relationship is insignificant in Panel A (p = 0.119). Consistent with K&S, we do not find that prior IRS audit experience is related to tax practice risks. K&S did find that female taxpayers appear more likely to hold paid preparers responsible than male clients (p = 0.07). Based on their findings, the 64% male subjects in our sample represents a conservative bias. However, our MANCOVA analyses in Table 4 do not provide evidence that gender affects the likelihood of tax practice risks. Finally, the factor score analysis in Panel B provides marginal evidence that subjects previously involved in legal suits may represent higher tax practice risks (p = 0.099). Reimbursement Requested Of the 162 participants, 50% indicated they would seek reimbursement for their tax liability. In contrast, 82 and 89%, respectively, responded that they would seek reimbursement for interest charges and professional fees. Panel A in Table 5 presents descriptive statistics related to these dependent variables. Overall, participants indicating an amount they would request as a reimbursement asked for 31, 67, and 76% of total tax assessment, interest, and professional fees as reimbursements, respectively. H1b posits that using engagement letters reduces the percentage reimbursement clients request. The ANCOVA in Panel B provides evidence that using engagement letters reduces the percentage of the tax adviser’s professional fee subjects request as a reimbursement following an unfavorable IRS audit (p = 0.039), but not the percentage of additional tax and interest.14 H2b predicts a positive relationship between engagement magnitude and the percentage of additional tax, interest, and fee clients request as a reimbursement. The ANCOVA results do not support H2b. Thus, we conclude that larger engagement magnitudes do not result in proportionately higher risk exposures for tax professionals. In contrast, K&S found that the dollar amount requested as a reimbursement varied directly with assessment magnitude for both of their fact scenarios.15 The ANCOVA also suggests that higher income and older taxpayers tend to request larger reimbursement for professional fees (p = 0.027 and 0.050, respectively). Subjects who had previously filed legal suits against others tend to request larger reimbursements (p = 0.079) too. Further, the results suggest that male participants request larger percentages of professional fees as refunds following an unfavorable IRS audit (p = 0.054). Interestingly, K&S found female taxpayers more likely to hold tax preparers responsible for unfavorable outcomes (p = 0.07). Though our dependent variable for the ANCOVA (PERCfee ) does
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Table 5. Percentages Requested as Reimbursements (Tests of H1b and H2b). Panel A: Descriptive Statistics [Mean (n)] PERCtax Letter Small magnitude Large magnitude Combined magnitudes Overall
No Letter
0.30 (49) 0.38 (48) 0.20 (31) 0.30 (34) 0.26 (80) 0.35 (82) 0.31 (162)
PERCint Letter
No Letter
0.65 (49) 0.79 (48) 0.59 (31) 0.62 (34) 0.62 (80) 0.72 (82) 0.67 (162)
PERCfee Letter
No Letter
0.69 (49) 0.85 (48) 0.71 (31) 0.76 (34) 0.70 (80) 0.81 (82) 0.76 (162)
Panel B: ANCOVA Results [Dependent Variable: PERCfee ] F Stat
P-Value
Main effects LETTER MAG
4.339 0.048
0.039 0.826
Interaction LETTER × MAG
0.499
0.481
1.600 3.125 0.000 3.788 3.894 0.011 4.999 2.371
0.208 0.079 0.986 0.054 0.050 0.916 0.027 0.013
Covariates Used paid preparer Filed legal suit Audited by IRS Gender Age Locus of control Income level Corrected model Adjusted R2 = 0.082
Note: ANCOVAs for testing H1b and H2b using PERCtax and PERCint as dependent variables were insignificant and, thus, are omitted. Variables defined: PERCtax = percentage of subject’s requested reimbursement from CPA for additional tax; PERCint = percentage of subject’s requested reimbursement from CPA for interest; PERCfee = percentage of subject’s requested reimbursement from CPA for professional fee; LETTER = 1 if subject receives engagement letter and 0 otherwise; MAG = 1 if engagement magnitude is large and 0 otherwise.
differ from K&S’s likelihood measure, the findings seem inconsistent. Perhaps distinguishing between attitude and action can reconcile these apparent differences. Specifically, female clients might be more likely to hold tax professionals responsible for unfavorable audit outcomes, while male aggressiveness may explain why male clients tend to request larger refunds of professional fees. Researchers may wish to explore this relationship further.
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CONCLUSIONS, LIMITATIONS, AND FUTURE RESEARCH This study experimentally examines the effects of engagement letters and magnitude on tax practice risks. As predicted, we find that engagement letters help tax practitioners reduce the likelihood of incurring client loss and reimbursement risks following an adverse IRS audit. Also, for subjects who would seek reimbursements from tax professionals, we find that using engagement letters reduces the percentage of professional fees they would request, but not the percentages of additional tax and interest. These results suggest that engagement letters narrow client expectation gaps and, thus, lessen the extent to which clients blame tax professionals for adverse IRS audit results. Consistent with K&S, engagement magnitude does not appear related to the likelihood of legal action or any other measure of tax practice risks. In retesting one of K&S’s hypotheses, we confirm that engagement magnitude is a dominant factor explaining the dollar amount of tax, interest, and fees that our subjects would seek as reimbursements from their tax advisers. Nonetheless, scaling the dollar amount of reimbursement requests by total tax, interest, and fees and redoing the analysis does not reveal a significant relationship. Anecdotal evidence suggests the usefulness of engagement letters in mitigating litigation-related tax practice risks. Our results support this commonly held belief but extend beyond corroborating the anecdotal evidence. Accounting practitioners and researchers traditionally have thought about tax practice risks as consisting primarily of legal exposure and have paid relatively little attention to other practice risks. To address this void, we define tax practice risks broadly to include client loss and reimbursement forms. Client loss risk consists of costs from clients not recommending tax professionals to others and lost business from dissatisfied clients switching tax advisers. Reimbursement risk manifests itself when clients request that tax practitioners reimburse them for additional tax, interest, and professional fees following an unfavorable IRS audit or when clients bring legal suit. We find that engagement letters reduce both client loss and reimbursement forms of tax practice risks. In short, our results are robust to alternative risk measures. We do not compare alternative ways of confirming agreements or communicating information. For example, some accounting professionals document phone conversations with contemporaneously prepared written notes. Other researchers may wish to explore the effect on tax practice risks of documenting agreements or understandings by alternative means. Another limitation of our study is that we do not consider the direct and indirect costs associated with using engagement letters such as preparation and client
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relation costs. Gibbs (1990, p. 14) and Wolosky (1998, p. 45) indicate that some practitioners do not consistently use tax engagement letters because they are difficult and time consuming to write. Godwin (1993) and Kahan (1998b, p. 48) observe that drafting a quality tax engagement letter is especially costly for new clients and those needing “customized services.” Similarly, Demery (1997, p. 40) suggests that tax practitioners who have not routinely used engagement letters might hesitate to begin their use with long-standing clients. Murray (1992, p. 62) asserts that overly restrictive engagement letters can damage client relations. One possible avenue for future research is to investigate the direct and indirect costs associated with using engagement letters and how such costs affect tax practitioners’ decisions to use engagement letters. A third limitation of this study is its focus on individual taxpayers. Institutional clients also pose tax practice risks. Whether the usefulness of engagement letters in managing client loss and reimbursement risks extends to other types of clients is a question for future research. Our study and the literature suggest four additional areas for future research. First, one might examine differences between engagement letters that merely inform the client and those that the client must sign and return. To the extent clients perceive the latter to be more binding, a signed and returned engagement letter may affect client expectations and, thus, may decrease tax practice risks more than merely informative letters. Second, the relevant risk factors may differ depending on the type of client. For example, engagement letters may affect tax practice risks differently for small business clients than it does for individual clients, or the effect may vary depending on the sophistication of the client. Third, one could examine other risk factors such as whether the practitioner takes the time to discuss and explore client objectives (e.g. avoiding audit vs. minimizing taxes) and whether the practitioner is readily accessible. Christensen (1992) suggests that such factors might affect client expectations. Along similar lines, Danzinger (2001) indicates that unclear communication in the engagement letter is a frequent factor in malpractice suits. Finally, future research might consider the effect other variables have on tax practice risk such as the cost of bringing legal action, the nature of the tax issue, the number of years the taxpayer has used his or her tax preparer (short-term vs. long-term relationship), and differences in taxpayer objectives (e.g. tax minimization vs. avoiding contact with the IRS).
NOTES 1. Our later factor analysis separates multiple risk measures into these two categories of tax practice risks.
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2. When clients request reimbursements stemming from tax return controversies, the parties often settle their differences without litigation. Thus, instances in which clients request reimbursements in tax-related conflicts exceed instances in which such conflicts result in litigation. The difference is even larger when one compares occurrences of all non-litigation risks with instances of litigation risks. 3. K&S (1995, p. 85) state “this study could be extended to compare the perceptions of taxpayers receiving engagement letters to those of taxpayers who do not receive such letters.” 4. K&S (1995, p. 83) examined three covariates: gender, tax knowledge, and prior audit experience. 5. Ashton and Kramer (1980, pp. 1–2) observe that students generally are reasonable surrogates in decision-making studies. Recent studies to use students as surrogates for taxpayers include Kaplan et al. (1997), Maroney et al. (1998), Moser et al. (1995), Rupert and Wright (1998), and Wartick et al. (1999). 6. Both questions tested the subjects’ recall of two dollar amounts mentioned in the experiment. Of the 162 students choosing to participate in the drawing, 145 answered both questions correctly (89.5%). This high percentage suggests that students took the experimental task seriously. 7. The IRS (2003) indicates that 53.4% of taxpayers used paid preparers in 2000. Though only 28.3% of our sample used paid preparers, the use of paid preparers was not a significant factor in any of our analyses. 8. For a judicial decision examining the hobby loss issue in the context of a fruit orchard, see Zdun, T.C. Memo 1998-296, 76 T.C.M. 278. In finding that the taxpayer lacked a profit motive, the court disallowed sizeable losses from aggregate farm expenses. For example, the court disallowed losses exceeding $50,000 for Zdun’s 1994 taxable year. 9. Based on debriefing questions, participants receiving an engagement letter did not put any less effort into the task (t = 0.338) and found the task just as interesting (t = 0.320). 10. The questionnaire instrument invited participants to complete the following statement: “The purpose of this experiment is to .” Two-thirds of our subjects attempted to identify the purpose. None of the attempts mentioned either of our manipulations. Thus, the evidence does not suggest that manipulations were transparent. 11. The first question on the questionnaire is “What is the likelihood you will recommend this CPA to others?” If a participant chooses 7, it means he is very likely to recommend the CPA to others, so the client loss risk for the CPA is very low. For consistency with the other likelihood measures and ease of exposition, we reverse the scores on this first question. Thus, we record the NOTREC score for the participant mentioned above as 1 instead of 7. 12. Bebchuk (1984) notes two contrary considerations that affect settlement demands of plaintiffs. First, demanding higher amounts leads to greater wealth if the defendant agrees to pay. Second, demanding higher amounts reduces the likelihood that the defendant will agree to pay. 13. If we eliminate those subjects that the debriefing questions suggest paid less attention, the results are substantially the same. 14. We also retested K&S’s hypothesis that the dollar amount requested as a reimbursement is positively related to assessment magnitude and found consistent results (p < 0.01). Further, we found a positive relationship between magnitude and both the dollar amount of interest (p < 0.01) and professional fees (p < 0.01) requested as reimbursements. These results support the notion that higher reimbursements for tax assessments, interest charges, and professional fees occur in larger engagements.
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15. Alternatively, one might view each participant’s cognitive process as two interrelated decisions: (1) Should I request a reimbursement? This demands a dichotomous response. (2) If so, how much should I request? Based on this perspective, we converted Likert scale responses to “yes” or “no” answers using several different conversion rules. We also explored the effect of converting participants’ second stage responses to “zero” in those cases where we treated their first stage responses as “no.” Then, we ran Heckman’s Two Step Model, but results were not significant using any of our conversions. We have three thoughts about these results. First, the conversion from Likert to dichotomous responses might be inappropriate. For example, a subject responding with “5” on a Likert scale may answer “yes” or “no” if only a dichotomous response is solicited. Second, our participants may not have viewed these two responses as sequential since the first question requires a likelihood response. Third, our “second stage” question forces subjects to request a dollar amount, even when they might not otherwise do so: “Assume that you decide to request a reimbursement. For what dollar amount will you ask the CPA?” Some subjects who might otherwise respond with “zero” may have listed a dollar amount based on the assumption. Any or all of these factors may have conspired to result in no significance using the Heckman’s Two Step Model.
ACKNOWLEDGMENTS The Program for Applied Accounting Research and J. Mack Robinson College of Business’s Research Program provided financial support for this project. For their helpful comments, the authors thank Mike Calegari, Greg Geisler, Don Jones, Brian Mayhew, Bill Messier, Tad Ransopher, and two anonymous reviewers.
REFERENCES Ashton, R. E., & Kramer, S. S. (1980). Students as surrogates in behavioral accounting research: Some evidence. Journal of Accounting Research, 18(Spring), 1–15. Bandy, D. (1996). Limiting tax practice liability. CPA Journal, 66(May), 46–49. Bebchuk, L. A. (1984). Litigation and settlement under imperfect information. RAND Journal of Economics, 15(Autumn), 404–415. Campbell, D., & Parisi, M. (1999). Individual income tax returns, 1997. SOI Bulletin (Fall), 1–45. Christensen, A. L. (1992). Evaluation of tax services: A client and preparer perspective. Journal of the American Taxation Association, 14(Fall), 60–87. Cronbach, L. (1987). Statistical tests for moderator variables: Flaws in analyses recently proposed. Psychological Bulletin, 102(November), 414–417. Danzinger, E. (2001). Practice management: How to be careful and still be clear. Journal of Accountancy, 191(January), 65–71. Davis, W. L., & Davis, D. E. (1972). Internal-external control and attribution of responsibility for success and failure. Journal of Personality, 40(March), 123–136. Demery, P. (1997). Detecting malpractice danger zones. Practical Accountant, 30(January), 40–43. Deutsch, M. (1985). Distributive justice. New Haven, CT: Yale University Press.
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Ferguson, E. (1993). Rotter’s locus of control scale: A ten-item two-factor model. Psychological Reports, 73(December), 1267–1278. Folkes, V. S. (1984). Consumer reactions to produce failure: An attributional approach. Journal of Consumer Research, 10(March), 398–409. Gibbs, L. W. (1990). Avoiding malpractice suits: Some sound advice, Trusts. Trusts & Estates, 129(April), 12–29. Godwin, L. (1993). Reducing the likelihood of litigation: Debits and credits. National Public Accountant, 38(February), 16–17. Holl, S. H., & Colby, H. R. (2001). Closing the “expectation gap.” Practical Accountant, 34(March), 37. Internal Revenue Service (2003). Tax stats at a glance. Retrieved from www.irs.gov/taxstats. Jorgensen, B. K. (1996). Components of consumer reaction to company-related mishaps: A structural equation model approach. Advances in Consumer Research, 23, 346–351. Kahan, S. (1998a). Watching where you step: Malpractice lawsuits against accounting firms. Practical Accountant, 31(April), 49–54. Kahan, S. (1998b). Noted malpractice attorney speaks out. Practical Accountant, 31(September), 47–50. Kahan, S. (2001). Push engagement letters. Practical Accountant, 34(March), 35–37. Kaplan, S. E., Newberry, K. J., & Reckers, P. M. J. (1997). The effect of moral reasoning and educational communications on tax evasion intentions. Journal of the American Taxation Association, 19(Fall), 38–54. Karys, A. (1998). Risky business. Outlook, 66 (Spring), 10–16, 45. Krawczyk, K., & Sawyers, R. B. (1995). The effect of magnitude of IRS assessment and engagement letters on tax preparer liability. Journal of the American Taxation Association, 17(Fall), 71–88. Lefcourt, H. M. (1991). Locus of control. In: J. P. Robinson, P. R. Shaver & L. S. Wrightsman (Eds), Measures of Personality and Social Psychological Attitudes. San Diego, CA: Academic Press. Maroney, J. J., Rupert, T. J., & Anderson, B. H. (1998). Taxpayer reaction to perceived inequity: An investigation of indirect effects and the equity-control model. Journal of the American Taxation Association, 20(Spring), 60–77. Moser, D. V., Evans, J. H., III, & Kim, C. K. (1995). The effects of horizontal and exchange inequity on tax reporting decisions. The Accounting Review, 70(October), 619–634. Murray, M. F. (1992). Drafting accountant engagement letters. Practical Lawyer, 38(December), 61–80. Phares, E. J., Wilson, K. G., & Klyver, N. W. (1971). Internal-external control and the attribution of blame under neutral and distractive conditions. Journal of Personality and Social Psychology, 18(3), 285–288. Reinstein, A., & Bayou, M. E. (1999). Helping accountants develop more effective engagement letters. National Public Accountant, 44(January), 10–15. Rotter, J. B. (1966). Generalized expectancies for internal vs. external control of reinforcement. Psychological Monographs, 80(1), 1–28. Rupert, T. J., & Wright, A. M. (1998). The use of marginal tax rates in decision making: The impact of tax rate visibility. Journal of the American Taxation Association, 20(Fall), 83–99. Scutellaro, J. F., & Muirhead, T. C. (2000). Tax practice review and SSTSs. Tax Adviser, 31(December), 890–892. Stevens, M. G. (2000). Managing risk in a tax practice. Practical Accountant, 33(March), 39–41. Stimpson, J. (1999). Avoid getting gored by investment clients. Practical Accountant, 32(March), 29–32. Stimpson, J. (2000). The evolving engagement letter. Practical Accountant, 33(September), 54–60.
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Stones, C. R. (1983). Self-determination and attribution of responsibility: Another look. Psychological Reports, 53(October), 391–394. St. Pierre, K., & Anderson, J. A. (1984). An analysis of the factors associated with lawsuits against public accountants. Accounting Review, 59(April), 242–263. Wartick, M. L., Madeo, S. A., & Vines, C. C. (1999). Reward dominance in tax-reporting experiments: The role of context. Journal of the American Taxation Association, 21(Spring), 20–31. Williams, S. (1997). The importance of engagement letters: Avoiding malpractice suits. National Public Accountant, 42(June), 31–32. Wolfe, J., & Anderson, S. (2001). A nice niche – If you minimize liability risk. Journal of Accountancy, 191(February), 49–54. Wolosky, H. W. (1998). Reducing your chance of getting burned. Practical Accountant, 31(November), 42–52. Yancey, W. F. (1996). Managing a tax practice to avoid malpractice claims. CPA Journal, 66(February), 12–17.
APPENDIX Sample Experimental Instrument This small engagement version includes an engagement letter. Several years ago, you planted a peach tree orchard on your property. You normally spend ten hours per week working in the orchard. Your regular job consumes most of your other time. During harvest season, your teenager sells the peaches your family does not eat to passing motorists from a roadside stand. You expect the money from these sales to be less than the orchard-related expenses during the first few years (that is, you expect net losses). In August 1997, you asked a CPA if the expected net loss for 1997 could be deducted on your 1997 Federal tax return to offset some of the income from your regular job. In September 1997, you received an “engagement letter” from the CPA. As requested, you signed and returned one copy. The letter read: I appreciate the opportunity of working with you and advising you regarding this tax matter. To ensure a complete understanding between us, I am setting forth the pertinent information about the advice that I will be rendering. I use my judgment in resolving questions where the tax law is unclear, or where there may be conflicts between the taxing authorities; interpretations of the law and other supportable positions. Unless otherwise instructed by you, I will resolve such questions in your favor whenever possible. The Internal Revenue Service (IRS) is not bound by any opinion that I may express. Accordingly, I cannot guarantee the outcome in the event the IRS challenges my opinion. It is understood that you remain responsible for any adverse determination by the IRS or the courts in this situation. The law provides various penalties that may be imposed when taxpayers understate their tax liabilities. CPAs also may be subject to penalties when an understatement of tax liability is
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due to a position for which there is not a realistic possibility of being sustained on its merits. A position has a realistic possibility of success if a CPA has a good faith belief that the position has at least a 1 in 3 chance of being sustained on its merits if challenged. The law regarding whether an activity is engaged in for profit is based on a consideration of all facts and circumstances with respect to the activity. Under the related regulations, nine factors have been found to influence this judgment, including but not limited to the taxpayer’s level of expertise, the time and effort devoted to the business, the financial status of the taxpayer, the presence of personal pleasure, and the manner in which the activities are conducted. After I have researched these issues, I will let you know my opinion about whether you can deduct any net loss from your peach operations.
In December 1997, the CPA responded to your request for tax advice as follows: The activity should qualify as a trade or business. This classification means that you should be entitled to deduct the peach orchard’s net loss on Schedule C of your return.
You paid the CPA $1,000 for the advice and deducted the net loss on your 1997 Federal tax return. The deduction saved you $10,000 in tax. In November 2000, the IRS audits your 1997 tax return and decides to disallow your deduction from the peach operation. They explain that the peach operation is primarily a personal activity, not a business. As a result, you must pay $10,000 tax and $2,300 interest. Questionnaire: Part 1 (1) What is the likelihood you will recommend this CPA to others? Very Unlikely 1
Unlikely 2
Somewhat Unlikely 3
No Opinion 4
Somewhat Likely 5
Likely 6
Very Likely 7
(2) What is the likelihood you will switch to a different CPA the next time you need tax advice? Very Unlikely 1
Unlikely 2
Somewhat Unlikely 3
No Opinion 4
Somewhat Likely 5
Likely 6
Very Likely 7
(3a) What is the likelihood you will request that the CPA reimburse you for at least part of your $10,000 additional tax? Very Unlikely 1
Unlikely 2
Somewhat Unlikely 3
No Opinion 4
Somewhat Likely 5
Likely 6
Very Likely 7
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(3b) What is the likelihood you will request that the CPA reimburse you for at least part of your $2,300 interest? Very Unlikely 1
Unlikely 2
Somewhat Unlikely 3
No Opinion 4
Somewhat Likely 5
Likely 6
Very Likely 7
(3c) What is the likelihood you will request that the CPA reimburse you for at least part of your $1,000 tax advice fee? Very Unlikely 1
Unlikely 2
Somewhat Unlikely 3
No Opinion 4
Somewhat Likely 5
Likely 6
Very Likely 7
(4) Assume that you decide to request a reimbursement. For what dollar amount will you ask the CPA? (a) Provide a dollar amount for the additional tax (not to exceed $10,000). $ (b) Provide a dollar amount for the interest (not to exceed $2,300). $ (c) Provide a dollar amount for the tax advice fee (not to exceed $1,000). $ (5) Assuming that you request a reimbursement but the CPA refuses to pay any portion of the $10,000 tax, $2,300 interest, or $1,000 professional fee to you, what is the likelihood that you will begin legal action against the CPA? Assume that you will incur no court costs or other legal expenses (e.g. because you have an attorney on retainer). Very Unlikely 1
Unlikely 2
Somewhat Unlikely 3
No Opinion 4
Somewhat Likely 5
Likely 6
Very Likely 7
(6) Did you have someone (other than a relative) prepare your 1999 Federal tax return (due on April 15, 2000, unless extended) for a fee? Yes No (7) If your answer to question 6 is “yes,” who prepared the return? Attorney Other CPA (8) If your answer to question 6 is “yes,” did the tax return preparer give you a written agreement or understanding about the work to be done (sometimes called an engagement letter) before beginning? Yes No (9) If your answer to question 8 is “yes,” were you required to sign a copy of the agreement and return it before the tax return preparer began? Yes No
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(10) Has the IRS ever audited your Federal tax return?
Yes
No
(11) Have you ever filed a legal suit against anyone (other than for divorce, separation, or child custody)? Yes No (12) Your gender is: (13) Your age is: (14) Your race is: Other
Male
30 or less Caucasian
Female 31 to 50
Above 50
African-American
Hispanic
Asian
Questionnaire: Part 2 This part of the questionnaire seeks to determine how certain important events in our society affect different people. Each item consists of a pair of alternatives lettered a or b. Please circle the letter for one statement of each pair (and only one) which you more strongly believe to be the case as far as you’re concerned. Be sure to select the one you actually believe to be more true rather than the one you think you should choose or the one you would like to be true. This is a measure of personal belief. Obviously, there are no right or wrong answers. Please answer these items carefully but do not spend too much time on any one item. Be sure to choose an answer for every pair of items. In some instances you may discover that you believe both statements or neither one. In such cases, be sure to select the one you more strongly believe to be the case as far as you’re concerned. Also try to respond to each item independently when making your choice. Do not be influenced by your previous choices. (1a) Children get into trouble because their parents punish them too much. (1b) The trouble with most children nowadays is that their parents are too easy with them. (2a) Becoming a success is a matter of hard work, luck has little or nothing to do with it. (2b) Getting a good job depends mainly on being in the right place at the right time. (3a) When I make plans, I am almost certain that I can make them work. (3b) It is not always wise to plan too far ahead because many things turn out to be a matter of good or bad fortune anyhow. (4a) Heredity plays the major role in determining one’s personality. (4b) It is one’s experiences in life which determine what they’re like. (5a) Who gets to be the boss often depends on who was lucky enough to be in the right place first.
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(5b) Getting people to do the right thing depends upon ability; luck has little or nothing to do with it. (6a) Most people don’t realize the extent to which their lives are controlled by accidental happenings. (6b) There really is no such thing as “luck.” (7a) A good leader expects people to decide for themselves what they should do. (7b) A good leader makes it clear to everybody what their jobs are. (8a) Many times I feel that I have little influence over the things that happen to me. (8b) It is impossible for me to believe that chance or luck plays an important role in my life. (9a) What happens to me is my own doing. (9b) Sometimes I feel that I don’t have enough control over the direction my life is taking. Did you circle one letter for all nine items in Part 2? If not, please do so now. It is very important that we have a response for all nine pairs of questions. Thanks. Questionnaire: Part 3
(1) I have responded to the survey questions to the best of my ability. (2) The questions, phrases, and words in this survey are clear in their meaning. (3) I understand the facts describing the peach tree orchard, CPA advice, and IRS audit. (4) This task is interesting. (5) The instructions for completing this questionnaire are clear.
Strongly Disagree 1
Neutral 2
3
4
Strongly Agree 5
1
2
3
4
5
1
2
3
4
5
1
2
3
4
5
1
2
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5
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(6) As best as you can remember, approximately how much gross income (before deductions) did you report on your 1999 Federal tax return (due April 15, 2000) or, if not yet filed, do you expect to report? If you filed a joint return with your spouse, please estimate the combined income for you and your spouse. $25,000 or less $75,001 to $100,000 $25,001 to $50,000 Above $100,000 $50,001 to $75,000 (7) What was (or will be) Joint Single Other your filing status on your 1999 Federal tax return (due April 15, 2000)? Please complete the following statement if you can. If you cannot, leave it blank. The purpose of this experiment is to
Please feel free to provide any written comments in the space below or on the back. Such comments often are very helpful to us. We know your time is valuable. Thank you very much for your help. You will find a 3 × 5 card in your package. Please do not fold this card. Write your name and phone number on one side. In a few minutes, we will ask you two questions about this experiment. You must answer both questions correctly to be eligible for the $100 drawing. The drawing will be held in about two weeks. If your name is drawn, you will be contacted. If your name is not drawn, but you would like to know who won, please contact the project director.
THE ALTERNATIVE MINIMUM TAX: EMPIRICAL EVIDENCE OF TAX POLICY INEQUITIES AND A RAPIDLY INCREASING MARRIAGE PENALTY John J. Masselli, Tracy J. Noga and Robert C. Ricketts ABSTRACT We use the 1995 IRS Public Use Tax File in simulation models to examine the factors associated with the widely anticipated growth in the alternative minimum tax (AMT). The evidence suggests that the changes in the marginal tax rate structure associated with the 2001 and 2003 tax legislation are likely to result in exponential growth in AMT incidence and create a substantial hidden marriage tax penalty, a result contradictory with the intent of these tax law changes. The evidence further suggests that the elimination of preferential long-term capital gain rates for the AMT could effectively fund structural changes in the AMT that would substantially reduce the impact of the AMT on middle and lower income taxpayers, many of whom are liable for the AMT due to the add-back for AMT purposes of such non-tax preferential items as Schedule A adjustments and personal and dependency exemptions.
Advances in Taxation Advances in Taxation, Volume 16, 123–146 © 2004 Published by Elsevier Ltd. ISSN: 1058-7497/doi:10.1016/S1058-7497(04)16006-7
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INTRODUCTION In recent years, the alternative minimum tax (AMT) has been the subject of growing controversy not only by academics and practitioners (e.g. Atwood, 2003; Burman et al., 2003; Everett & O’Neil, 2000; Gale & Potter, 2002; Harvey & Tempalski, 1997; Jolly et al., 2001; Kern, 1999; Kiefer et al., 2002; Lathrope, 2000; Maroney et al., 2000; Murray, 2003; Sloan, 2003; Tully, 2003; Weiner, 2001) but also by the United States Congress (2001, 1999, 1998 Committee Reports). In fact, the Joint Committee on Taxation (JCT) (1998a, b, 1999, 2001) estimated in 1999 that the AMT would impact approximately nine million tax returns by year 2009, up from only 132,000 in 1990, and that a large portion of those affected would not be the type of individual the tax was originally designed to target (i.e. high income taxpayers paying relatively small amounts of tax due, in large part, to their ability to shelter taxable income using tax preference items). More recently, Burman et al. (2003) estimated, after considering full implementation of the 2001 tax legislation, that the number of taxpayers likely to be subject to the AMT in 2010 could sky rocket to over 36 million taxpayers. In April 2003, the Statistics of Income group (SOI) of the Internal Revenue Service (IRS) published select tax return data for tax year 2000. That report indicates that 1.3 million tax returns were subject to the AMT in year 2000 paying over $9.6 billion in AMT. These statistics represent a 215% increase from tax year 1995 in the number of taxpayers subject to AMT with an increase in AMT revenues for the same period of 319%. These data clearly provide confirmatory support for the trends anticipated by the JCT. Nevertheless, a potentially bigger concern for tax policy makers, practitioners and taxpayers is the drastic impact on AMT incidence expected from the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001) and Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA 2003) given that these legislative changes result in reductions in regular marginal tax rates without a corresponding reduction in the AMT tax rates (Burman et al., 2003; Gale & Potter, 2002; Kiefer et al., 2002). In this study, we use tax return data contained in the IRS Public Use Tax File for filing year 1995 to project the number of taxpayers who will potentially be affected by the AMT following the implementation of both EGTRRA 2001 and JGTRRA 2003. Although much prior literature projects the incidence of the AMT, we compare these projections with those that would be obtained under a number of hypothetical scenarios in which certain characteristics of the current AMT are changed. This analysis allows us to determine which attributes of the AMT are primarily responsible for growth in the AMT burden and which groups in the population are most significantly affected.
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Because we lack information about tax preference items (e.g. interest on private activity bonds, intangible drilling costs, depreciation) for those taxpayers not subject to the AMT in 1995, we project every filer’s 2003 AMT liability based solely on projected increases in his or her non-preference tax attributes (e.g. AMT adjustments for personal and dependency exemptions and those itemized deductions not allowed for the AMT). This non tax-preferential component of the AMT liability is important to document because virtually all of the projected increase in the impact of the AMT on the American taxpayer is attributable not to increases in tax shelter activity but rather to increases in normal or “everyday” tax deductions as a percentage of income. Our 2003 estimates are projected under the assumptions that the applicable provisions of EGTRRA 2001 and JGTRRA 2003 are fully phased in and operational. Our results indicate that, after enactment of the new legislation, the number of taxpayers likely to be subject to the AMT, due to Schedule-A non-preference items and the disallowance of personal exemptions alone, will increase by approximately 337% over 1995 levels with a corresponding increase in AMT revenues of over 390%. These increased estimates are largely attributable to the changes in tax rate structure brought about the new tax laws and are consistent with the analyses provided by Burman et al. (2003), Kiefer et al. (2002), and Gale and Potter (2002). While the aggregate forecasts are quite high, the allocation of the AMT burden also is of concern. We estimate that married taxpayers bear the substantial majority of the burden of the AMT. This outcome is particularly interesting in light of the fact that EGTRRA 2001 and JGTRRA 2003 focus on eliminating the marriage penalty inherent in the regular tax system. Data from this study provide evidence that, in general, married taxpayers are currently liable for approximately 80% of the overall AMT tax liability burden. However, despite the goals of EGTRRA 2001 and JGTRRA 2003 to eliminate the marriage penalty, the Acts result in an increase in the married taxpayer AMT burden to 86% of a substantially increased AMT liability. Therefore, while the marriage penalty is being corrected for regular tax purposes, the corresponding AMT rules contain no changes to reflect the inequity of the AMT tax system on married couples resulting in an alternate form of marriage penalty. These results lead to two inescapable conclusions. First, the AMT is clearly reaching a far different cross-section of taxpayers than Congress intended in 1978 when it first implemented the framework for the current system,1 or in 1986 when it substantially revised the AMT. Second, the longer Congress waits to make substantive reforms to the AMT (keeping in mind that the recently enacted tax legislation makes only minimal adjustments to offset the impending AMT problem), the more significant the AMT burden on unintended taxpayers will be.
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Our study, in an attempt to provide cogent tax policy alternatives to remedy the inequities in the current AMT system, provides evidence that, if the AMT were extended to apply to long-term capital gains, as was the case when it was originally enacted, sufficient revenues could be raised to fund reforms of the AMT system so that it would no longer be triggered by non-abusive exemptions and deductions. Whether or not one believes that the capital gains rate should be offset by the AMT, most would likely agree that taxpayers with large amounts of capital gains more closely resemble the intended target of the AMT than do those with large families or with large deductions for medical expenses or miscellaneous itemized deductions. The remainder of this article is organized as follows. In the next section, we describe the current AMT environment – its intended targets, the “ordinary” deductions that trigger the increased tax liability and the types of inequities that can result. Following is a summary of the research method and data. We then present the results and analysis. The final section summarizes the conclusions and provides suggestions for reform.
BACKGROUND AND CURRENT TAX POLICY Congress created the current AMT system “to ensure that no taxpayer with substantial economic income could avoid significant tax liability by using exclusions, deductions and credits” (Senate Report No. 99–313, 1986–3 C. B. Vol. 3, 518). However, voluminous empirical evidence (e.g. Burman et al., 2003; Gale & Potter, 2002; Harvey & Tempalski, 1997; Joint Committee on Taxation, 1998a, b; Kern, 1999; Kiefer et al., 2002) indicates that the AMT is overshooting its target. Although Congress initially designed the AMT to curtail the ability of high-income taxpayers to use tax preferences and tax shelter vehicles to minimize their income tax liabilities, it has made numerous decisions since 1986 that have muddled its aim. For example, Wilkins (2000) notes that Congress, focusing on the income tax distribution, chose to deny the state and local income tax deduction for AMT purposes to increase the progressivity of the tax distribution after the Tax Reform Act of 1986. A similar concern motivated the decision not to allow miscellaneous itemized deductions where taxpayers claim investment expenses (among other items) against the AMT.2 Other features of the current AMT reflect apparent concerns over government tax revenues. For example, the decision not to index the AMT exemption amount (until JGTRRA 2003) and, in 1993, to increase the AMT rates in tandem with an increase in the maximum rate applicable to ordinary income in the regular tax system, were likely motivated by Congressional concerns over revenues.
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Similarly, for AMT purposes, a deduction is allowed for medical expenses only to the extent they exceed 10% of AGI (versus 7.5% for purposes of the regular tax). This provision also demonstrates Congress’ concern about revenues because most individuals would not consider medical expenditures to be a tax preference item. Nevertheless, these AMT features, either alone or in tandem, contribute extensively to the capture of “regular” taxpayers in its snare – those that generally would not be considered to be receiving preferential treatment in the regular tax system. For instance, taxpayers claiming unreimbursed employee business expenses as miscellaneous itemized deductions will often trigger the AMT, especially if they are subject to marginal tax rates that are sufficiently close to the AMT rates of 26 and 28% such that any deduction that reduces regular taxable income but is not allowed for AMT purposes can easily trigger the AMT. Wilkins (2000) suggests that the IRS frequently uses this feature of the AMT as a “litigating weapon” when negotiating with taxpayers over whether they are employees or independent contractors.3 Moreover, the reduction of the regular marginal tax rates as part of the EGTRRA of 2001 and JGTRRA of 2003, without a concurrent reduction in the AMT rates or AMT structure, serves to exacerbate an already severe problem. Other examples of inequities in the application of the AMT have arisen in situations involving legal settlements. For example, in Faragher v. City of Boca Raton (76 F.3d 1155 (CA-11, 1996), the plaintiff in a sexual harassment trial was awarded a modest amount in damages and $400,000 in attorneys’ fees. For purposes of the regular tax, the IRS held that the taxpayer must report just over $400,000 in income, offset by a miscellaneous itemized deduction of $400,000 (less 2% of AGI) for the attorneys’ fees.4 In this case, a significant AMT liability will arise because of the disallowance of the legal fees for AMT but not for regular tax. It is difficult to imagine that these deductions (i.e. legal expenses incurred in defense of discriminatory actions) represent a tax preference. Similarly, because personal and dependency exemptions are not allowed for AMT purposes, taxpayers with large families may be subject to the AMT even if they claim no itemized deductions (Maroney et al., 2000).5 In light of these inequities, this study provides additional empirical evidence to support the perceived tax policy failures. Our analysis provides confirmatory support for the results of earlier studies (i.e., Burman et al., 2003; Gale & Potter, 2002; Harvey & Tempalski, 1997; Kiefer et al., 2002), in addition to highlighting the dramatic increase in the inequities likely to occur if Congress does not revise the current provisions of the AMT, especially given the anticipated impact of EGTRRA 2001 and JGTRRA 2003. Furthermore, this study provides an analysis of alternatives Congress might consider to alleviate some of the problems in the
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current system while funding these changes with other, perhaps more appropriate, alternative minimum tax options.
EMPIRICAL ANALYSES AND SIMULATION Data Source In this study, we use the Internal Revenue Service’s 1995 Public Use Tax File that contains detailed tax information from over 95,000 individual tax returns filed for tax year 1995. The IRS compiles the file from a stratified probability sample of unaudited returns. The estimates in the sample are configured to be representative of all returns filed for tax year 1995. The sample data is used to: (1) analyze the distribution of the AMT across taxpayer family status groups (i.e. single, married, or heads of household) and marginal tax bracket groupings; and (2) extend the analysis to provide evidence of anticipated growth in both the number of taxpayers and aggregate AMT revenues likely to occur in tax year 2003 resulting from non-tax preference items, factoring in the applicable provisions of EGTRRA 2001 and JGTRRA 2003. Based on these results and the various simulations performed, we propose and discuss structural changes in AMT provisions that are designed to help redistribute the AMT burden to those taxpayer groups originally intended by Congress. In analyzing the 1995 tax return data for AMT purposes, we isolate those tax returns in the sample that reported an AMT liability on Form 6251. Multiplying these observations by the sample weight assigned to each return6 produces an estimate of the total number of tax returns, and the corresponding AMT liability, filed for tax year 1995. Table 1 presents data comparing these estimates with the official published SOI data (1998) on AMT for tax year 1995. The SOI publication indicates that, in the 1995 tax year, 414,106 taxpayers were subject to AMT, generating tax revenues of $2.290 billion. Our analysis results in similar Table 1. Comparison of 1995 IRS and Public Use File AMT Data. 1995 SOI Publication Data Total number of returns in AMT for tax year 1995 Total AMT revenues generated in 1995 Average AMT per return
414,106 $2,290,576,000 $5,531
1995 Public Use File Estimates 414,164 $2,285,771,116 $5,519
Percentage Difference 0.014% 0.21% 0.21%
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findings with an estimated 414,164 taxpayers (a 0.014% difference) subject to AMT with corresponding revenues of $2.286 billion (a 0.21% difference), thus providing confirmatory evidence of the reliability of our data source. Of course, the primary focus of this study is not a review of the 1995 AMT distribution. Rather, the purpose is to provide empirical evidence of the anticipated growth in AMT burden derived from non-preference items likely to occur in the wake of the EGTRRA 2001 and JGTRRA 2003, and, more importantly, to provide evidence to support the consideration of various AMT policy modifications.
Economic Growth and Tax Relief Reconciliation Act of 2001 and The Jobs Growth Tax Relief Reconciliation Act of 2003 and the AMT The reduction in marginal tax rates enacted as part of EGTRRA 2001 and JGTRRA 2003, absent any additional changes to the AMT system, will exacerbate the problems associated with an already troublesome AMT system (Gale & Potter, 2002; Kiefer et al., 2002). These tax law changes reduce regular marginal tax rates, thereby decreasing the spread between regular and AMT rates. As a result, Kiefer et al. (2002), in an analysis of EGTRRA 2001 provisions, project that as many as 32% of taxpayers will be subject to the AMT with a corresponding AMT liability of approximately $132 billion. Although JGTRRA 2003 makes a modest increase in the AMT exemption, the primary impact of this Act is the acceleration of the problems resulting from the changes in tax rates EGTRRA 2001. We consider these issues as we develop the following simulations.
Simulation Model To simulate the effects of potential structural reforms in the AMT, we first restate the 1995 tax data into 2003 dollars7 by multiplying each relevant tax return item in the 1995 sample (excluding tax preference items and other AMT adjustments not considered herein due to incomplete information in the data source) by the ratio of the 2003 Consumer Price Index (CPI) to the 1995 CPI.8 Stated differently, many taxpayers who did not owe AMT in 1995 still may have had such tax preference items or AMT adjustments that they did not report. As such, data source constraints make it impossible to restate this missing information into 2003 dollars. Moreover, this study is not focused, per se, on the AMT liability derived from those AMT adjustments and preferences (e.g. depreciation adjustments,
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intangible drilling costs, and ESOP adjustments), the nature of which give rise to genuinely preferential tax treatment and have a greater potential for abuse. Rather, our primary interest is on the magnitude of the AMT liability arising from taxpayer characteristics (e.g. state and local taxes and personal exemptions) that few in Congress or elsewhere would consider aggressive in nature. After restating the tax figures into 2003 dollars, we apply the relevant provisions of EGTRRA 2001 and JGTRRA 2003 to estimate the regular and alternative minimum tax liabilities (calculated without adjustment for tax preferences and other non-itemized deduction AMT adjustments such as depreciation) for each taxpayer in the sample. The following provisions of JGTRRA 2003 were included in our analyses: (1) the revised tax rate procedure, which includes the new marginal tax rate tables (reflecting both the decrease in tax rates as well as the provisions to eliminate the marriage penalty) and the new 15% long-term capital gain rates; (2) the revised standard deduction amounts, again designed to eliminate the marriage penalty; and (3) the new AMT exemption. We first compute the base 2003 analysis that estimates the incidence of AMT as calculated by current law and generated solely from the disallowance of various Schedule-A “non-preference” items along with the disallowance of personal exemptions. We compare the amounts from this analysis to key AMT items from tax years 1995, 2000, and 2003 for trend analysis purposes. These estimates indicate both the growth in the AMT burden attributable to “normal” tax deductions and the impact of EGTRRA 2001 and JGTRRA 2003 on this trend. We then re-estimate the 2003 base model with modifications to simulate the following proposed structural reforms to the AMT: (1) Increase the JGTRRA 2003 AMT exemption by 15%; (2) Allow personal and dependency exemptions against the AMT; (3) Allow miscellaneous itemized deductions as deductions against AMT income; (4) Allow state and local taxes as deductions against AMT income; (5) Subject long-term capital gains to the “regular” AMT tax rates of 26 and 28%, rather than the lower preferential rates; and (6) Show all changes indicated in items 1–5 above concurrently. We first estimate the effect of each of the above proposals independently. Subsequently, we present a combined analysis that examines the aggregate effect of enacting all the options simultaneously. For each of the models, estimates of the number of taxpayers in AMT along with projected AMT revenues for low, middle and high marginal tax bracket groups are categorized by family status grouping (single, head of household, and married).
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RESULTS AMT Trend Analysis Table 2 presents a comparison of published AMT statistics for 1995 (SOI, 1998) and 2000 (SOI, 2003). The data show a 215% increase in the number of tax returns subject to AMT from 1995 to 2000 with a corresponding increase in AMT revenues of 319%. Using our data source and simulation model, we estimate the incidence of AMT resulting from the disallowance of various itemized deduction and/or personal exemptions for tax years 1995, 2000, and 2003. The results, also presented in Table 2, indicate that the number of taxpayers in an AMT situation because of these “normal” deductions and adjustments will increase in 2003 by over 337% from 1995 levels with a corresponding 390% increase in AMT revenues attributed to these adjustments. In addition, the clear burden of the rapidly increasing AMT is being borne by married individuals, who are liable for over 80% of the AMT liability attributed to non-preference items in 1995 with an estimated increase to 86% likely by 2003. Table 2. Comparison of 1995, 2000 and 2003 AMT Incidence Due to Itemized Deduction and Personal Exemption Add-Backs. 1995
2000
Total returns in AMT % increase from 1995
414,106a
1,304,197a
Total AMT revenues % increase from 1995
2,290,576,000a
9,600,840,000a 319%
Returns generating AMT from non-preferenceb items % increase from 1995 % increase from 2000 % of returns from married taxpayers
276,392c
852,275c
1,207,371c
208% 93.7%
85.7%
337% 41% 87.6%
AMT revenues generated from non-preference items % increase from 1995 % increase from 2000 % of revenue borne by married taxpayers
$1,039,223,920c
$2,753,700,525c
$5,094,393,937c
165%
390% 85% 86%
a Data
Not yet available
215%
80.9%
81.6%
obtained from Statistics of Income Publications for 1995 and 1998. items = add-back of personal exemptions and Sch. A items. c Data estimated using Public Use Tax File. b Non-preference
2003
Not yet available
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JOHN J. MASSELLI ET AL.
Simulation Analyses Before estimating the proposed AMT modifications presented above, we compute a base year analysis using the indexed 2003 numbers under the assumption that all provisions of the current AMT system remain in place. For purposes of comparison, this analysis is referred to as the “base analysis” and is shown as Panel A of Tables 4–7. The “base analysis” forecasts that AMT revenues generated because of non-preference adjustment items will increase over tax year 2000 levels by more than 85% (see Table 2 above). The analysis further suggests that approximately 86% of the AMT burden will be borne by married taxpayers with the remaining burden carried 11% by single taxpayers and 3% by heads of household. Recall, however, that this analysis only reflects those AMT adjustments that relate to Schedule-A itemized deductions and the add-back of personal exemptions, unless otherwise indicated. Table 3 provides a summary report of the simulation models estimated in this study. Subsequent tables contain detailed results of each model as indicated. Each simulation model is considered independently, unless otherwise indicated, and adjusts the year 2003 “base model” for the respective variable manipulation, ceteris paribus.
Increase in the AMT Exemption by 15% One criticism of the AMT is that no provision exists for the systematic adjustment of the AMT exemption. As such, one school of thought suggests that regular indexation of the AMT exemption or a total revision of the exemption may achieve the goal of limiting the AMT on lower- and middle-income taxpayers. Clearly, the current AMT exemption is not functioning well in this regard. To examine the sensitivity and effectiveness of changing the AMT exemption, we calculate the effects assuming an increase in the post-JGTRRA 2003 AMT exemption of 15%.9 Panel A of Table 3, in conjunction with Panel B of Table 4, provides evidence that increasing the post-JGTRRA 2003 AMT exemption by 15%, although partially effective, is not sufficient alone to shift the substantial majority of the AMT burden to higher income taxpayers who were originally intended to bear the majority of the AMT liability. More specifically, the data in Panel A of Table 3 suggest that a 15% increase of the AMT exemption would result in a decrease in the number of taxpayers subject to AMT from about 1,207,371 to 632,225, or a 48% decrease, with a corresponding decrease in AMT revenues of approximately 33%, or approximately $1.66 billion.
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Table 3. Comparison of Simulation Analyses (Dollar amounts in 000s). Number of Taxpayers in AMT 2003 Base
2003 Proposed
% Chg
Projected AMT Revenues in (000s) 2003 Base
2003 Proposed
% Chg
Panel A: (Manipulation 1: 15% increase in 2003 AMT exemption) from Table 4 Total 1,207,371 632,225 −48 $5,094,394 $3,426,975 Married 1,056,818 536,777 −49 $4,375,766 $2,867,176 Single 103,134 68,146 −34 $545,766 $439,037 Head/Hshld 47,419 27,302 −42 $172,862 $120,762
−33 −34 −20 −30
Panel B: (Manipulation 2: No personal exemption add-back) from Table 4 Total 1,207,371 635,774 −47 $5,094,394 Married 1,056,818 534,000 −49 $4,375,766 Single 103,134 81,129 −21 $545,766 Head/Hshld 47,419 20,645 −56 $172,862
$3,749,477 $3,133,838 $500,281 $115,358
−26 −28 −8 −33
Panel C: (Manipulation 3: No miscellaneous deduction add-back) from Table 5 Total 1,207,371 964,073 −20 $5,094,394 $4,027,826 Married 1,056,818 869,699 −18 $4,375,766 $3,570,146 Single 103,134 59,552 −42 $545,766 $338,705 Head/Hshld 47,419 34,822 −27 $172,862 $118,975
−21 −18 −38 −31
Panel D: (Manipulation 4: No state tax add-back) from Table 5 Total 1,207,371 96,114 −92 $5,094,394 Married 1,056,818 70,737 −93 $4,375,766 Single 103,134 16,437 −84 $545,766 Head/Hshld 47,419 8,940 −81 $172,862
$293,225 $215,506 $60,490 $17,229
−94 −95 −89 −90
Panel E: (Manipulation 5: Long-term capital gains subject to AMT rates) from Table 6 Total 1,207,371 1,834,527 52 $5,094,394 $18,424,463 Married 1,056,818 1,552,100 47 $4,375,766 $15,534,370 Single 103,134 213,402 107 $545,766 $2,468,923 Head/Hshld 47,419 69,025 46 $172,862 $421,170
262 255 352 144
Panel F: (All proposed changes made simultaneously) from Table 7 Total 1,207,371 284,161 −76 $5,094,394 Married 1,056,818 231,103 −78 $4,375,766 Single 103,134 41,911 −59 $545,766 Head/Hshld 47,419 11,147 −76 $172,862
54 52 103 −25
$7,869,010 $6,631,081 $1,107,917 $130,012
Table 4, Panel B provides more detailed information relating to the AMT exemption simulation. The data presented indicate that, even with a higher AMT exemption, married taxpayers bear the burden of approximately 84% of the, albeit lower, AMT liability with single individuals and heads of household bearing 13% and 3% of the liability, respectively. One key policy improvement from this proposed modification is that approximately 67% ($2.29 billion) of the total AMT tax burden (measured by reference to AMT revenues) under this scenario is borne
134
Table 4. Dollar Amounts in 000s. Marginal Tax Bracket
Panel A: 2003 Projections/No Preferences Base Analysis
Single Low: 10 & 15% Middle: 25, 28, & 33% High: 35% Total Married Low: 10 & 15% Middle: 25, 28, & 33% High: 35% Total
Totala Grand total a Percentages
%
12,732 69,495
12 67
20,907
%
# Of Taxpayers
%
# Of Taxpayers
%
$14,760 $249,451
3 46
4,022 44,279
6 65
$3,546 $163,217
1 37
5,131 55,091
6 68
$6,790 $211,937
1 42
20
$281,555
52
19,845
29
$272,273
62
20,907
26
$281,555
56
103,134
9
$545,766
11
68,146
11
$439,037
13
81,129
13
$500,281
13
76,650 722,902
7 68
$89,703 $1,980,689
2 45
12,448 300,045
2 56
$20,042 $881,228
1 31
9,894 268,644
2 50
$22,011 $832,910
1 27
257,266
24
$2,305,374
53
224,284
42
$1,965,906
69
255,462
48
$2,278,917
73
1,056,818
88
$4,375,766
86
536,777
85
$2,867,176
84
534,000
84
$3,133,838
84
11,687 32,322
25 68
$12,902 $109,642
7 63
4,040 19,894
15 73
$3,066 $68,745
3 57
1,023 16,212
5 79
$864 $64,176
1 56
3,410
7
$50,318
29
3,368
12
$48,951
41
3,410
17
$50,318
44
47,419
4
$172,862
3
27,302
4
$120,762
3
20,645
3
$115,358
3
1,207,371
AMT Revenue in 000s
$5,094,394
632,225
AMT Revenue in 000s
%
Panel C: Manipulation 2: No Personal Exemption Add-Back
$3,426,975
on the total line represent the respective percentage of the total to the grand total amounts.
635,774
AMT Revenue in 000s
$3,749,477
%
JOHN J. MASSELLI ET AL.
Head of household Low: 10 & 15% Middle: 25, 28, & 33% High: 35%
# Of Taxpayers
Panel B: Manipulation 1: 15% Increase in 2003 AMT Exemption
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135
by taxpayers in the highest marginal tax bracket. Thus, despite the fact that 33% of the forecasted AMT liability would continue to be borne by lower and middle income taxpayers, this modification would yield results that are more consistent with levying the AMT on the intended taxpayer group.
Allowing Personal and Dependency Exemptions Against the AMT Panel B of Table 3 and Panel C of Table 4 provide an estimate of the changes in AMT incidence if personal and dependency exemptions were allowed for AMT purposes. Panel B of Table 3 shows that allowing personal and dependency exemptions as deductions against AMT would result in a 47% decrease in the number of taxpayers subject to AMT, with a corresponding decrease in AMT revenues of approximately 26% or $1.3 billion. Table 4, Panel C provides evidence that, while allowing personal exemptions to be claimed against AMTI reduces the overall AMT burden, the distribution of this burden across taxpayers in different family statuses remains relatively unchanged resulting in married taxpayers bearing approximately 84% of the reduced AMT burden under this assumption. The relative shares of the AMT liability remain unchanged for single taxpayers and heads of household. Moreover, after adjusting for this modification, our results suggest that over $1.1 billion or just over 30% of the estimated $3.75 billion would still be borne by taxpayers in the low and middle marginal tax bracket categories, down from 49% borne by these same taxpayers in the base year. While these results are clearly an improvement from the current system, the incidence of AMT at the lower tax rate levels still requires additional improvements.
No AMT Adjustment for Miscellaneous Itemized Deductions Next we analyze the significance of disallowing miscellaneous itemized deductions in the computation of the AMT. Panel C of Table 3 and Panel B of Table 5 provide details of the third simulation where the proposed 2003 model assumes no adjustment to AMTI for miscellaneous itemized deductions claimed against a taxpayer’s regular tax. Reflecting the relatively small number of taxpayers claiming miscellaneous itemized deductions as compared to personal exemptions, our results indicate a much smaller effect on the distribution of the AMT burden if these deductions were allowed for AMT purposes. As Panel C of Table 3 indicates, a deduction against AMTI for miscellaneous itemized deductions would eliminate only 20% of
136
Table 5. Dollar Amounts in 000s. Marginal Tax Bracket
Panel A: 2003 Projections/No Preferences Base Analysis
Single Low: 10 & 15% Middle: 25, 28, & 33% High: 35% Total Married Low: 10 & 15% Middle: 25, 28, & 33% High: 35% Total
Totala Grand total a Percentages
%
12,732 69,495
12 67
AMT Revenue in 000s
%
# Of Taxpayers
%
$14,760 $249,451
3 46
5,968 34,810
10 58
AMT Revenue in 000s
Panel C: Manipulation 4: No State Income Tax Add-Back
%
# Of Taxpayers
%
AMT Revenue in 000s
%
$7,629 $113,147
2 33
3,500 10,663
21 65
$2,996 $33,926
5 56
20,907
20
$281,555
52
18,774
32
$217,929
64
2,274
14
$23,568
39
103,134
9
$545,766
11
59,552
6
$338,705
8
16,437
17
$60,490
21
76,650 722,902
7 68
$89,703 $1,980,689
2 45
27,769 590,849
3 68
$39,692 $1,479,874
1 41
7,631 41,103
11 58
$6,617 $96,086
3 45
257,266
24
$2,305,374
53
251,081
29
$2,050,581
57
22,003
31
$112,803
52
1,056,818
88
$4,375,766
86
869,699
90
$3,570,146
89
70,737
74
$215,506
73
11,687 32,322
25 68
$12,902 $109,642
7 63
4,328 27,337
12 79
$792 $77,878
1 65
2,400 5,948
27 67
$1,769 $9,406
10 55
3,410
7
$50,318
29
3,157
9
$40,305
34
592
7
$6,054
35
47,419
4
$172,862
3
34,822
4
$118,975
3
8,940
9
$17,229
6
1,207,371
$5,094,394
964,073
$4,027,827
on the total line represent the respective percentage of the total to the grand total amounts.
96,114
$293,225
JOHN J. MASSELLI ET AL.
Head of household Low: 10 & 15% Middle: 25, 28, & 33% High: 35%
# Of Taxpayers
Panel B: Manipulation 3: No Miscellaneous Deduction Add-Back
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137
the taxpayers subject to AMT in the base analysis with a similar decrease in AMT revenues of 21%. The data from Table 5, Panel B reveal a very similar pattern. Interestingly, the benefits would accrue disproportionately to single taxpayers, so that the burden borne by married taxpayers, if this reform were enacted alone, would rise to 90% of total returns affected and 89% of total AMT revenues. The fact that single taxpayers receive a bigger AMT benefit from this proposal is not counterintuitive given the mechanics of the 2% itemized deduction floor. Since married taxpayers with two wage earners are likely to have higher adjusted gross incomes, and the itemized deduction floor is 2% regardless of filing status, the corresponding floor amount for double income married couples will be higher thus limiting the benefit of these deductions for both regular and AMT taxation.
No AMT adjustment for State and Local Taxes As mentioned earlier, Wilkins (2000) suggests that Congress denied the state and local income tax deduction for AMT purposes to increase the progressivity of the tax distribution after the Tax Reform Act of 1986. The next simulation examines the extent to which the add-back of state and local taxes impacts the incidence of AMT. Panel D of Table 3 indicates that the add-back of itemized state and local tax deductions in the AMT structure would result in a 92% decrease in the number of taxpayers subject to AMT with a decrease in AMT revenues of 94% from the base analysis (i.e. a reduction of over $4.8 billion in AMT revenues). Thus, this provision appears to be the single largest factor explaining the projected growth of the AMT burden and obviously affects those taxpayers living in high income tax states. The data from Panel C, Table 5 show that, while this reform would dramatically reduce the AMT, approximately 73% of the burden of the reduced liability continues to fall on married individuals. Although still disproportionate, the percentage borne by married taxpayers under this proposal is down approximately 14% from the analyses presented in the previous discussions. Perhaps even more relevant is that eliminating this adjustment to the AMT would benefit high tax bracket taxpayers relatively more than those in the middle and low-brackets. Over 60% (57,714) of all taxpayers (96,114) subject to AMT under this scenario are in the middle marginal tax brackets of 25, 28 or 33%. These results support Wilkins’ tax system progressivity suggestion. Stated differently, because higher income individuals are likely to have higher state tax liabilities than their lower income counterparts, the elimination of this adjustment to AMTI would have a much larger effect on the higher income individuals, thereby causing
138
JOHN J. MASSELLI ET AL.
a shift of the AMT burden downward to lower income taxpayers who typically would report a lower state tax deduction. Thus, while the overall tax burden is substantially reduced, those taxpayers bearing the burden of the AMT are clearly not the ones Congress presumably intended to bear the brunt of this tax system again raising the overall equity issue in the AMT system.
Elimination of the Preferential Long-Term Capital Gain Rate for AMT In this simulation, we estimate the effects of subjecting long-term capital gains to the full AMT tax rate keeping all other provisions of the AMT system constant. Until 1986, the preferential treatment afforded net long-term capital gains for regular tax purposes was eliminated when computing the AMT liability. With the repeal of the long-term capital gains deduction in 1986, this adjustment became unnecessary. When the reduced rate for net long-term capital gains was reintroduced in 1997, however, it was made effective for both regular and alternative minimum tax purposes.10 In Panel E of Table 3 and Panel B of Table 6, the data summarizing the effect of subjecting these long-term gains to the full AMT tax rate are presented. Panel E of Table 3 indicates that subjecting long-term capital gains to the AMT would result in a 52% increase in taxpayers subject to AMT with a corresponding 262% increase of AMT revenues (almost $13.5 billion) compared to the 2003 base model. Table 6 indicates that married taxpayers again bear the brunt of the AMT burden with approximately 84% of the revenues attributable to taxpayers in this group. Of particular interest, however, is that within each taxpayer group, the primary burden of the AMT is shifted to taxpayers in the highest marginal tax bracket (i.e. 69 and 71% for single and married taxpayers, respectively). Therefore, the adjustment would meet Congress’s objective of imposing the AMT on high-bracket taxpayers. Part of the difficulty in estimating long-term capital gains for a simulation analysis such as this lies in determining the extent to which long-term capital gains will be recognized. Panel C of Table 6 provides an analysis of net long-term capital gain recognitions relative to adjusted gross income (AGI) provided by SOI for years 1980–2001. In our simulations, we used the CPI index to adjust the tax return data from 1995 to 2003. That factor resulted in an increase of approximately 23% for each item. The dramatic, and perhaps anomalous, increase in capital gains reported in years 1997–2000 disappeared in 2001. Thus, further adjustments to net long-term capital gains from our base year data (beyond the CPI adjustment) is likely unnecessary for simulation purposes as it would almost certainly over inflate our analysis.
Marginal Tax Bracket
Single Low: 10 & 15% Middle: 25, 28, & 33% High: 35% Total
Married Low: 10 & 15% Middle: 25, 28, & 33% High: 35% Total
Panel A: 2003 Projections/No Preferences Base Analysis # Of Taxpayers
%
12,732 69,495
12 67
20,907
AMT Revenue in 000s
Panel B: Manipulation 5: Long-Term Gain Subject to AMT Tax Rates %
# Of Taxpayers
%
$14,760 $249,451
3 46
19,362 157,059
9 74
20
$281,555
52
36,981
103,134
9
$545,766
11
76,650 722,902
7 68
$89,703 $1,980,689
257,266
24
1,056,818
88
AMT Revenue in 000s
Panel C: Longitudinal Analysis of Long Term Capital Gain Realizations %
Tax Year
L-T Capital Gains as a % of AGI
$20,515 $771,393
1 31
1980 1985
2 3
17
$1,677,014
68
1990
3
213,402
12
$2,468,923
13
1995 1997 1998
4 7 8
2 45
160,833 1,049,553
10 68
$215,634 $4,290,988
1 28
1999 2000
9 10
$2,305,374
53
341,714
22
$11,027,747
71
2001a
5
$4,375,766
86
1,552,100
85
$15,534,370
84 2001 tax year 1995 base year
Head of household Low: 10 & 15% Middle: 25, 28, & 33% High: 35% Totalb Grand total
11,687 32,322
25 68
$12,902 $109,642
7 63
18,498 45,071
27 65
$24,232 $191,236
6 45
3,410
7
$50,318
29
5,456
8
$205,702
49
47,419
4
$172,862
3
69,025
4
$421,170
2
1,207,371
$5,094,394
1,834,527
% increase 95 to 01
% Base Yr
The Alternative Minimum Tax
Table 6. Dollar Amounts in 000s.
5 4 25
CPI index used to adjust 95 data to 2003
23
$18,424,463
a
139
The 2001 figures are the most current data available from SOI. b Percentages on the total line represent the respective percentage of the total to the grand total amounts.
140
JOHN J. MASSELLI ET AL.
Nevertheless, while total AMT revenues under this scenario (subjecting capital gains to the full AMT tax rate) are extremely sensitive to the level of capital gain realizations11 , the basic conclusions are the same. Subjecting capital gains to the AMT at the same rates as other income would generate substantial revenues. These revenues are easily sufficient, under even the most pessimistic realization assumptions, to offset the cost of eliminating those adjustments analyzed above, which clearly do not reflect the types of reporting positions originally targeted by the system.12
Simultaneous Consideration of All the Above AMT Policy Manipulations Panel F of Table 3 and Panel B of Table 7 provide an overall analysis of our simulation assuming that all the proposed structural reforms, including the application of the AMT to long-term capital gains, were enacted simultaneously. Although Congress has been aware for several years of the growing burden of the AMT, it has thus far failed to act in any meaningful way to address the problem, presumably because of the substantial revenue effects of AMT reform or abolition. Indeed, our results suggest that the structural reforms analyzed in this paper would diminish federal revenues significantly. Enactment of the reforms analyzed, other than extension of the AMT to long-term capital gain income, would eliminate over 99% of the AMT revenues attributable to non-preference adjustments – we estimate a revenue loss of over $5 billion in 2003 alone.13 While this cost may diminish Congress’ interest in addressing these problems, our results also indicate that extension of the AMT to long-term capital gain income would provide more than enough revenues to pay for reform. As indicated in Panel B of Table 7, combining all the reforms analyzed in this study, including extension of the AMT to the preferential treatment of long-term capital gain income, would generate an estimated $7.9 billion in AMT revenues, ignoring the effects of tax preferences such as depreciation adjustments, intangible drilling costs, incentive stock options, etc. More importantly, our results indicate a projected reduction of more than 75% in the number of taxpayers who would be subject to the AMT, again ignoring the effects of actual tax preference items. Moreover, almost 93% ($7.3 billion) of the total AMT burden, measured in terms of AMT revenues, would be borne by taxpayers in the highest income tax brackets. This is true even though only 53% (approximately) of the taxpayers who would be subject to the AMT are in the highest brackets. In summary, extending the AMT to long-term capital gain income would provide the federal government with substantially higher revenues from the AMT, even after eliminating adjustments for personal exemptions and itemized
Marginal Tax Bracket
Panel A: 2003 Projections/No Preferences Base Analysis # Of Taxpayers
Single Low: 10 & 15% Middle: 25, 28, & 33% High: 35% Total Married Low: 10 & 15% Middle: 25, 28, & 33% High: 35% Total Head of household Low: 10% & 15% Middle: 25%,28%, 33% High: 35% Totala Grand total
AMT Revenue in 000s
%
# Of Taxpayers
%
AMT Revenue in 000s
%
$236 $128,251
0 12
12,732 69,495
12 67
$14,760 $249,451
3 46
51 21,986
0 52
20,907
20
$281,555
52
19,874
47
$979,430
88
103,134
9
$545,766
11
41,911
15
$1,107,917
14
76,650 722,902
7 68
$89,703 $1,980,689
2 45
25,739 77,751
11 34
$19,898 $404,423
0 6
257,266
24
$2,305,374
53
127,613
55
$6,206,760
94
1,056,818
88
$4,375,766
86
231,103
81
$6,631,081
84
11,687
25
$12,902
7
6,180
55
$3,418
3
32,322
68
$109,642
63
2,461
22
$14,879
11
3,410
7
$50,318
29
2,506
22
$111,715
86
47,419
4
$172,862
3
11,147
4
$130,012
2
1,207,371
$5,094,394
284,161
on the total line represent the respective percentage of the total to the grand total amounts.
$7,869,010
141
a Percentages
%
Panel B: All Proposed Changes Including LTCG Calculated Simultaneously
The Alternative Minimum Tax
Table 7. Dollar Amounts in 000s.
142
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deductions that clearly are not the types of items originally intended to be subjected to AMT. In addition, this combination of changes would result in the AMT being distributed more equitably, with the largest share of the burden being borne by those for whom the AMT was intended. Although subjecting long-term capital gains to the AMT and thereby minimizing the regular tax preference afforded these transactions would likely not be a popular reform among tax legislators, it is difficult to defend treating the payment of items such as state and local taxes or the claiming of dependency exemptions as a form of tax abuse when the elimination of all the non-preference items analyzed above could be totally funded (and then some) by subjecting long-term capital gains to the AMT.
SUMMARY AND CONCLUDING REMARKS Many researchers, most recently Burman et al. (2003), Kiefer et al. (2002) and Gale and Potter (2002), have forecasted the dire consequences of Congress leaving the AMT unchanged. However, in this article we take the analysis one step further by simulating the effects of inflation, a series of AMT-related variable manipulations, and the recently EGTRRA 2001 and JGTRRA 2003 on the number of tax returns subject to the AMT and the amount of potential revenues involved. Our results indicate that over 1.2 million individual tax returns are expected to incur an AMT liability in 2003 derived solely from the AMT adjustments for itemized deductions and personal exemptions. The comparable figures for 1995 and 2000 are 276,392 and 852,275, respectively. Thus, our figures suggest an increase of over 40% in the numbers of taxpayers affected, and over 85% in the total AMT burden, again attributable to personal exemptions and itemized deductions alone. Moreover, since married taxpayers bear more than 85% of this burden, this problem represents a sizable hidden marriage penalty. Taking preference items into account (e.g. ESOP adjustments, depreciation adjustments, intangible drilling costs), the total number of returns subject to AMT will be potentially much higher than our estimate.14 Nonetheless, our results suggest a growing, and unnecessary, problem for tax policy makers. These results are perhaps not surprising since the JCT has projected that by 2006 over four million returns will be subject to the AMT, with that number increasing to over nine million by 2009. In fact, Burman et al. (2003), forecast an astounding 36 million returns subject to AMT by 2010 as a result of EGTRRA 2001, which, when deemed fully implemented, closely mirrors the impacts of JGTRRA 2003 from an AMT sensitivity standpoint. The distribution of the AMT burden also is a problem. Although the extent of the tax burden is partially a function of AGI and circumstances common to
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married taxpayers, the marriage penalty inherent in the AMT system has gone unchecked in the AMT tax laws even though the intent to promote equity in the regular tax system by eliminating the marriage penalty was at the forefront of EGTRRA 2001 and JGTRRA 2003. One example of the failure of the AMT system to address this inequity is that the AMT exemption for married couples filing jointly is not twice the individual amount. Nevertheless, in virtually all simulations presented, married taxpayers bear the substantial majority of the AMT tax burden. In fact, in most cases their burden exceeds 80% of the overall AMT liability. By far the bulk of the AMT liability attributable to exemptions and itemized deductions is borne by taxpayers in the middle tax brackets who clearly are not those taxpayers intended to be the target of AMT. Although the results presented in this study are not new, they are quite troubling. Congress implemented the AMT to curb the perceived “abuse” of preferential tax treatment for such things as accelerated depreciation deductions, oil and gas drilling costs and the long-term capital gains tax rate preference. Few would have imagined when it was implemented that medical expenses might someday be considered an AMT adjustment item. Similarly, it is not clear why employee business expenses, legal expenses and state and local tax payments are deemed abusive under current law. Equally confusing is the current treatment of long-term capital gains for AMT purposes. Throughout its history, the AMT has fully taxed capital gains. Only in the last decade have these gains been subject to preferential treatment for both the regular and alternative minimum taxes. While there is room for disagreement on the extent to which lower taxation of capital gains is equitable, surely few would argue that taxpayers who deduct expenditures for medical expenses, state and local taxes, employee business expenses, legal fees, etc. are taking advantage of “loopholes” or otherwise abusing the provisions of federal tax law, while those realizing substantial amounts of net long-term capital gains are not. In any event, whether or not long-term capital gains are brought within the reach of the AMT, it seems likely that structural reform of the AMT system may prove to be easier, and less expensive, in the long run than trying to explain to growing numbers of taxpayers why they suddenly find themselves subject to the AMT. Like Burman et al. (2003) and Gale and Potter (2002), we agree that it is unlikely that Congress will allow the AMT to grow as projected in this and previous studies. We also agree, however, that “how the AMT problems are resolved will significantly influence the impact” of future tax acts (Gale & Potter, 2002, p. 139). We suggest that, at a minimum, the provisions of the AMT denying a deduction for such items as personal and dependency exemptions, the standard deduction and non-abusive itemized deductions be repealed. To pay for this, Congress could bring long-term capital gains back under the AMT umbrella.
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NOTES 1. Although Congress first enacted the concept of a minimum tax in 1969, the system largely in place today remains the AMT system enacted in 1978. 2. Harvey and Tempalski (1997) provide a detailed history of the AMT and Kern (1999) provides a detailed explanation of the mechanics of the tax, along with useful examples. 3. To illustrate, Wilkins offers an example of a taxpayer who incurs 60 cents in expenses for every dollar of income. If classified as an employee rather than an independent contractor, a tax of 28% (the maximum AMT rate) on the taxpayer’s gross income is equivalent to a tax of 70% on her net income. 4. For additional examples, see Alexander, 72 F3d 938 (CA-1 1995); Bagley, 105 TC 396 (1995), aff’d on other grounds 121 F3d 393 (CA-8 1997); Coady, TCM 1998-291; and Bend-Woodward TCM 1998-395. 5. Elimination of the adjustments for personal exemptions, miscellaneous itemized deductions and state taxes, along with increasing the AMT exemption by 15%, eliminates virtually all the “non-preference” AMT burden analyzed in this paper. Although we do not report these results, we estimate that 2003 revenues from the AMT, ignoring tax-preference items, would fall to $35 million (from $5.094 billion). The remaining difference is primarily attributable to the larger floor applied to the medical expense deduction for AMT purposes (10%) relative to the regular tax (7.5 %). These results are available from the authors upon request. 6. See also Klaasen, 83 AFTR 2d 99 (CA-10 1999), aff’g TCM 1998-241, in which a taxpayer with 13 children challenged the application of AMT on grounds that it was not intended to be applied to taxpayers in his situation. The courts sided with the IRS. 7. The sample weight is a variable provided in the SOI data set. It specifically indicates how many tax returns are represented with that one tax return sample. For example, a sample weight may be 3.5. This number means that the sample tax return represents 3.5 tax returns in the population. To extrapolate to the population, if the AMT on the sample tax return is $1,000, the AMT for the population would be $3,500. Summing the extrapolated number from each sample provides an estimated total for the population. 8. It is worthy to note here, however, that the preliminary 2001 data released by the SOI in April 2003 forecast a decrease for tax year 2001 from tax year 2000 in both the number of returns and estimated AMT liability expected for tax year 2001. Nevertheless, while the AMT liability decreased, the SOI also estimates increases in total itemized deductions including increased state tax deductions and medical deductions. Furthermore, the SOI also provided data in the same publication showing an increased incidence of child credit allowances as distinguished from the increased child credit allowed from the EGTRRA 2001 (they separated this information out in the analysis) that suggests that there would be a corresponding increase in personal exemptions as well. Therefore, the decrease in AMT liability projected for 2001 is likely due to a decrease in “real” tax preference items such as decreased depreciation deductions and lower ESOP income recognition rather than reduced AMT incidence due to the non-preferential items discussed in this article. 9. This study uses the 1995 Public Use file and restates the 1995 dollars into 2003 dollars using the aforementioned indexing method. At the time we commenced this project,
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the 1995 tax return data was the most recent available. While the 1999 file is now available for use, a 4-year indexing would still have been necessary. Since we feel comfortable that our CPI indexing method is sufficiently robust to provide reasonable estimates for our analysis, we are confident that using any later tax return data file (i.e. 1996–1999) would not have resulted in any significant differences in our findings. 10. We considered a number of different approaches to restate the 1995 figures to 2003. For example, we experimented with using different indexes to restate different items such as interest rates to estimate interest income and expense, the S&P500 index to estimate capital gains, average wage growth to restate salaries and wages, etc. We tested each of these alternative measures using panel data for the period 1985–1988 and compared them to the simpler CPI measure. None of our alternative measures proved to be as effective in restating 1985 figures to 1988 as did the CPI index. Thus, we use the CPI index to adjust the 1995 figures to year 2003 figures. Also, we used a published estimate of the 2003 CPI and extended the data to 2003 because we are incorporating JGTRRA 2003. We felt this approach would increase the accuracy and validity of our estimates. 11. Because the AMT exemption offsets all AMT income, including true tax preference items, we resisted increasing the exemption by more than 15% to ensure that the benefits were not accrued to the taxpayers legitimately intended to bear the brunt of the AMT. For this reason, we settled on 15% as we felt it was a reasonable adjustment. 12. The current AMT system does factor in a preference item for part of the gain exclusion under Section 1202. 13. We certainly recognize that taxpayers may modify behaviors in response to changes in tax laws as examined in many tax elasticity studies. To better assess the trends associated with the items we evaluate in our study, we examined the data provided in the SOI Bulletins for tax years 1995–2000 (tax year 2000 being the most recent finalized information available). We consistently find steady increases in AGI, itemized deductions (in particular medical expenses, state and local taxes, and miscellaneous itemized deductions), and taxable incomes over that period of time. The steady increases of these items, at a time when AMT is capturing more taxpayers in its snare each year, suggest that taxpayers are not extensively modifying their behaviors to escape AMT. Capital gain recognitions, however, are certainly more discretionary than the other items considered herein. Nevertheless, based on the SOI capital gain trends shown in Table 6 from 1980 to 2001 during which time the taxation of long-term capital gains changed several times, long-term gains recognized as a percentage of AGI appear to be more closely related to the strength of the capital markets rather than taxation. Most notably, the 1986 tax act increased the maximum capital gain rate from 20 to 28%. Yet, gain realizations in 1985 and 1990 are the same. With that said, subjecting capital gains to the maximum AMT rate of 28% could result in some behavioral response. 14. For example, based on the ratio of capital gains to AGI reported in tax year 2000, we would have to more than double the realization of capital gains in our 1995 base year, potentially resulting in an overstatement of the benefit associated with the proposed capital gain modification to AMT. We did, however, prepare a sensitivity analysis assuming that the capital gains in our simulation were doubled and halved. In the case of doubling the capital gain revenue, we estimate that AMT revenues would increase by almost 200% from the analysis provided to over $50 billion. If, on the other hand, net-long term capital gains were only 50% of our analysis, potential AMT revenues would decrease by approximately $10 billion from our original estimate of $18.4 billion.
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REFERENCES Atwood, T. J. (2003). Implicit taxes: Evidence from taxable, AMT, and tax-exempt state and local government bond yields. The Journal of the American Taxation Association, 25(1), 1–20. Burman, L. E., Gale, W. E., & Rohaly, J. (2003). The expanding reach of the individual alternative minimum tax. Journal of Economic Perspectives, 17(2), 176–186. Everett, J., & O’Neil, C. J. (2000). AMT planning strategies. The Tax Adviser, 31(11), 788–799. Gale, W. G., & Potter, S. R. (2002). An economic evaluation of the economic growth and tax relief reconciliation act of 2001. National Tax Journal, 55(1), 133–186. Harvey, R. P., & Tempalski, J. (1997). The individual AMT: Why it matters. National Tax Journal, 50(3), 453–473. Internal Revenue Service (1998). Statistics of income – Individual income tax returns 1995, Publication 1304. Internal Revenue Service (2000). Statistics of Income Bulletin, Publication 1136 (Spring). Internal Revenue Service (2003). Statistics of Income Bulletin, Winter 2002–2003 issue. Joint Committee on Taxation (1998a, February 4). Present law and issues relating to the individual alternative minimum tax (“AMT”) (JCX-3–98). Joint Committee on Taxation (1998b, June 22). Description of possible proposals relating to the individual alternative minimum tax (“AMT”) (JCX-48–98). Joint Committee on Taxation (1999, April 15). Overview of present law and issues relating to individual income taxes. (JCX-18–99). Joint Committee on Taxation (2001, May 26). Estimated budget effects of the conference agreement for H. R. 1836[1] (JCX-51–01). Jolly, S., Cathey, J., & Godfrey, H. (2001). Measuring a taxpayer’s vulnerability to the AMT. The Tax Adviser, 32(2), 117–123. Kern, B. (1999). The AMT trap. Journal of Accountancy, 188(4), 87–90. Kiefer, D., Carroll, R., Holtzblatt, J., Lerman, A., McCubbin, J., Richardson, D., & Tempalski, J. (2002). The economic growth and tax relief reconciliation act of 2001: Overview and assessment of effects on taxpayers. The National Tax Journal, 55(1), 89–117. Lathrope, D. J. (2000). Reduce the impact of the alternative minimum tax. Practical Tax Strategies, 64(4), 196–206. Maroney, J., Rupert, T., & Fischer, C. (2000). Alternative minimum tax: Bane of middle income taxpayers. The CPA Journal, 70(4), 20–24. Murray, S. (2003). Firestorm looms on minimum tax: About 33 million people will be paying levy in 2010 unless Congress Acts. Wall Street Journal (July 1). Sloan, A. (2003). The tax cut: Whose is bigger? Newsweek, 141(18), 53. Tully, S. (2003). Taxpayer beware! Fortune, 147(13), 148. Weiner, L. (2001). This tax could sneak up on you without any warning. U.S. News and World Report, 130(10), 78. Wilkins, W. (2000). Taming the individual alternative minimum tax. Business Entities, 2(May/June), 14–19.
AN EMPIRICAL INVESTIGATION OF FACTORS INFLUENCING TAX-MOTIVATED INCOME SHIFTING Toby Stock ABSTRACT This article examines the extent to which costs imposed on customers and other factors influence tax-motivated income shifting when corporate taxpayers expect tax rates to decline. I find that sellers of durable goods shift defer less income to lower tax rate periods than sellers of nondurable goods. This is consistent with shifting firms considering the effect of their income shifts on their customers. There is also limited evidence that firms with greater market power shift more income than other firms. In addition, I find evidence that, controlling for political costs and scale effects, smaller firms shifted more income than larger firms. This result is inconsistent with a “tax sophistication” hypothesis that larger firms are better able to engage in tax planning activities than smaller firms.
INTRODUCTION AND MOTIVATION This study provides empirical evidence on factors that influenced firms’ decisions to shift operating income across time in response to the statutory rate reductions of the Tax Reform Act of 1986 (TRA86). Several studies already have examined firm tendencies to shift income forward to take advantage of TRA86 rate reductions.
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However, extant research has not considered the extent to which costs imposed on shifting firms’ customers moderates this income shifting behavior. Research in corporate acquisition behavior suggests that taxpayers engaging in tax planning strategies will compensate other parties for increases in their tax costs (e.g. Erickson & Wang, 2000; Henning et al., 2000). Shifting firms can impose tax costs on customers because deferring a shifting firm’s gross income from a sale also defers a customer’s purchase, which can reduce the customer’s tax deductions in the higher tax rate year. However, as discussed in a later section, it is possible that shifting firms might avoid these costs in pursuing an income deferral strategy when tax rates decline. Examining the extent to which these costs imposed on customers affect income shifting behavior is the primary issue investigated, and I find that firms consider the costs they impose on their customers when deciding to defer sales. That is, firms that impose higher tax costs on their customers when shifting income shift significantly less income than other firms. This implies that the cost of coordinating and implementing an income shifting strategy are non-trivial, even when such a strategy involves a relatively uncomplicated change in tax rates (Plumlee, 2003). In addition, this study also clarifies whether larger or smaller firms shift relatively more income in response to statutory tax rate changes. Prior research produces inconsistent evidence on this issue. Results indicate that, controlling for a scaling effect and for political costs, smaller firms shifted more income than larger firms, consistent with smaller firms being more aggressive tax planners (Boynton et al., 1992). Scholes et al. (1992) (SWW) conclude that the larger firms in their sample deferred gross profit one quarter into the future, while smaller firms did not.1 They find little evidence that large or small firms accelerate selling, general and administrative expenses (SG&A). SWW do not investigate factors other than firm size that impact tax-motivated income shifting behavior. Guenther (1994) finds evidence that firms made income-increasing accruals from 1986 (the year before the tax rate decreases) to 1987.2 He finds no relation between discretionary accounting accruals and the size of the tax rate reductions. In addition, the larger firms in his sample made greater income-reducing accruals than smaller firms in the year before a rate decrease. Lopez et al. (1998) add to Guenther’s work by controlling for the tax aggressiveness of shifting firms. They document that the degree to which firms are aggressive tax planners influences their income shifting behavior, with more aggressive firms shifting more income than less aggressive firms. Maydew (1997) finds that firms with net operating loss (NOL) carrybacks in the three years after the TRA86 rate reductions shifted gross profit, SG&A, and nonrecurring items to reduce their tax payments.3 Further, he generally finds
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greater income shifting with larger tax rate decreases. He finds little evidence that shifting behavior correlates with firm size. Collectively, these studies establish what income items firms shift to reduce their tax payments. They also examine the impact of some firm-specific variables that influence firms’ tendencies to shift income; their results provide only limited, and sometimes conflicting, evidence on which firms are more likely to shift income to reduce tax payments.4 For instance, they document that financial reporting costs (using debt ratios as a proxy) moderate an income shifting strategy. However, these studies do not investigate the extent to which shifting firms consider the costs that their income deferral imposes on their customers. If a shifting firm’s customers also face decreasing statutory tax rates, then they potentially defer a tax deduction from a high tax rate year to a low tax rate year when they delay purchases from shifting firms. The size of these “bilateral” tax costs depends on the type of the goods sold (durable or nondurable goods), the seller’s difficulty in finding trading partners willing to shift their income, and the seller’s market power. In addition, customers also incur nontax costs from delaying purchases because the delay can affect their short-run operations. The size of these nontax costs depends on deferral period length because longer deferrals likely impede customer operations more than shorter deferrals. Prior research has not considered these bilateral costs in the setting of taxmotivated income shifting across time in response to tax rate decreases. However, several studies have investigated whether firms “share” tax benefits when implementing tax planning strategies. For instance, Shackelford (1991) finds that lenders pass about three-fourths of the tax benefits from the exclusion of a portion of the interest income on ESOP loans to borrowers. In addition, several studies document that, in merger and acquisition settings, acquirers compensate target firms or their shareholders for their tax costs (see, for example, Erickson & Wang, 2000; Henning et al., 2000). However, Erickson (1998) finds little evidence that target firm tax characteristics affect acquisition structure. In these studies, the tax consequences of the buyer largely determine those of the seller. In contrast, when firms expect tax rates to decline, it is possible that shifting firms could coordinate with customers to reduce or eliminate customers’ tax costs of deferring purchases of goods to accommodate shifting firms’ income deferral strategy. Thus, the result of the literature cited above are not generalizable to the setting investigated in this article. That is, costs imposed on shifting firms’ customers can be large or small depending on the size of the tax rate decreases faced by the customers and the difficulty of shifting firms finding customers willing to engage in a deferral strategy. In addition, shifting firm market power can affect the extent to which the shifting firm can impose costs on its customers. The results
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in this study support the hypothesis that firms that impose greater tax costs on their customers shift less income to capture tax benefits. However, I find weaker evidence that shifting firms with relatively greater market power shift more income than other firms, and this evidence is not consistent across alternative model specifications. The results of this study provide evidence on factors that impede firms’ tax-minimizing actions and therefore should interest organizational theorists researching ways to improve organizational efficiency. These results also should interest tax policy makers because they provide evidence on the extent to which economic frictions impede tax-motivated income shifting. Prior income shifting studies suggest that policy makers cannot rely on past gross profit or SG&A streams to predict government revenues during periods of tax law changes. This study increases our understanding of factors that influence managers to alter firms’ income streams when tax rates change, and the likely transitional revenue effect of those changes for the government.5 In addition, these results provide no evidence that TRA86 complexity put smaller firms at a competitive disadvantage relative to larger firms, consistent with the conclusion reached in Lopez et al. (1998). The next section of this article describes the theory underlying the specific hypotheses tested. The third section presents the methods used to arrive at the hypothesis tests. The fourth section presents research results and conclusions, and the last section summarizes the article.
THEORY AND HYPOTHESIS DEVELOPMENT The hypotheses below assume that managers act to maximize their personal wealth, and that shareholder wealth increases with the net benefit of shifting the income. This net benefit includes the shifting firm’s tax benefit from shifting the income, firm-specific nontax costs incurred in reducing current income, and the tax and nontax costs imposed by the firm on its customers from shifting customer income.
Tax Benefit of Shifting Income TRA86 reduced statutory corporate tax rates by 12 percentage points over either one or two tax years, depending on the firm’s year-end. The top rate during the phase-in year(s) was 48 percent less one percentage point for every month after
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June 1987 in the tax year. Figure 1 depicts the tax rate reductions for all year-ends. For example, firms with a September 30 year-end faced 1986, 1987 and 1988 tax rates of 46, 43 and 34%, respectively. These firms permanently saved three cents (nine cents) in income taxes for every dollar of income shifted from the fourth quarter of 1986 (1987) to the first quarter of 1987 (1988). Both Guenther (1994) and Maydew (1995) test the hypothesis that income shifting should be larger for firms facing larger tax rate reductions. Guenther finds no evidence supporting this hypothesis for profitable firms, but he dichotomizes his tax benefit variable into two groups: firms with “large” 1987 tax benefits (May, June, and July year-end firms with 11 or 12 percentage point rate reductions) and firms with “small” 1987 tax benefits (December year-end firms with 6 percentage point rate reductions). This operationalization is unlikely to yield a powerful test of this hypothesis because it ignores firms with rate reductions of between 7 and 10 percentage points and less than 6 percentage points. Maydew (1997) finds support for the tax benefit hypothesis for unprofitable firms. He includes the percentage point reduction in the tax rate for each firm in his sample. Similarly, Lopez et al. (1998) find that firms facing a larger tax rate reduction made greater income-decreasing accruals prior to the 1987 tax rate reductions. They argued that Guenther’s (1994) design did not control for tax aggressiveness and that this omitted variable could have masked the effect of the size of the tax rate reduction. Given the results in this literature, the empirical model in this study includes the tax rate reduction faced by the firm.
Shifting Firm Nontax Costs of Reducing Accounting and Taxable Income Prior research suggests that managers consider both tax and nontax factors when making tax reporting decisions.6 The empirical model in this study includes three sets of proxies representing firm-specific nontax costs. These include firm size, controls for alternative explanations for size effects documented previously, and controls for costs of reducing financial accounting income. Firm Size and Tax-motivated Income Shifting The studies examining income shifting decisions during the TRA86 tax rate reduction phase-in period produce conflicting results about the relation between firm size and income shifting behavior. SWW and Guenther (1994) find that larger firms defer more income to capture tax benefits than smaller firms. Boynton et al. (1992) find that smaller firms shift more income to reduce alternative minimum
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Fig. 1.
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tax payments. In addition, Maydew (1997) and Lopez et al. (1998) find little evidence of a relation between firm size and income shifting. However, it is very difficult to compare results from these studies due to differing samples, methods and control variables. SWW find that larger firms defer statistically significant amounts of gross profit while smaller firms do not.7 SWW offer a “tax sophistication” hypothesis that smaller firms were unable to take advantage of TRA86 rate decreases because the Act’s compliance requirements overwhelmed them. This explanation is not plausible if smaller firms hired outside tax advisors to suggest and help implement an income shifting strategy. Thus, it is not clear that the reason for the SWW finding reflects smaller firms’ inability to plan for the TRA86 tax rate reductions. Guenther suggests that higher political costs provided large firms with incentives to reduce current income. However, it is not clear that a political cost hypothesis leads to an unambiguous prediction of greater income deferrals by large firms. Reductions of current income increase next year’s accounting income by the amount deferred plus the permanent tax savings from the deferral. Boynton et al. (1992) offer a “tax aggressiveness” explanation for their result that smaller firms shifted more income to reduce alternative minimum tax payments, citing a lower probability of IRS intervention for smaller firms relative to larger firms. However, Boynton et al. (1992) examined financial accounting discretionary accruals, and so this explanation might not apply to shifting the timing of sales because the IRS generally cannot successfully challenge transaction timing between unrelated parties. In addition, Lopez et al. (1998) suggest that prior size results could be spurious because prior studies do not control for tax aggressiveness. They find no evidence of a size effect on income shifting once they control for tax aggressiveness. This study includes a proxy for firm political sensitivity (the next section of this article discusses the operationalization of this variable) that separates this effect from the tax sophistication and tax aggressiveness hypotheses. Given the difficulty of constructing a proxy for the firm-specific probability of IRS audit and sanction, ←−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−−− Fig. 1. TRA86 Tax Rate Reduction Phase-In. Notes: The SWW sample includes only firms with March, June, September and December year-ends. These months are shaded under the “Year-end” column. The dark shading under the 1986, 1987 and 1988 columns depicts event quarters for firms, while the lighter shading depicts the quarter of the tax rate decrease. So July, August and September in 1986 and 1987 are darkly shaded for firms with September year-ends because these months comprise the first and second event quarters for September firms. October, November and December are lightly shaded because these months comprise the quarters during which firms with September year-ends first experience the lower tax rates required by TRA86.
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the size hypothesis below is two-tailed. Greater income shifting by larger firms is consistent with the SWW tax sophistication hypothesis, while the opposite result is consistent with the Boynton et al. (1992) tax aggressiveness hypothesis. H1. Gross profit and SG&A shifting for larger and smaller firms will differ significantly. Other Costs of Reducing Financial Accounting Income The accounting literature identifies firm size, financial leverage, and managerial compensation contracts as three variables that appear to relate relatively consistently to the timing of income/expense recognition. Bondholders have incentives to limit managerial actions that can impair bondholder wealth. Borrowing firms agree to covenants limiting their freedom to reduce bondholder risk and the borrowing firm’s cost of capital. Prior studies show that the costs imposed by bond covenant limitations relates to firm debt-equity ratios. Firms that defer current income reduce equity and increase expected default costs (Watts & Zimmerman, 1986). Guenther (1994) and Maydew (1997) find a significantly negative relationship between leverage and income shifting. This study includes a similar variable to control for the effects of financial leverage on firms’ income shifting decisions. The agency costs of separating ownership from management include managerial consumption of firm resources, managerial shirking, firm over-retention of cash, underinvestment in positive net present value projects, and other costs (Jensen & Meckling, 1976; Myers, 1977). Firms frequently try to mitigate such problems with compensation contracts tying a manager’s compensation to accounting income. These contracts generally award managers an income-based bonus if reported income is between a lower and upper limit. Healy (1985) shows that managers are more likely to make accounting decisions that increase reported income if managers’ compensation rises with increases in firm income.8 McNichols and Wilson (1988) assert that informal contracts reward (punish) managers for high (low) income performance, inducing behavior consistent with an income-based bonus plan. If true, this assertion extends the Healy (1985) compensation hypothesis to most firms and makes tests of this hypothesis possible without examining individual firm compensation contract provisions. Thus, this study includes a proxy for the impact of income shifting on current or future managerial compensation. Bilateral Cost Hypotheses This section develops the hypotheses relating to costs imposed on customers when a firm decides to defer a sale until the following quarter to capture tax benefits. The analysis first considers tax costs imposed and then considers nontax costs imposed,
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assuming that all firms have the same year-end and that markets for the shifting firm’s goods are competitive. A later section develops additional hypotheses by relaxing those assumptions. Tax Costs Imposed on Customers One way to defer income to a low tax rate year is to postpone a sale from late in the fourth quarter until early in the first quarter of the next year. This will defer the gross profit on the sale until the low tax rate year. However, this tactic also can defer a customer’s purchase to a low tax rate year, which will increase the customer’s after-tax costs if it defers a customer tax deduction relating to the purchase to a low tax rate year.9 Suppose in the fourth quarter of 1986 a manager decided how much income to defer one quarter to take advantage of the TRA86 tax rate reductions. Let S equal the sales price of one unit of its product, C equal the cost to produce and distribute that unit, H equal the high tax rate, and L equal the statutorily reduced low tax rate. Deferring the sale of one unit by up to one quarter would reduce the firm’s 1986 tax liability by H × (S − C) and increase the 1987 tax liability by L × (S − C). Therefore, the firm’s tax savings are10 TAX = (H − L )(S − C)
(1)
which is positive as long as S > C. Firms will shift gross profit only if Eq. (1) exceeds the tax and nontax costs of deferring the income. The analysis below examines the tax costs imposed on customers by considering three distinct cases differing in customer type. The first case includes sales of goods resold by the customer. That is, the shifting firm’s goods are included in the customer’s inventory. If the customer holds inventory at year-end, delaying the purchase of additional inventory has no effect on taxable income because the timing of the deduction depends on the later resale of the goods.11 In this case, the net tax benefit for the shifting firm equals Eq. (1) above. The second case consists of customers who use purchased durable goods (i.e. goods with a life exceeding one year) in a trade or business rather than reselling them. Accordingly, each year’s depreciation is S/n, where n is the asset’s life.12 If the customer delays purchasing the asset until 1987, it loses the tax benefit of the 1986 depreciation deduction, or H (S/n), and benefits from year n depreciation, or L (S/n)/(1 + r)n , where r is the after-tax discount rate for the firm. The tax effect of shifting this purchase is zero for all other years. The present value of the customer’s tax cost is TAXD =
S L (S/n) − H < 0 (1 + r)n n
(2)
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Equation (2) is negative for reasonable values of r and n, implying that delayed purchases impose a tax cost on the customer. For example, if S = $1, n = 5, r = 0.05, H = 0.46 and L = 0.34, then the tax cost to the customer is 4 cents (rounded). The positive first partial derivative of Eq. (2) with respect to n shows that the customer’s tax cost falls as n rises. Thus, for reasonable parameter values, the customer of a seller of durable goods will incur a tax cost that decreases as the life of the durable asset increases. The third case consists of customers using purchased nondurable goods in a trade or business rather than reselling them. If a customer does not immediately expense nondurable goods or services, postponing the purchase of such items imposes no tax costs on the customer. Capitalization is a likely accounting treatment for material purchases of nondurable goods, because the deferred purchases occur near year end. Tax-motivated purchase delays could last only a few days, from the last days of the customer’s current year until the first few days of the customer’s next year. (As discussed below, if the nontax costs of delaying purchases increases in the deferral period, firms have incentives to keep the deferral period short.) Thus, most nondurables would be on hand at the end of the year, requiring capitalization for financial statement purposes. Given this book treatment, it would be difficult for an accrual-basis customer to take an immediate deduction for nondurable goods. Accordingly, the most likely tax cost for buyers of nondurable goods is zero, and the resulting net tax benefit to sellers of these types of goods equals Eq. (1).13 On average, I expect tax costs imposed by sellers of durable goods to exceed those imposed by sellers of nondurable goods. This expectation suggests that gross profit shifting for sellers of nondurable should exceed that for sellers of durable goods. However, the amount and nature of nontax costs imposed on a shifting firm’s customers also affects this prediction, as discussed below. Nontax Costs Imposed on Customers Note that the customer incurs the same tax cost when deferring a purchase from any date during the high tax rate year to any date during the low tax rate year. That is, the tax benefits to the shifting firm and the tax costs to the customer discussed above occur whether the deferral period is one day or several months, as long as the deferral is from a high to a low tax rate year. In contrast, it is likely that the nontax costs imposed on a customer from deferring a sale increase as the deferral period lengthens. Since the tax incentives to defer sales are obtained for very short or very long deferral periods, the shifting firm and its customers have incentives to shorten this period as much as possible. Thus, many sales deferrals will be structured to minimize the deferral period and the related nontax costs imposed on customers. Accordingly, nontax costs
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imposed on customers will not change the prediction that sellers of durable goods will defer less gross profit than sellers of nondurable goods. This hypothesis is restricted to non-retail sellers because retail sellers (i.e. sellers to individuals) impose no tax costs on their customers, regardless of the durability of the goods sold. H2. Non-retail sellers of nondurable goods shift more gross profit one quarter ahead than non-retail sellers of durable goods. Coordination Costs and Market Power The model above describes customer tax effects when all firms have identical year-ends. However, firms facing incentives to defer income could have sold goods to customers with a different year-end and no incentive to accelerate deductions. Thus, buyers and sellers with different year-ends enjoyed greater potential reductions of their joint tax payments by deferring sales transactions than buyers and sellers with the same year-end. Because most firms have December year-ends, shifting firms with a December year-end are likely to have greater difficulty finding customers willing to shift their income than fiscal year-end firms. The selling firm’s year-end should affect its ability to find trading partners, and therefore can proxy for a firm’s relative difficulty in finding willing trading partners. H3. Non-retail sellers with December year-ends will defer less gross profit one quarter ahead than those with fiscal year-ends. In perfectly competitive markets, the seller bears the tax and nontax costs incurred by buyers through negotiated price reductions for the seller’s goods. However, sellers with market power face imperfectly elastic demand curves (Tirole, 1988). These sellers are more likely to impose some of the tax and nontax costs on their customers. This suggests that sellers with relatively greater market power will shift more income than other firms. H4. Sellers with relatively more market power will shift more gross profit than sellers with less market power.
RESEARCH METHODS Dependent Variable Measures This study uses measures of shifted gross profit and SG&A consistent with those used in SWW and Maydew (1997). The first step in estimating tax-motivated
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shifted income is to compute expected gross profit and SG&A with no taxmotivated shift. SWW estimate shifted income using a modified Foster (1977) seasonally differenced, first-order autoregressive time series model.14 This model implies that seasonal changes in gross profit in quarter t equal a constant plus a “shock factor” proportional to the immediately preceding seasonal change in gross profit plus noise. G ∗t − G ∗t−4 = ␣0 + ␣1 (G ∗t−1 − G ∗t−5 ) + t
(3)
where G ∗t = unmanaged gross profit (i.e. gross profit before any tax-motivated income shifting) in quarter t, ␣0 = a constant, ␣1 = the first-order autoregressive coefficient, and t = error term. SWW modify this model by including indicator variables for the tax incentives to defer income. The coefficients on these indicator variables are the SWW estimates of shifted gross profit and SG&A, and this study uses these measures in my main analysis. Maydew (1997) uses a non-seasonal random walk model to estimate unmanaged gross profit and SG&A. To assess the impact of an alternative time-series model on the reported results, I estimate shifted income using a seasonal random walk model.15 The seasonal first-order autoregressive model should outperform the seasonal random walk model because the latter is a restricted Foster (1977) model for which ␣1 in Eq. (3) equals one for all firms. The mean first-order autoregressive coefficient was 0.598, ranging from 0.214 to 0.862. Thus, this study emphasizes the SWW-based results as better representing the income shifting behavior of firms in the sample. Prior studies use different controls for size. SWW use unscaled shifted income as the basis for their statistical tests. Maydew (1997) uses shifted income scaled by assets as the basis for his tests. Neither of these studies justifies their selection of scaled or unscaled dependent variables. Lev and Sunder (1980) note that using a scaled dependent variable is theoretically correct only when it is reasonable to assume that the dependent variable is strictly proportional to size. Otherwise, including size as an independent variable is more appropriate. Given the different hypothesized intercept values for factors other than size (e.g. product type, compensation status, and political sensitivity), it is unlikely that size is strictly proportional to income shifting. In addition to the theoretical justification for using an unscaled dependent variable, Barth and Kallapur (1996) document that scaling by size often results in efficiency losses. They recommend including size as an independent variable and reporting White’s (1980) standard errors to control for unspecified heteroskedasticity. Given these theoretical and empirical reasons, this study takes the Barth and Kallapur (1996) approach.16
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Independent Variable Measures The tax benefit measure used in this study can take on values ranging from 0.00 to 0.12, depending on the year-end and the event quarter of the observation. As Fig. 1 indicates, December year-end firms had rate changes of from 46 to 40% and from 40 to 34% in the following year. Thus, the tax benefit measure for December year-end firms is 0.06 for each of their two event quarters. The studies examining the relationship between firm size and income shifting differ in the proxies they select for firm size. SWW control firm size by placing firms in sales quintiles.17 Guenther (1994) and Lopez et al. (1998) code a dichotomous measure to equal one if the firm’s total assets were in the top quartile of Guenther’s sample and zero otherwise. Since the dependent variable measure is unscaled, the equations for shifted gross profit and SG&A both include two size-related measures. ASSETS equals beginning of the year total assets. Although it is common to take the natural log of assets in cross-sectional regressions, this transformation assumes a functional form that is inappropriate given the size hypothesis tested. Consistent with Guenther (1994), HIASSETS equals one if the firm is in the top ASSETS quartile and zero otherwise. ASSETS controls for larger firms shifting more income because they have more income to shift, allowing HIASSETS to test the tax sophistication and the tax aggressiveness hypotheses. The positive theory literature frequently uses firm size as a measure of political sensitivity, but many criticize firm size as a measure of political sensitivity (e.g. Watts & Zimmerman, 1990). In addition, this measure prevents a separation of the political cost hypothesis from the tax sophistication hypothesis. Regulators rarely increase regulation on highly profitable small firms or unprofitable large firms; they appear to focus instead on firms that are both large and profitable. Accordingly, POL is a dichotomous indicator variable coded one for firms that are in the top decile of both 1985 assets and 1985 income before extraordinary items, and zero otherwise. To control for the costs of deferring reported income, the empirical model includes proxies for financial leverage and managerial compensation effects. Both Guenther (1994) and Maydew (1997) use the ratio of long-term debt to total assets as their financial leverage proxy, and I also use this proxy, measured as of the current year, as a measure of financial leverage. The last variable, COMP, equals one if the change in current return on assets is in the sample’s top or bottom decile and zero otherwise. This is consistent with McNichols and Wilson (1988), who assume that income of firms in the highest (lowest) decile of current change in return-on-assets exceeds (falls below) the income ceiling (floor).
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The tax cost proxies discussed below test for tax-motivated income shifting attributable to the tax and nontax costs of the firm’s customers. I use the shifting firm’s Standard Industrial Classification (SIC) code reported in Compustat as the basis for my bilateral cost proxies. This code describes the primary business and product of the shifting firm. However, many public firms operate in multiple markets, and these firms are likely to add considerable noise to tests of the bilateral cost hypotheses. Accordingly, the sample used to test these hypotheses includes only firms with one SIC code listed in the 1989 Compact Disclosure data base. There is likely to be measurement error from using shifting firm SIC codes. Guenther and Rosman (1994) note that 38% of the two-digit industry codes Compustat assigns to firms differ from self-reported codes, indicating high variability in assigning firms to industries. Assuming that one can infer the customer’s use of the goods and accounting treatment for the expenditure from the seller’s primary SIC code is another source of measurement error. However, there is no reason to believe that this measurement error varies systematically in a way that could drive the reported results. The empirical model includes four indicator variables to test the bilateral cost hypotheses. NON equals one if the shifting firm is a manufacturer or wholesaler of nondurable goods, and zero otherwise. DUR equals one if the firm is a manufacturer or wholesaler of durable goods, and zero otherwise. D equals one for all firms coded zero for both NON and DUR, and zero otherwise. DECYE equals one if the firm is coded one for either NON or DUR and has a December year-end. Since the coefficients for NON, DUR and D are mutually exclusive and collectively exhaustive, they measure the mean shifting for each of these groups of firms. The coefficient for DECYE captures the incremental shifting by manufacturing and wholesaling December year-end firms. Table 1 presents the assignment of the industry variables to SIC codes. I estimate market power using 1987 Census of Business industry Herfindahl indices, with a higher index indicating higher market power.18 This is consistent with much of the empirical industrial organization literature (Schmalensee, 1986; Tirole, 1988).
Empirical Model The one-quarter-ahead income shifting model is a two-equation seemingly unrelated regression model (one equation for gross profit and one for SG&A). This model assumes no simultaneity between the dependent variables in the equations but allows for contemporaneous correlation between the error terms in the equations. This approach is consistent with that used in SWW to estimate
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Table 1. Assignment of Industry Membership. Two-Digit Sic Code
Sic Code Description
Industry Membership
01 02 07 08 09 10 12 13 14 15 16 17 20 21 22 23
Agricultural production – crops Agricultural production – livestock and animal specialties Agricultural services Forestry Fishing, hunting and trapping Metal mining Coal mining Oil and gas extraction Mining and quarrying of nonmetallic minerals, except fuels Building construction – general contractors and operative builders Heavy construction other than building construction – contractors Construction – special trade contractors Food and kindred products Tobacco products Textile mill products Apparel and other finished products made from fabrics and similar materials Lumber and wood products, except furniture Furniture and fixtures Paper and allied products Printing, publishing and allied industries Chemicals and allied products Petroleum refining and related industries Rubber and miscellaneous plastics products Leather and leather products Stone, clay, glass and concrete products Primary metal industries Fabricated metal products, except machinery and transportation equipment Industrial and commercial machinery and computer equipment Electronic and other electrical equipment and components, except computer equipment Transportation equipment Measuring, analyzing, and controlling instruments; photographic, medical and optical goods; watches and clocks Miscellaneous manufacturing industries Railroad transportation Local and suburban transit and interurban highway passenger transportation Motor freight transportation and warehousing Water transportation Transportation by air Pipelines, except natural gas
D D D D D NON NON NON NON DUR DUR DUR NON NON NON NON
24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 44 45 46
DUR DUR NON NON D D D D DUR DUR DUR DUR DUR DUR DUR D NON NON NON NON NON D
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Table 1. (Continued ) Two-Digit Sic Code
Sic Code Description
Industry Membership
47 48 49 50 51 52 53 54 55 56 57 58 59 70 72 73 75 76 78 79 80 81 82 83 84 86 87 88 89
Transportation services Communications Electric, gas, and sanitary services Wholesale trade – durable goods Wholesale trade – nondurable goods Building materials, hardware, garden supply and mobile home dealers General merchandise stores Food stores Automotive dealers and gasoline service stations Apparel and accessory stores Home furniture, furnishings and equipment stores Eating and drinking places Miscellaneous retail Hotels, rooming houses, camps and other lodging places Personal services Business services Automotive repair, services and parking Miscellaneous repair services Motion pictures Amusement and recreation services Health services Legal services Educational services Social services Museums, art galleries, and botanical and zoological gardens Membership organizations Engineering, accounting, research, management and related services Private households Miscellaneous services
NON D NON DUR NON DUR D D D D DUR D D NON D NON D NON D D D NON NON D D D NON D D
All others not on this list
D
shifted income. Breaking income shifted into gross profit shifted and SG&A shifted is desirable because the tax and nontax costs of shifting these items are likely to differ. The empirical model directly follows from the conceptual model discussed in the hypothesis development section of this article. G it = ␣1 it + ␣2 ASSETSit + ␣3 HIASSETS + ␣4 POLit + ␣5 DAit + ␣6 COMPit + ␣7 NONi + ␣8 DURi + ␣9 D i + ␣10 DECYEi + ␣11 POWERi + it
(4)
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X it = 0 + 1 it + 2 ASSETSit + 3 HIASSETS + 4 POLit + 5 DAit + 6 COMPit + it
(5)
where = gross profit for firm i shifted from event quarter t to quarter t + 1, as estimated in SWW. Higher values indicate more one quarter ahead gross profit deferral. it = the tax rate decrease for firm i in event quarter t. NONi = 1 if the firm is a manufacturer or wholesaler of nondurable goods and 0 otherwise. = 1 if the firm is a manufacturer or wholesaler of durable goods, DURi and 0 otherwise. Di = 1 for all firms coded 0 NON and DUR, and 0 otherwise. The coefficient for this variable represents income shifting for firms not categorized as NON or DUR. DECYEi = 1 for all firms coded 1 for DUR or NON with December year-ends. POWERi = industry Herfindahl index reported in the 1987 Census of Business. ASSETSit = firm i’s total assets at the beginning of event quarter t. HIASSETSit = 1 if firm i’s total assets are in the top decile for the sample and 0 otherwise. POLit = 1 if the firm is in the top decile of both 1985 assets and 1985 income before extraordinary items. DAit = firm i’s debt-total assets ratio at the beginning of event year t. COMPit = 1 if firm i’s change in return on assets from the prior year to the current fiscal year is in the upper or lower decile for all firms in the sample, and 0 otherwise. it = disturbance term for firm i in event quarter t. Xit = SG&A expense for firm i shifted from the quarter after event quarter t into event quarter t. Lower values mean more SG&A expense is accelerated by one quarter. it = disturbance term for firm i in event quarter t. Git
I estimate Eq. (4) using two different samples. The full sample includes firms with one or several SIC codes. I delete the bilateral cost terms in the equation for this sample, because testing these hypotheses requires a sample of firms in one line of business. The second sample includes only firms with one SIC code, and tests using
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Table 2. Summary of Hypotheses and Related Tests. Hypothesis
Gross Profit Equation Coefficient Prediction
SG&A Equation Coefficient Prediction
H1: Larger and smaller firms will shift different amounts of gross profit and SG&A. H2: Non-retail sellers of nondurable goods shift more gross profit one quarter ahead than non-retail sellers of durable goods. H3: Non-retail sellers with December year-ends will defer less gross profit one quarter ahead than those with fiscal year-ends. H4: Firms with relatively more market power will shift more gross profit than firms with less market power.
HIASSETS = 0 (a3 )
HIASSETS = 0 (b3 )
NON > DUR (a7 > a8 )
N/A
DECYE < 0 (a10 )
N/A
POWER > 0 (a11 )
N/A
Note: In the table above, ak is the kth estimated coefficient for the gross profit equation (i.e. a k = ␣ˆ k ). Similarly, bk is the kth estimated coefficient for the SG&A equation (i.e. b k = ˆ k ).
this sample include all the terms in Eq. (4). Table 2 summarizes the hypotheses and their relationship to predicted coefficient signs. Sensitivity Tests Many other provisions of TRA86 could affect firm incentives to shift income. Firms paying the alternative minimum tax (AMT) had a marginal tax rate of 20%. If these firms expected to pay alternative minimum tax in 1987, they would have had incentives to accelerate income into 1986 to avoid the book-income adjustment used in computing alternative minimum taxable income.19 I test for the impact of AMT status by re-estimating the main model after including indicator variables for AMT status in both event periods. Specifically, consistent with Gramlich (1991), I code AMT1(AMT2) equal to one if the firm is in the bottom decile of taxes paid over tax expense in event period 1 (period 2), and zero otherwise. The results in Smith (1976) and Dhaliwal et al. (1982) suggest that firms with higher rates of managerial ownership should more aggressively pursue tax-reducing strategies. Further, Klassen (1994) and Wolfson (1993) document ownership structure effects on firm tax planning aggressiveness. Guenther (1994) included an ownership structure variable in his model and found no difference between firms with high and low manager ownership ratios. I include an “owner-control” variable in Eqs (4) and (5) to test for the possibility that ownership structure influenced firms’ tendencies to shift income.
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Table 3. Sample Selection Criteria. Panel A: Sample Selection Criteria Sample Firms Compustat firms with March, June, September or December year-ends Publicly-traded firms or a subsidiary of a publicly traded firm No missing quarterly sales from 1982-III to 1990-II No missing quarterly assets from 1982-III to 1990-II No missing quarterly SG&A from 1982-III to 1990-II Pass the following screens from 1982-III to 1990-II: • Sales > 0.001 • SG&A > 0.001 • % change in end-of-quarter assets < 300% • % change in end-of-quarter assets > −75% • Sales/ending assets > 0.001 • SG&A/sales > 0.001 • SG&A/sales < 3.00 No missing gross profit from 1982-III to 1990-II and annual sales and asset data for 1989
7,482 7,241 2,785 2,398 1,346 1,305
1089
Data available for all independent variables
662
Firms that had no change in accounting periods during 1985–1987 nor NOL carryforwards during 1986–1987 (full sample)
401
Firms reporting one SIC code on compact disclosure (restricted sample)
108
Panel B: Full Sample Year-End Composition January February March April May June
6 12 16 16 9 47
July August September October November December
9 6 31 19 11 219
Total firms = 401
Sample Compact Disclosure provided a list of all SIC codes for sample firms. The 1987 Census of Business Industry Concentration Series provides the H-index data. SIC code classifications provide the descriptions needed to classify firms for the industry dummy variables. Compustat provides all other data.
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I adopt the sample selection criteria of SWW, except that the sample does not limit year-ends to March, June, September, and December year-end firms. These sample screens include limiting the sample to publicly traded firms or their subsidiaries, firms with nonmissing quarterly sales, SG&A, and assets from 1982-III to 1990-II. Additionally, for each quarter, sales and SG&A must exceed 0.001 ($million), the percentage increase (decrease) in assets must be less than 300 (75) percent, sales over assets must exceed 0.001, and SG&A over assets must exceed 0.001. In addition to the SWW criteria, firms must have all annual data required to estimate Eqs (4) and (5). Additionally, the sample excludes financial institutions (for example, banks, savings and loans and insurance companies) due to the unique incentives they face for managing income (Beatty et al., 1995; Collins et al., 1995; Scholes et al., 1990). Also excluded are firms with NOL carryforwards in a year containing an event quarter because these firms derive no benefit from shifting income. As Table 3 shows, the final sample consists of 401 firms, and the sample of firms with only one SIC code consists of 108 firms. These samples yield 802 and 216 separate income shifting observations (one observation per firm for each of two event periods). Table 3 also shows the year-end distribution of firms in this sample.
RESULTS AND ANALYSIS Descriptive Statistics Tables 4 and 5 present descriptive statistics for the dependent and independent variables, respectively, for the sample of 401 firms analyzed in this article. Table 4 reports mean deferred gross profit equaling $7.31 million. This variable has a standard deviation of 62.6; some of the shifting observations are negative, and some are large and positive, resulting in high variance. Despite this variability, average income shifting is significantly positive (p = 0.00). Mean deferred SG&A is $.23 million and is not significant. These results are generally consistent with the results obtained in SWW, who document significant one-quarter ahead gross profit deferral but not one-quarter ahead SG&A acceleration. The tax savings from mean income deferral is about $849,600 [($7.31–0.23 million) × 2 event quarters × 0.06 average tax rate decrease].20 Table 5 reports descriptive statistics for the interval-scale variables and frequencies for the nominal-scale variables. The mean (median) size of the sample firms in Panel A is approximately $1.3 billion ($130.9 million), which is larger than the firms in the Maydew (1997) sample (mean of $800 million). Note also that the sample firms are not highly leveraged. The mean (median)
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Table 4. Descriptive Statistics for Dependent Variable Measures Full Sample ($millions). Variable (n = 401)
Mean
Shifted gross profit e1 e2 Mean (e1, e2)
7.53 7.08 7.31
67.46 67.04 62.63
−0.19 0.66 0.23
32.26 15.30 14.17
Shifted SG&A e1 e2 Mean (e1, e2)
Standard Deviation
p-Valuea
75th Percentile
Median
25th Percentile
0.04 0.00 0.00
1.42 1.58 1.57
0.06 0.00 0.10
−0.86 −0.42 −0.49
0.44 >0.50 >0.50
0.39 0.54 0.43
0.00 0.00 0.03
−0.44 −0.30 −0.37
Note: Shifted gross profit = estimated tax-motivated gross profit shifted in response to the corporate tax rate reductions of the Tax Reform Act of 1986. Higher numbers indicate greater gross profit deferral. Estimates obtained via the method used in Scholes, Wilson and Wolfson (1992). Shifted SG&A = estimated tax-motivated SG&A shifting in response to the corporate tax rate reductions of the Tax Reform Act of 1986. Lower numbers indicate greater SG&A acceleration. Estimates obtained via the method used in Scholes, Wilson and Wolfson (1992). e1, e2 = event periods 1 and 2, respectively. These are the fiscal quarters preceding tax rate reductions of the Tax Reform Act of 1986 in which corporations had tax incentives to defer income into the next quarter. a Wilcoxon sign-ranks test for the one-tailed alternative hypothesis that shifted gross profit (SG&A) is greater than (less than) zero.
debt ratio is 0.17 (0.14), indicating less leverage than Maydew’s (1995) reported 0.23 (0.18). In addition, less variability occurs in the debt ratio for this sample (standard deviation = 0.16) than in Maydew (1997) (standard deviation = 0.22). Thus, the sample firms appear to have lower debt levels than the Maydew sample, which is reasonable given that his sample consisted of loss firms. There is also substantial variance in the market power variable. Panel B presents frequencies for the nominal-scale variables used in this study.
Main Results for the SWW-based Dependent Variable Measures Full Sample Results Tables 6–8 report the results of testing the seemingly unrelated regressions model of Eqs (4) and (5).21 Table 6 presents results of tests of Hypothesis 1 using the SWW-based estimates of shifted income. The model tested includes controls for financial leverage and compensation effects. Table 7 tests Hypotheses 2, 3, and 4 using a sample restricted to firms selling only one type of product. Table 8 presents
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Table 5. Panel A: Full Sample Descriptive Statistics for Interval Scale Independent Variable Measures ($millions, Except for DA, which is a Percentage) Variable (n = 401) ASSETS DA POWER
Mean
Standard Deviation
75th Percentile
Median
25th Percentile
1,314.85 0.17 599.39
5,328.75 0.16 513.69
559.86 0.25 696.22
130.90 0.14 432.00
37.08 0.05 273.00
Panel B: Full Sample Frequencies for Nominal Scale Variables (n = 401) Variable DUR NON D POL COMP (e1) COMP (e2)
Value
Frequency
Percentage
1 0 1 0 1 0 1 0 1 0 1 0
83 318 165 236 82 319 30 371 42 359 42 359
20.7 79.3 41.1 58.9 20.4 79.6 7.5 92.5 10.5 89.5 10.5 89.5
Notes: ASSETS = year-end 1985 assets for the sample firms. DA = average long-term debt to assets ratio for the two event years. POWER = Herfindahl index for top 50 firms in four-digit SIC code industry. DUR = 1 if the firm is a manufacturer or wholesaler of durable goods (see Table 1 for coding based on SIC codes), and zero otherwise. NON = 1 if the firm is a manufacturer or wholesaler of nondurable goods (see Table 1 for coding based on SIC codes), and zero otherwise. D = 1 if the firm is coded zero for both DUR and NON, and zero otherwise. There were some missing industry codes in the sample. POL = 1 if the firm is in the top decile for both 1985 income before extraordinary items and 1985 assets and zero otherwise. COMP = 1 if the firm is in the top or bottom decile in current change in return on assets, and zero otherwise. e1, e2 refer to event periods one and two, respectively. These are the quarters preceding tax rate reductions in which firms have incentives to defer income into the next quarter.
results for the analysis in Table 7 using seasonal random walk-based dependent variable estimates. However, this article emphasizes the results based on the SWW estimation technique given its greater generality than the seasonal random walk model. Note that multicollinearity appears not to be a problem for any of these measures or samples. Condition numbers never exceed 15 for any regression.
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Table 6. Regression Results SWW-Based Shifted Gross Profit and SG&A. Variable
Parameter Estimate
Dependent variable: SWW estimates of shifted gross profit INTERCEPT −1.615 TAU 17.386 ASSETS 0.006 HIASSETS −9.085 POL −6.860 DA 0.014 COMP −0.240 Analysis of variance
Model mean square = 22381.430 Error mean square = 343.509
Dependent variable: SWW estimates of shifted SG&A INTERCEPT 0.291 TAU 5.986 ASSETS 0.0004 HIASSETS −1.731 POL 3.377 DA −4.459 COMP 0.369 Analysis of variance
Model mean square = 915.26 Error mean square = 634.90
t-Statistic
p-Value
1.265 3.054 −2.337 −0.762 0.005 −0.137
0.103 0.002 0.019 0.446 >0.500 >0.500
F-value = 65.155 Adjusted R2 = 0.327
0.826 0.182 0.501 0.327 2.138 0.266
>0.50 >0.50 0.62 0.74 >0.50 >0.50
F-value = 1.44 Adjusted R2 = 0.00
Notes: See Tables 4 and 5 for variable definitions. p-Values for TAU, ASSETS, DA, and COMP are one-tailed; the others are two-tailed.
The results reported in Table 6 relate to the full sample of 401 firms. However, analyses of standardized residuals suggested by Belsley et al. (1980) revealed that four firms have an unusually strong effect on the regression coefficients. Table 6 reports results after deleting these firms from the sample. The overall results in Table 6 support the SWW findings of significant one quarter ahead gross profit deferral but insignificant one quarter ahead SG&A acceleration. The adjusted R2 for the gross profit equation is 0.327, but is virtually zero for the SG&A equation. In fact, the SG&A equation is insignificant, suggesting that the model performs no better than chance in predicting shifted SG&A. This finding is reasonable because firms have greater long-term discretion over the items comprising SG&A. Consistent with this finding, SWW find no evidence of one-quarter ahead income shifting of SG&A, but they find evidence consistent with firms accelerating SG&A by more than one quarter ahead. Given the lack of results for the SG&A equation, the discussion that follows primarily addresses the results of the gross profit equation.
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Table 7. Regression Results Restricted Sample Excluding Firms With Multiple SIC Codes (n = 216). Variable
Parameter Estimate
Dependent variable: SWW estimate of shifted gross profit TAU 3.018 ASSETS 0.002 HIASSETS 3.592 POL −3.166 DA 2.387 COMP −0.106 NON −0.241 DUR −2.874 D 0.417 DECYE 1.415 POWER −0.0003 Analysis of variance
Model mean square = 171.440 Error mean square = 54.260
t-Statistic
p-Value
0.345 0.614 0.849 0.270 1.022 0.122 −0.249 −1.522 0.394 1.328 –0.312
0.429 0.270 0.396 0.788 >0.50 >0.50 0.804 0.128 0.694 >0.50 >0.50
F-value = 3.160 Adjusted R2 = 0.100
Note: Test of alternative hypothesis that NON > DUR: t = 1.690, p = 0.046 (one-tailed). See Tables 4 and 5 for variable definitions. p-Values for TAU, ASSETS, DA COMP, DECYE, and POWER are one-tailed; the others are two-tailed.
Hypothesis 1 states that income shifting will differ between larger and smaller firms. The tax sophistication hypothesis suggests that larger firms will defer more gross profit than smaller firms, while the tax aggressiveness hypothesis implies that smaller firms will defer more gross profit than larger firms. The evidence in Table 6 supports the Boynton et al. (1992) tax aggressiveness argument, as HIASSETS is significantly negative (t = −2.337, p = 0.019). Note that ASSETS, the variable controlling the scale effect, is significantly positive, as expected (t = 3.054, p = 0.002). Thus, controlling for the fact that larger firms can defer more income than smaller firms due to their size, smaller firms appear to defer gross profit more aggressively to capture tax benefits. This result also is consistent with the Lopez et al. (1998) finding that more tax-aggressive firms shift more income than other firms. Note that the control variables are not significant in either equation. Thus, there is no evidence supporting Guenther’s (1994) political cost explanation for a size effect. Restricted Sample Results The full sample tested above includes firms in several lines of business. Some of these firms sell both durable and nondurable goods, reducing the power of the
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Table 8. Regression Results Seasonal Random Walk-based Shifted Gross Profit and SG&A. Variable
Parameter Estimate
t-Statistic
Dependent variable: Seasonal random walk estimates of shifted gross profit TAU 6.514 0.355 ASSETS 0.003 0.215 HIASSETS −32.819 −1.637 POL 5.241 0.255 DA 8.650 1.815 COMP 4.249 2.577 NON −4.295 −1.986 DUR −9.481 −1.962 D −6.730 −1.257 DECYE −1.132 −0.768 POWER 0.003 1.353 Analysis of variance
Model mean square = 2,330.724 Error mean square = 327.524
Model mean square = 14,703.964 Error mean square = 3,321.385
0.362 0.415 0.051 0.399 >0.50 0.005 0.047 0.050 0.209 0.221 0.088
F-value = 7.116 Adjusted R2 = 0.239
Dependent variable: Seasonal random walk estimates of shifted SG&A INTERCEPT −4.622 TAU 35.314 0.782 ASSETS −0.001 −0.218 HIASSETS −13.090 −1.537 POL −5.391 −0.231 DA 9.006 1.789 COMP 3.508 2.045 Analysis of variance
p-Value
>0.50 0.827 0.12 0.82 0.04 >0.50
F-value = 4.427 Adjusted R2 = 0.022
Note: Test of alternative hypothesis that NON > DUR: t = 1.345, p = 0.089.
model to test Hypothesis 2. Accordingly, the restricted sample examined in this analysis includes firms with only one SIC code. This restriction reduced the sample size to 108 firms (216 observations). Thus, it is possible that tests of some or all of the effects documented above will not be significant due to a reduction of statistical power. Table 7 reports results using this restricted sample. Influential observation analysis indicated that one firm had an unusually strong impact on the regression coefficients, and this firm was deleted from the restricted sample.22 The results in Table 7 fail to support Hypothesis 1. However, as expected, the results support Hypothesis 2. Despite reducing the sample size by almost 75%, the coefficient for NON significantly exceeds that for DUR (t = 1.690, p = 0.46). This is evidence that firms consider the imposition of tax costs on their customers
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when deciding whether to defer income to capture tax benefits. Presumably due to the large difference in sample sizes, the data do not support Hypotheses 3 or 4 for this restricted sample. The results in Table 7 raise the possibility that omitting the bilateral cost variables induced the full-sample results reported in Table 6. However, adding these variables to the model tested in Table 6 produced virtually no change in the coefficients or their significance levels. In addition, none of the bilateral cost variables were significant, which is consistent with the inclusion of firms with multiple lines of business introducing measurement error in these measures and tests.
Sensitivity Checks and Other Analyses This section reports results of three sensitivity checks that assess the impact of other methods and variables on the results reported above. These include re-estimating the model tested in Table 7 using a seasonal random walk model to estimate shifted income. In addition, I include variables for potential alternative minimum taxpaying status and ownership structure in the full sample analysis. Table 8 reports restricted sample results when using a seasonal random walkbased income shifting estimator. HIASSETS is significantly negative, confirming the earlier result of relatively greater income shifting for smaller firms. In addition, the results weakly support the bilateral cost hypotheses. The coefficient for NON is significantly greater than the DUR coefficient at the 0.089 level (t = 1.345). Also, POWER is significantly positive at the 0.088 level (t = 1.353), indicating the possibility that, to a limited extent, firms with market power use that power to impose some of the costs of shifting gross profit on their customers. The coefficient for DECYE is negative, as expected, but insignificant. Theoretically, firms expecting to pay the AMT in the 1987 have incentives to accelerate income into 1986 to reduce the impact of the book income adjustment. Neither of these indicator variables for AMT status was significant in either the gross profit or the SG&A equation. Also, the owner-control variable was insignificant in both equations, and otherwise did not alter the results reported above.
SUMMARY The goal of this research was to document factors associated with firm taxmotivated income shifting decisions. This research tested a conceptual model positing that income shifting is a function of the tax benefit to the shifting firm,
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firm-specific nontax costs, and tax and nontax costs imposed on the shifting firms’ customers. Prior research yields inconsistent results on the relation between firm size and income shifting. This article controls for competing explanations for a size effect, including a simple scale effect and political costs. Given these controls, I find that smaller firms shifted relatively more income than larger firms, consistent with the findings of Maydew (1997) and Boynton et al. (1992), but inconsistent with the findings of SWW and Guenther (1994). Thus, the results do not support the tax sophistication hypothesis suggested by SWW. This article also documents that shifting firms consider the effects of their decisions on the tax and nontax costs of their customers. There is evidence consistent with sellers of nondurable goods shifting more gross profit than sellers of durable goods. The reason for this is that the latter firms impose greater tax costs on their customers in the form of deferring depreciation deductions from a high to a low tax rate year. However, the results do not support the notion that December year-end firms incurred higher coordination costs than fiscal year-end firms. Finally, there is only weak evidence supporting the hypothesis that firms with greater market power shift more income to capture tax benefits because they can impose tax and nontax costs on their customers.
NOTES 1. This study and SWW focus on transactions treated the same way for financial and tax reporting purposes. SWW assert that most transactions affecting financial operating income affect taxable income similarly. 2. Guenther’s measure of discretionary accruals is the difference between the actual change in “current accruals” (defined as current assets minus current liabilities) and the predicted change in current accruals, estimated using the approach developed in Jones (1991). 3. Firms could carry NOLs back three years and forward for 15 years. So for 1987–1990, firms could carry losses back to pre-TRA86 years with relatively high tax rates. Losses carried forward would offset income at lower tax rates. 4. In addition to firm-specific costs, Shane and Stock (2004) investigate costs imposed by analysts and marginal investors on publicly-held firms that pursue a tax-motivated income shifting strategy. They find that analysts and market prices do not appear to incorporate information about income shifting efficiently, possibly increasing the cost of capital for shifting firms. 5. Although statutory tax rates change infrequently, numerous tax law changes cause marginal tax rates to change for specific items of income and deduction, providing incentives for managers to shift these items across time to reduce the firm’s effective tax rate for these items. Thus, the applicability of these results extends beyond the setting of statutory tax rate reductions.
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6. Examples of this literature in various contexts include Ronen and Aharoni (1989), who consider tradeoffs between tax benefits and compensation effects on manager accounting choices; Scholes et al. (1990) who consider tradeoffs between tax benefits and expected regulatory costs for banks; Cloyd (1995) and Cloyd et al. (1996), who examine book-tax conformity decisions for public and private firms; and Mills (1998), who documents trade-offs between IRS audit probabilities and book-tax differences for corporate taxpayers. 7. The mean annual 1989 sales for firms in each of the size-based quintiles SWW form to analyze the size effect are $10.89 million (mean sales for firms in the first quintile), $51.83 million, $170.55 million, $634.70 million, and $6,260.24 million (mean sales for firms in the fifth quintile). 8. Holthausen et al. (1995) find evidence that accruals are lower for firms with income exceeding the upper bound but not for firms with income beneath the lower bound. 9. The analysis of customer tax costs holds shifting firm tax benefits constant and ignores all nontax costs of delaying purchases. This simplifies the analysis and permits derivation of testable bilateral cost hypotheses. 10. I ignore the time value of money since short time periods are involved. Positive numbers represent tax savings, negative numbers represent tax payments. 11. Customers using LIFO may incur a tax cost if the delayed purchase causes the firm to liquidate a LIFO layer. A search of the NAARS data base revealed two firms with LIFO liquidations during the sample period. Deleting these firms from the analysis does not change the results reported in this article. 12. For simplicity, I assume that the purchaser uses straight line depreciation for both financial accounting and tax purposes, the asset’s life equals its tax recovery period, and the purchaser records a full year of depreciation in the acquisition year. Departures from these assumptions do not change the conclusions because the amount of tax depreciation is still positive, and thus the customer’s tax cost is positive. 13. If a customer immediately expenses nondurable goods or services, postponing the purchase of such items replaces a tax deduction in a high tax rate year with a deduction in a low tax rate year. The tax cost for the customer who delays this purchase by one quarter is TAXN = −(H − L )S < 0
(a)
where the subscript N denotes a customer purchasing a nondurable good. The net tax cost to the shifting firm is Eq. (1) minus Eq. (a), or NETTAXN = −(H − L )C < 0
(b)
Thus, if the buyer and seller have the same year-ends, the selling firm will not shift income forward. The buyer and seller will be better off jointly by accelerating the sale because this generates tax benefits to the buyer that exceed the tax cost to the seller. 14. This is an ARIMA (1,0,0)∗ seasonal ARIMA (0,1,0)4 model. Foster applied this time-series model to firm earnings; SWW applied it to gross profit and SG&A separately. Only the equation for gross profit is presented in this article; the equation for SG&A is similarly derived. 15. A seasonal random walk model, in which unmanaged gross profit equals gross profit (SG&A) four quarters ago, is incompatible with Maydew’s loss-firm sample because it could induce apparent income shifting for loss firms with variable earnings streams. Since my sample consists of profitable firms, selecting a seasonal random walk is less likely to induce “shifted” income as an artifact of the time-series model.
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16. The model with scaled dependent variables was not significant and had virtually no explanatory power. Neither equation provided evidence supporting any research hypotheses. Maydew deflated his shifted income numbers with assets; he reports adjusted R2 values ranging from 0.01 to 0.021, but he had over three thousand observations in his sample. 17. SWW compute t-statistics for each firm and report descriptive statistics for each of the five size quintiles. Thus, they do not explicitly control for firm size in the formulation of their t-statistics. However, because their t-tests amount to within-firm tests, a more direct control was unnecessary for their study. 18. The Herfindahl index provided in the Census of Business equals the sum of the squared market shares of the largest 50 firms in each 4-digit industry. 19. From 1987 to 1989, the book income adjustment required firms to add 21 of the difference between financial accounting income and modified taxable income to alternative minimum taxable income. Congress replaced this adjustment with a different adjustment that did not use financial accounting income to compute the amount of the adjustment. 20. This amount exceeds the SWW estimate of tax savings of $459,000 per firm. However, a sample of 1089 firms closely matching the SWW sample generated estimated tax savings of $402,000. 21. A seemingly unrelated regression model consisting of an equation in which the independent variables are a subset of those in another equation yields no efficiency gains over ordinary least squares (Greene, 1990, p. 512). Because the cross-equation correlation between the error terms in the gross profit and SG&A equations is only 0.053, there appears to be little relationship between the random shocks affecting shifted gross profit and shifted SG&A. For these reasons, this article reports ordinary least squares results. 22. This was one of the four firms deleted from the analysis reported in Table 6. The other three firms were not present in the restricted sample.
ACKNOWLEDGMENTS This article is derived from my dissertation at Indiana University. I am very grateful to my dissertation co-chairs, Jerry Salamon and Jerry Stern, and my other committee members, Peggy Hite and Heejoon Kang, for their many excellent comments. In addition, this article benefited greatly from comments from participants of research workshops at the University of Colorado at Boulder, Indiana University, and the State University of New York at Buffalo. Finally, the generous financial support of the Arthur Andersen Foundation is appreciated.
REFERENCES Barth, M. E., & Kallapur, S. (1996). The effect of cross-sectional scale differences on regression results in empirical accounting research. Contemporary Accounting Research, 13(Fall), 527–567. Beatty, A., Chamberlain, S., & Magliolo, J. (1995). Managing financial reports of commercial banks: The influence of taxes. Journal of Accounting Research, 33(2), 231–261.
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Belsley, D., Kuh, E., & Welsch, R. (1980). Regression diagnostics: Identifying influential data and sources of collinearity. New York: Wiley. Boynton, C., Dobbins, P., & Plesko, G. (1992). Earnings management and the corporate alternative minimum tax. Journal of Accounting Research, 30(Suppl.), 131–160. Cloyd, C. (1995). The effect of financial accounting conformity on the recommendations of tax preparers. The Journal of the American Taxation Association, 17(Fall), 50–70. Cloyd, C., Pratt, J., & Stock, T. (1996). The use of financial accounting choice to support aggressive tax positions: Public and private firms. Journal of Accounting Research, 34(1), 23–43. Collins, J., Shackelford, D., & Wahlen, J. (1995). Bank differences in the coordination of regulatory capital, earnings and taxes. Journal of Accounting Research, 33(2), 263–291. Dhaliwal, D., Salamon, G., & Smith, D. (1982). The effect of owner versus management control on the choice of accounting methods. Journal of Accounting and Economics, 4(1), 41–53. Erickson, M. (1998). The effect of taxes on the structure of corporate acquisitions. Journal of Accounting Research, 36(2), 279–298. Erickson, M., & Wang, S. (2000). The effect of transaction structure on price: Evidence from subsidiary sales. Journal of Accounting and Economics, 30(1), 59–97. Foster, G. (1977). Quarterly accounting data: Time-series properties and predictive ability results. The Accounting Review, 52(1), 1–21. Gramlich, J. (1991). The effect of the alternative minimum tax book income adjustment on accrual decisions. The Journal of the American Taxation Association, 13(Spring), 36–56. Greene, W. (1990). Econometric analysis. New York: MacMillan. Guenther, D. (1994). Earnings management in response to corporate tax rate changes: Evidence from the 1986 tax reform act. The Accounting Review, 69(1), 230–243. Guenther, D., & Rosman, A. (1994). Differences between Compustat and CRSP SIC codes and related effects on research. Journal of Accounting and Economics, 18(1), 115–128. Healy, P. (1985). The impact of bonus schemes on the selection of accounting principles. Journal of Accounting and Economics, 7(1–3), 85–107. Henning, S., Shaw, W., & Stock, T. (2000). The effect of taxes on acquisition pries and transaction structure. The Journal of the American Taxation Association, 22(Suppl.), 1–17. Holthausen, R., Larker, D., & Sloan, R. (1995). Annual bonus schemes and the manipulation of earnings. Journal of Accounting and Economics, 13, 29–74. Jensen, M., & Meckling, W. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3, 305–360. Jones, J. (1991). Earnings management during import relief investigations. Journal of Accounting Research, 29(2), 193–228. Klassen, K. (1994). The impact of ownership concentration on the trade-off between financial and tax reporting. The Accounting Review, 72(3), 455–474. Lopez, T., Regier, P., & Lee, T. (1998). Identifying tax-induced earnings management around the TRA86 as a function of prior tax-aggressive behavior. The Journal of the American Taxation Association, 20(2), 37–56. Maydew, E. (1997). Tax-induced earnings management by firms with net operating losses. Journal of Accounting Research, 35(1), 83–96. Mills, L. (1998). Book-tax differences and internal revenue service adjustments. Journal of Accounting Research, 36(2), 343–356. McNichols, M., & Wilson, G. (1988). Evidence of earnings management from the provision for bad debts. Journal of Accounting Research, 26(Suppl.), 1–31.
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Myers, S. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5(November), 147–176. Plumlee, M. (2003). The effect of information complexity on analysts’ use of that information. The Accounting Review, 78(1), 275–296. Scholes, M., Wilson, G., & Wolfson, M. (1990). Tax planning, regulatory capital planning, and financial reporting strategy for commercial banks. Review of Financial Studies, 3, 625–650. Scholes, M., Wilson, G., & Wolfson, M. (1992). Firms responses to anticipated reductions in tax rates: The tax reform act of 1986. Journal of Accounting Research, 30(Suppl.), 161–185. Schmalensee, R. (1986). Inter-industry studies of structure and performance. In: Handbook of Industrial Organization. Amsterdam: North Holland. Shackelford, D. (1991). The market for tax benefits: Evidence from leveraged ESOPs. Journal of Accounting and Economics, 14(2), 117–145. Smith, D. (1976). Effect of separation of ownership from control on accounting policy decisions. The Accounting Review, 51(3), 707–723. Tirole, J. (1988). The theory of industrial organization. MIT Press. Watts, R., & Zimmerman, J. (1986). Positive accounting theory. Prentice-Hall. Watts, R., & Zimmerman, J. (1990). Positive accounting theory: A ten year perspective. The Accounting Review, 65(1), 131–156. Wolfson, M. (1993). The effects of ownership and control on tax and financial reporting policy. Economic Notes, 22, 318–332.
ACADEMIC TAX ARTICLES: PRODUCTIVITY AND PARTICIPATION ANALYSES 1980–2000 Paul D. Hutchison and Craig G. White ABSTRACT Productivity, participation, and trend analyses are used in this study to examine academic tax publications by accounting faculty. These analyses utilize a database of academic tax articles from 1980 through 2000 derived from 13 academic research journals. Results suggest that, on average, 46 tax articles have been published annually during the most recent five-year period, sole or dual authorship is the primary publication strategy by authors of academic tax articles, and assistant professors authored the most tax articles on an annual basis in these journals. The results also find that schools of residence for those publishing are far more diverse than the schools of training. Comparisons with Kozub et al. (1990) show some limited similarities for school at publication and university of degree productivity listings. This study also identifies some of the overall context for tax accounting research by noting groups making a significant contribution to the literature.
INTRODUCTION The purpose of this study is to provide insights on participation and productivity trends evidenced in academic tax accounting research articles from 1980 through Advances in Taxation Advances in Taxation, Volume 16, 181–197 Copyright © 2004 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(04)16008-0
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2000. A number of considerations merit addressing this issue. The data may have implications to decisions as to “reasonable” research productivity for purposes of promotion and tenure for tax faculty given the overall number of publications in a given year. It is also informative to measure the mix of research produced by different faculty ranks. Likewise, it is instructive to examine the sources of tax accounting research. This assists in further identifying institutions taking a lead in advancing tax accounting-related knowledge. It also provides some context for the location and background of the work. This research extends studies that have focused on measures within a taxfocused journal (Hutchison & White, 2003) and general studies that discuss tax research productivity (Campbell & Morgan, 1987; Englebrecht et al., 1994; Kozub et al., 1990). The use of a broad array of accounting journals allows for a comparison of attributes of the wider set of tax publications to those in a tax-focused journal. Further, the use of an extended time period provides an opportunity for examining changes from earlier studies. The objectives of this inquiry are accomplished by the development and utilization of a tax-article database that is derived from research published in a broad selection of academic accounting journals. The database allows examination of co-authorship strategies and faculty rank, and identifies key schools of residence and doctoral graduation for authors that have contributed to academic tax research. Results from this inquiry suggest that assistant professors produce the greatest quantity of academic tax accounting research. There are also a relatively small number of schools producing graduates who contribute the majority of academic tax publications. However, the authors of tax research are located primarily at a wide variety of state institutions. These findings contribute to an understanding of the context for academic accounting’s contributions to the general tax discourse. The article is organized in the following manner. First, a description of the tax article database developed and used in this study is presented. This is followed by productivity and participation analyses of academic tax articles. The final sections of the article present comparisons with other studies, limitations, and concluding remarks.
ACADEMIC TAX ARTICLE DATABASE The analyses for this study are performed using a database of tax-related articles published during the period 1980 through 2000, a 21-year period. The focus of the study is on contributions to tax research through the academic accounting literature. Thus, the journals chosen for inclusion are a broad group of academic accounting publication outlets. The journals identified for this study are a combination of:
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(1) those utilized by Kozub et al. (1990) in their research study that reviewed total publication productivity by accounting tax faculty; (2) American Accounting Association general journals; (3) journals that address additional methods and perspectives; and (4) highly-ranked accounting journals (Brown & Huefner, 1994; Daigle & Arnold, 2000; Hasselback et al., 2001). The following 13 academic journals are included in the database: Accounting Horizons (HOR), Accounting, Organizations and Society (AOS), Advances in Taxation (AIT), Behavioral Research in Accounting (BRIA), Contemporary Accounting Research (CAR), Issues in Accounting Education (IAE), Journal of Accounting and Economics (JAE), Journal of Accounting and Public Policy (JAPP), Journal of Accounting, Auditing & Finance (JAAF), Journal of Accounting Research (JAR), National Tax Journal (NTJ), The Accounting Review (AR), and The Journal of the American Taxation Association (JATA). Although this group of journals is not exhaustive, analyzing this same group over time provides a broad sample view of publication trends over the 21-year period. The 1980 beginning point for the study was selected as it corresponds closely with the emergence of the first academic tax accounting focused publication outlet.1 The 2000 end point was chosen to provide a manageable 21-year period (1980–2000) for analyses. Accounting faculty authors were identified using the Accounting Faculty Directory (1980, 1981, 1982, 1983, 1984, 1985, 1987, 1988, 1989, 1990, 1991, 1992, 1993, 1994, 1995, 1996, 1997, 1998, 2000) compiled by J. R. Hasselback.2 In total, approximately 831 journal editions and 6,636 articles were perused manually and electronically for inclusion in the tax article database.3,4 A broad approach was used for identifying tax articles. An article was included if it addressed or included a tax issue or provision. For each journal, except the National Tax Journal, all tax articles by all authors are included in the database.5 There were a total of 715 separate tax articles identified for the years 1980 through 2000 and included in the academic tax article database. These articles represent 662 different authors.6 Of the 662 authors, 552 were identified as accounting faculty. This statistic illustrates that individuals other than accounting faculty are making tax related contributions through accounting journals; however, the large majority of authors are accounting faculty members. Table 1 details the journals, publication years, and quantities of tax-related articles in the database. This table indicates that six of the 13 journals (JAPP, IAE, CAR, AIT, HOR, and BRIA) had their initial publication date after 1980 and, therefore, their time period in the database is shorter than the other journals. Further, as previously noted, NTJ articles in the database are limited to only accounting faculty and do not represent all publications in this particular
184
Table 1. Academic Tax Article Database 1980–2000.a Journal
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Total
0 1 0 0 0 10 0
0 2 0 2 0 7 1
0 1 1 1 0 9 0 0
0 2 1 3 1 12 1 4 0
0 1 0 2 0 17 2 2 2 0
0 6 0 6 2 14 2 2 0 0
0 1 0 1 1 12 0 0 0 1
0 5 0 0 0 11 0 1 1 0 10 4
1 0 3 0 0 14 2 3 3 0 0 5
1 3 0 9 0 14 1 2 0 1 12 10 0
0 2 0 0 1 14 1 2 0 0 11 3 0
0 5 1 6 0 12 2 0 0 0 0 1 0
1 3 1 0 13 13 2 0 0 3 11 3 0
0 2 0 3 5 14 2 0 0 0 11 2 0
0 2 1 3 1 17 2 3 1 4 10 2 2
0 5 0 0 2 19 2 1 0 1 7 2 0
1 1 3 3 2 18 4 1 2 5 8 1 2
0 2 5 0 1 18 2 3 1 1 7 1 0
0 4 1 0 6 21 3 0 2 1 8 2 0
0 3 2 0 1 19 2 2 1 3 9 3 1
1 3 3 1 1 20 2 0 0 4 7 1 0
5 54 22 40 37 305 33 26 13 24 111 40 5
Total
11
12
12
24
26
32
16
32
31
53
34
27
50
39
48
39
51
41
48
46
43
715
Note: NTJ data include only those articles authored by accounting faculty. There were no volumes of Advances in Taxation issued in 1988 nor 1991. a Journals are listed by year of initial publication and then, alphabetically: AOS = Accounting, Organizations and Society; JAPP = Journal of Accounting and Public Policy; AR = The Accounting Review; IAE = Issues in Accounting Education; JAE = Journal of Accounting and Economics; CAR = Contemporary Accounting Research; JAAF = Journal of Accounting, Auditing & Finance; AIT = Advances in Taxation; JAR = Journal of Accounting Research; HOR = Accounting Horizons; JATA = The Journal of the American Tax Association; BRIA = Behavioral Research in Accounting; NTJ = National Tax Journal; Total = By journal and by year for articles in database.
PAUL D. HUTCHISON AND CRAIG G. WHITE
1980
AOS AR JAE JAAF JAR JATA NTJ JAPP IAE CAR AIT HOR BRIA
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journal. All 13 journals were actively published during the last 12 years of the database. Table 1 shows a marked increase in the overall quantity of tax articles after 1989. The most recent five-year period in the database (1996 through 2000) had an average of 46 tax-related articles per year compared with an average of 17 articles per year in the first five years of the database (1980 through 1984). The seven journals (AOS, AR, JAE, JAAF, JAR, JATA, and NTJ) that are in the database for all 21 years collectively published an average of approximately 15 tax articles per year by accounting faculty for 1980 through 1984 compared to an average of 31 articles for 1996 through 2000. Although other factors may be involved, one explanation for this increase over time may be a larger number of accounting faculty tax researchers in later years.
PRODUCTIVITY AND PARTICIPATION ANALYSES The research method used in this study is to examine article counts to address productivity and participation by faculty. Similar to previous research, it is assumed that each author contributed equally to the development of an article (Bublitz & Kee, 1984; Daigle & Arnold, 2000; Hasselback et al., 2001; Kozub et al., 1990); thus, each article is weighted by the inverse of the number of authors (Zivney et al., 1995).7
Academic Tax Publication Outlets The first analysis examines the productivity of accounting authors.8 Of the 662 authors included in the database, 552 were accounting faculty. The accounting faculty authors produced 650.34 equivalent articles. This amount represents approximately 91% of the 715 articles in the database. A closer examination of accounting faculty contributions by each of the 13 identified academic journals in the database provides additional insights as illustrated in Table 2. Accounting authors primarily published academic tax articles in The Journal of the American Taxation Association, Advances in Taxation, The Accounting Review, Accounting Horizons, and the Journal of Accounting Research. These five journals account for approximately 80% of tax publications by accounting researchers in the database. Additionally, JATA and AIT together make up 60% of academic tax articles by accounting faculty in the database, clearly establishing them as key publication outlets for academic tax-related accounting research.
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Table 2. Academic Tax Article Database: Accounting Faculty Productivity 1980–2000.a Rank
Journal
1 2 3 4 5 6 7 8 9 10 11 12 13
The Journal of the American Taxation Association (JATA) Advances in Taxation (AIT) The Accounting Review (AR) Accounting Horizons (HOR) Journal of Accounting Research (JAR) National Tax Journal (NTJ) Contemporary Accounting Research (CAR) Journal of Accounting, Auditing & Finance (JAAF) Journal of Accounting and Public Policy (JAPP) Journal of Accounting and Economics (JAE) Issues in Accounting Education (IAE) Behavioral Research in Accounting (BRIA) Accounting, Organizations and Society (AOS)
Total
Quantity
%
286.50 104.67 51.67 36.67 35.83 28.50 22.83 22.00 21.50 20.00 12.50 4.67 3.00
44.1 16.1 7.9 5.6 5.5 4.4 3.5 3.4 3.3 3.1 1.9 0.7 0.5
650.34
100.0
Note: Each article is weighted by the inverse of the number of authors (Zivney et al., 1995). a Total articles in database = 715 from 1980 through 2000. Total accounting faculty contributions represent 91.0% (650.34/715) of the articles in the database. Rank = relative ranking. Publication outlets are listed in declining order from largest to smallest totals for these journals. % = % of total contributions by 552 accounting faculty.
Number of Authors per Article Figure 1 presents the number of articles with sole, dual, and tri authorship for each year of the database. Five articles had more than three authors and are not included in this figure, but are in the weighted averages in the tables. During the 21-year time period presented, there were 278 sole-authored, 292 dual-authored, and 140 tri-authored tax articles in the 13 academic journals. Dual-authored works were the predominant publication strategy for the first 13 years of the database and in the last two years presented. While close in total quantity with dual-authored articles, sole authorship has had a significant impact from 1993 to 2000. Sole-authored works led or tied the dual-authored approach in six of the eight years in that time period. Comparisons of totals for the same time period (1993 to 2000) show 146 sole vs. 128 dual works. Tri-authorship of tax articles in the database placed third in all years presented. The trend lines for authorship seem to increase during the 1980s and stabilize thereafter. As indicated in Table 1, 1989 was the first year that all 13 journals were included in the database. Therefore, increases in the total number of tax publications from 1989 may be attributable to more publication outlets.
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Fig. 1. Academic Tax Article Database: Authorship 1980–2000. Note: There were 715 tax articles in the database from 1980 through 2000. This table omits 5 articles that had authorship with more than three authors. Further, this table includes authors from accounting and other disciplines. It should be noted that 1989 was the first year that all 13 journals published articles.
Finally, the increase in sole-authored tax articles is a significant trend. It suggests an underlying benefit to sole-authored work that exceeds the cost. The trend may imply that promotion and tenure committees weight sole, dual, and triauthored articles differently over time, and faculty change publication strategies in response.
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Tax Publications by Accounting Faculty Rank Another question addressed in the database is the rank of faculty making the largest number of contributions to accounting tax literature. Figure 2 illustrates equivalent articles by rank for the 552 accounting authors.
Fig. 2. Academic Tax Articles Database: Accounting Faculty Rank 1980-2000. Note: There were 1,177 record entries for 552 accounting authors in the database from 1980 through 2000; Each article is weighted by the inverse of the number of authors (Zivney et al., 1995). Additionally, accounting doctoral students contributed 14.08 equivalent articles and accounting graduate students, lecturers, etc. contributed 9.33 equivalent articles. It should be noted that 1989 was the first year that all 13 journals published articles.
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Focusing on participation by rank and year, results indicate that assistant professors led in equivalent academic tax articles in 19 of the 21 years presented. Associate professors ranked second for most of the years presented, while full professors placed third for all years, except one. Of note, the graphic clearly indicates dominance by assistant professors from 1992 through 2000 with associate professors trending upward in this time period. This suggests that the majority of contributions to the tax literature is being made by newer academics. Comparisons by rank for the first ten years (1980 through 1989) to the last ten years (1991 through 2000) provide additional insights about productivity. There was a 110% increase from 95.84 equivalent articles to 201.25 for assistant professors, a 75% increase from 66.16 equivalent articles to 115.51 for associate professors, and a 64% increase from 44.67 equivalent articles to 73.16 for full professors. Interestingly, the percentage increase for assistant professors was almost double that of full professors, suggesting that they are benefiting the most from increased journal outlets and that publication in these journals is increasingly more important to achieve tenure and promotion. In addition to more publication outlets by 1989, another explanation for increased productivity by assistant professors could be the number of accounting doctoral degrees granted, which peaked in the late 1980s. There were 201 degrees in 1987, 205 degrees in 1988, 209 degrees in 1989, and 173 degrees in 1990 based on data obtained from Hasselback’s Accounting Faculty Directory (2000). In order to obtain tenure and promotion, assistant professors would need academic publications in the early years of their academic careers. Therefore, with an increased pool of academics in the early 1990s, the expectation would be an increase in the number of publications by assistant professors in the years immediately after their graduation (the early 1990s). This explanation also may support the increase in publications by associate professors in the late 1990s seeking promotion from associate to full professor.
School at Publication A school’s research expectations directly affect promotion and/or tenure and, therefore, journal publications by academic researchers. This analysis examines the university location of the 552 accounting authors included in the database. There were 226 different universities at publication identified including some foreign schools. Aggregations are made by school at publication and then, ranked and presented in Table 3.9 Based on weighted number of tax articles by accounting faculty in the identified 13 academic journals, the University of Texas at Austin had the largest quantity of
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Table 3. Academic Tax Article Database: School at Publication 1980–2000.a Rank
University
Total
Size-Adjusted
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28
University of Texas at Austin University of North Carolina Arizona State University University of Illinois University of Southern California Georgia State University Michigan State University University of Arizona Penn State University Indiana University University of Chicago University of Alabama University of Oklahoma University of Michigan Texas A&M University Brigham Young University University of Colorado at Boulder University of North Texas Virginia Polytechnic Institute and State University Dartmouth College Miami University University of Tennessee University of Missouri-Columbia George Mason University Texas Tech University University of Iowa University of South Carolina University of Wisconsin-Madison
26.90 19.50 19.25 19.08 18.83 15.50 14.70 14.00 12.00 11.17 11.00 10.50 9.17 8.83 8.50 7.67 7.50 7.50 7.50 7.33 7.33 7.33 7.25 7.17 7.17 7.17 7.17 7.17
0.97 1.60 0.71 0.66 0.79 0.56 0.66 1.04 0.66 0.50 0.85 0.63 0.61 0.48 0.30 0.27 0.65 0.36 0.34 1.40 0.40 0.47 0.52 0.76 0.46 0.57 0.42 0.44
Note: Each article is weighted by the inverse of the number of authors (Zivney et al., 1995). Only schools >7.00 total weighted publications are displayed. For the size-adjusted results, total weighted publications are deflated by average accounting faculty from 1980 through 2000. a From the Tax Article Database, there were 715 articles by 552 accounting faculty from 1980 through 2000. There were 226 different universities at publication identified.
equivalent faculty publications with 26.90 weighted publications. The next three schools, the University of North Carolina (19.50), Arizona State University (19.25), and the University of Illinois (19.08), had similar publication results. Rounding out the top five was the University of Southern California (18.83). Three observations can be made about the results presented in Table 3. First, the top five schools on this listing are large, state institutions with a heavy emphasis on research missions and, as such, faculty might have greater access to
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research-support resources. Relative to private or teaching-mission state schools, one would expect a higher research emphasis at these universities. In addition, this list of schools exhibits a great deal of overlap with the Public Accounting Report’s (PAR) 2003 rankings of top graduate accounting programs. Of the 28 schools listed, 12 rank in the PAR top 20 list. Second, a large majority of these universities offer a doctoral degree in accounting. Further supportive of their research mission, these doctoral granting institutions train future educators/researchers. Third, geographically, these top schools are quite diverse in location. This suggests academic research in taxation is not dominated by one particular school or region of the country but receives contributions from many universities throughout the entire United States. A closer examination of tax publications by the top five universities in this table indicates they produced 103.56 equivalent articles out of a total of 715 or 14%. On an aggregate basis, the faculties of the 28 listed schools presented in the table produced 314.19 weighted articles or 44%. These results suggest a broad base of participation by multiple schools of residence. Further, the faculties at schools on this listing produced less than 50% of all equivalent articles in the 13 identified academic journals. In an effort to obtain improved comparability among universities, the authors deflated the quantity of weighted publications by the average number of accounting faculty from 1980 through 2000 at each school.10 This produced a shift in the productivity rankings. The University of North Carolina moved to the top spot with 1.60 size-adjusted, weighted publications per accounting faculty. This was followed by Dartmouth College (1.40), University of Arizona (1.04), University of Texas (0.97), and University of Chicago (0.85). These results suggest at least two ways to view accounting faculty’s productivity by university. First, a school may make a broad commitment to accounting tax research. This approach may favor a higher overall productivity. Second, a school with a smaller faculty may have particularly productive tax researchers. The total output may be smaller than a larger faculty; however, the individual contribution is relatively large.
University of Degree The training accounting academics receive during their doctoral program may have a significant influence on topics examined and research methods utilized to address research questions. It also may be at this stage that academics begin to form networks with colleagues that will impact their research efforts. This analysis focuses on the university of degree for the 552 accounting authors in
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Table 4. Academic Tax Article Database: University Of Degree 1980–2000.a Rank
University
Total
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
University of Texas at Austin University of Michigan University of Illinois Arizona State University University of Arizona Indiana University University of Florida Michigan State University Georgia State University University of Colorado at Boulder University of Southern California Penn State University Stanford University New York University University of Iowa Virginia Polytechnic Institute and State University University of North Texas University of South Carolina University of Washington University of Minnesota University of Georgia University of Houston University of North Carolina University of Wisconsin University of Memphis
57.50 47.83 32.03 29.92 27.17 22.87 22.83 20.70 18.83 18.67 18.17 16.83 14.67 13.33 13.00 12.83 12.17 12.17 12.00 11.90 10.92 10.83 10.00 8.83 7.17
Note: Each article is weighted by the inverse of the number of authors (Zivney et al., 1995). Only schools >7.00 total weighted publications are displayed. a From the Tax Article Database, there were 715 articles by 552 accounting faculty from 1980 through 2000. There were 98 different universities of degree identified.
the tax article database. There were 98 different universities of degree identified including some foreign schools. Results are aggregated by school of degree, ranked, and presented in Table 4. Graduates of the University of Texas produced the largest number of equivalent articles (57.50). Next in ranking is the University of Michigan (47.83). Rounding out the top five, and close in total weighted articles, were the University of Illinois (32.03), Arizona State University (29.92), and University of Arizona (27.17). Graduates from these five universities published 194.45 equivalent articles out of a total of 715 or 27%. This represents a significant influence of these graduates on tax accounting research discourse. Also of note, the top three schools listed on Table 4 are all in the top five accounting doctoral programs as ranked by the PAR. On a cumulative basis, the graduates of the first 14 listed schools produced over
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50% of the 715 articles. These results suggest some concentration in the training grounds of accounting tax researchers. This point is discussed further below.
Comparisons of School at Publication/University of Degree Listings Comparisons between Tables 3 and 4 provide additional insights about schools of residence and training by accounting authors. There were more than twice as many schools at publication identified than those for university of degree (226 vs. 98) for accounting authors. Also, the institutions at publication are more diverse based on mission (public vs. private; teaching vs. research emphasis) and size of student population, while universities of degree are primarily large, pubic research-focused institutions. These results are expected since there are more universities where accounting faculty are employed than schools that offer doctorates in accounting throughout the world. Another finding is that approximately two-thirds (32 out of 53) of the universities are represented on both rank listings. This may indicate that faculty at these schools not only publish tax articles in the identified 13 journals but also train their graduates to publish in these particular journals.
COMPARISONS WITH PREVIOUS RESEARCH STUDIES Some general observations of the results of the present study will now be compared with previous research that examined tax faculty productivity. First, Hutchison and White (2003) analyzed JATA publications and participation. Similarly, both studies show that assistant professors led in tax publications, followed by associate and then, full professors. There were also significant increases in both studies by assistant faculty in 1994 with slight decreases to the present.11 Interestingly, an examination of their results in regard to authorship suggests that in the last eight years of their study (1993–2000) the primary form of authorship of main articles in JATA was dual, while the present study of all academic tax articles for the same time period indicates sole-authored works to be more pronounced. This may indicate that while sole authorship is still highly valued by promotion and tenure committees, publication in a quality tax journal using a co-authored approach is now valued as well. School at publication and university of degree listings provide additional insights with the Hutchison and White (2003) study. A review of the top ten universities from the school at publication listings indicates only six schools: University of Texas, Arizona State University, University of Illinois, University of Southern
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California, Michigan State University, and Penn State University that appear on both listings. Comparisons between university of degree listings show that nine of the top ten schools are on both: University of Texas, University of Michigan, University of Illinois, Arizona State University, University of Arizona, Indiana University, University of Florida, Michigan State University, and Georgia State University. The underlying implication may be that there is a mixture of emphasis placed on the journals at different schools and by different individual academics. Limited comparisons to the Kozub et al. (1990) tax study can be made about school of residence and university of degree.12 Comparing the top 10 schools in the current study to the Kozub et al. (1990) results shows only five schools on both listings: University of Texas, University of Illinois, University of Southern California, Michigan State University, and Penn State University. Both studies were only similar in ranking the University of Texas as first on their top 10 lists. Likewise, a comparison of top 10 schools on university of degree listings shows both studies contain six institutions: University of Texas, University of Michigan, University of Illinois, Indiana University, Michigan State University, and University of Colorado. Both studies identified the same top three university of degree schools: University of Texas, University of Michigan, and University of Illinois for their top 10 lists. Possible implications from these two comparisons are that 40–50% of the top 10 schools were replaced during the 1990s for school at publication and university of degree. Additionally, the top school in both studies for the two listings, University of Texas, remained unchanged. There was also more movement at the top of the list for school at publication than the university of degree by comparison. Finally, there are other studies (Campbell & Morgan, 1987; Englebrecht et al., 1994) that examined tax research productivity analysis, yet comparisons could not be directly made with the current study due to research method differences. Specifically, the Englebrecht et al. (1994) and Campbell and Morgan (1987) studies identified tax faculty productivity, yet they aggregated both professional and academic articles (both utilized 79 periodicals) and made no adjustment for authorship weights.
LIMITATIONS Certain limitations should be noted in the present study. An accounting author had to publish a tax article from 1980 through 2000 in one of the 13 identified academic journals to be included in the tax article database. There was also no attempt to weigh quality or rigor of journal or article when using the counting method for authorship. Another limitation was that weightings were not identified
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by accredited or non-accredited universities and accounting programs. Further, the authors selected the 13 journals reviewed for the present study although there are numerous accounting journals that publish academic tax research. While every attempt was made by the authors to identify academic tax articles in the 13 journals and make proper categorizations, errors in input or published information in the Accounting Faculty Directory (1980–2000) compiled by J. R. Hasselback may have occurred. Finally, tenure and promotion requirements vary by school and their related mission and, therefore, the results in this study should not be construed to represent any school’s actual research requirements for promotion and tenure.
CONCLUSIONS The purpose of this study was to examine academic tax research publications in 13 academic journals from 1980 through 2000 and provide insights by utilizing productivity, participation, and trend analyses. Results indicate that on average 46 tax articles have been published annually in the identified 13 journals during the most recent five-year period, sole or dual authorship is the primary publication strategy by authors of academic tax articles, and assistant professors authored the most tax articles on an annual basis from 1980 through 2000. Accounting faculty and doctoral graduates at the University of Texas also contributed the most equivalent-weighted tax articles in these journals. Further, authorship by school at publication is more diverse than university of degree for these identified journals. This study also provides accounting faculty with insights about common research publication strategies and a sense for the size of the pool of primary tax accounting research. Finally, this research provides evidence that there are more publication opportunities for academic tax articles by accounting faculty than were afforded 20 years ago.
NOTES 1. JATA began publication in 1979. As discussed further below, NTJ was published prior to this time; however its participation is not primarily from accounting academics. 2. The authors made a diligent effort to obtain all Hasselback Accounting Faculty Directories from 1980 to 2000. Unfortunately, they were not able to obtain the 1986 directory and elected to extrapolate data based on the 1985 and 1987 directories for their analyses to cover this shortfall. 3. This review included all categories in each of the journals except for the following: HOR – Comments and Reviews; CAR – Book Reviews; IAE – Book Reviews; JAAF – Views; AR – Book Reviews and Committee Reports; and JATA – Book Reviews,
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Committee Reports, Tax Software Reviews, and Doctoral Research. No publications in any of these categories were included in the tax article database. 4. There were no volumes of Advances in Taxation published in 1988 nor 1991. 5. Due to the relative number of tax articles published and, primary, accounting faculty focus of this study, database inclusion of tax articles in the National Tax Journal was restricted to accounting faculty identified in the Hasselback Accounting Faculty Directories (1980–2000). 6. To allow the authors to conduct various analyses, record entries are recorded in the database separately by each contributing author. The tax article database contains 17 distinct fields for each record: journal name; title of article; author’s first and last names; the journal edition’s volume, number, season, year, and page number(s); category within the journal, if identified (i.e., Main Article, Notes, Education Research, Shorter Articles, Forum, etc.); designation of sole or multiple authorship; author’s university at publication; author’s university department and rank at publication, when available; and university where the author received their highest degree, the degree, and year of award. The 715 identified articles comprise a total of 1,303 separate record entries in the database due to co-authorship. 7. For example, each author of an article with two co-authors is credited with 0.5 equivalent article, and each author of an article with three co-authors is credited with 0.33 equivalent article. 8. The authors elected to use accounting faculty rather than limit their study to accounting tax faculty. The rationale for this decision is twofold: Difficulty in identifying tax faculty and many accounting faculty publish tax articles. Specifically, Hasselback’s Accounting Faculty Directories (1980–2000) only identify teaching/research interests in tax (X, TAX, TX) by accounting faculty and not just tax faculty. Further compounding the issue is the fact that accounting academics without a tax interest also published academic tax articles during the time period of this study. 9. The authors arbitrarily chose to identify only those schools with >7.00 weighted articles to allow for comparisons between Tables 3 and 4. 10. The determination of an acceptable procedure to calculate size-adjusted results was difficult. As previously noted, the authors could not come up with a reliable means to identify only accounting tax faculty. Also, since all accounting faculty who published tax publications were used in this study, they elected to utilize average accounting faculty as the deflator. Note that only tenure-track faculty were included in the calculation of faculty averages, and instructors, lecturers, and visiting faculty were excluded. 11. As previously noted, these increases may be the result of significant numbers of accounting doctoral graduates in the late 1980s and early 1990s entering the market and seeking promotion and tenure. 12. Kozub et al. (1990) included only eight academic journals in their study that covered the period 1981 through 1988.
REFERENCES Accounting program rankings (2003). Public Accounting Report, 27(22). Brown, L. D., & Huefner, R. J. (1994). The familiarity with and perceived quality of accounting journals: Views of senior accounting faculty in leading U.S. MBA programs. Contemporary Accounting Research, 11(1-I), 223–250.
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Bublitz, B., & Kee, R. (1984). Measures of research productivity. Issues in Accounting Education (2), 39–60. Campbell, D. R., & Morgan, R. G. (1987). Publication activity of promoted accounting faculty. Issues in Accounting Education, 2(1), 28–43. Daigle, R. J., & Arnold, V. (2000). An analysis of the research productivity of AIS faculty. International Journal of Accounting Information Systems, 1(2), 106–122. Englebrecht, T. D., Iyer, G. S., & Patterson, D. M. (1994). An empirical investigation of the publication productivity of promoted accounting faculty. Accounting Horizons, 8(1), 45–68. Hasselback, J. R. (1980, 1981, 1982, 1983, 1984, 1985, 1987, 1988, 1989, 1990, 1991, 1992, 1993, 1994, 1995, 1996, 1997, 1998, and 2000). Accounting Faculty Directory 1979–1980, 1980–1981, 1982, 1983, 1984, 1985, 1987, 1988, 1989, 1990, 1991, 1992, 1993, 1994, 1995, 1996, 1997, 1998–1999, and 2000–2001. Englewood Cliffs, NJ: Prentice-Hall. Hasselback, J. R., Reinstein, A., & Schwan, E. S. (2001). Prolific authors of accounting literature. Working Paper, presented at 2001 Annual Meeting of the American Accounting Association, Atlanta, GA. Hutchison, P. D., & White, C. G. (2003). The Journal of the American Taxation Association 1979–2000: Content, participation, and citation analyses. The Journal of the American Taxation Association, 25(1), 100–121. Kozub, R. M., Sanders, D. L., & Raabe, W. A. (1990). Measuring tax faculty research publication records. The Journal of the American Taxation Association, 12(1), 94–101. Zivney, T. L., Bertin, W. J., & Gavin, T. A. (1995). A comprehensive examination of accounting faculty publishing. Issues in Accounting Education, 10(1), 1–25.
EXPORT INCENTIVES AFTER REPEAL OF THE EXTRATERRITORIAL INCOME EXCLUSION Ernest R. Larkins ABSTRACT With repeal of the extraterritorial income exclusion expected in 2004, many U.S. companies selling abroad must rethink tax strategies related to export profit. Many firms with net operating loss (NOL) carryforwards, foreign tax credit (FTC) carryforwards, and interest-charge domestic international sales corporations (ICDs) can reduce marginal tax rates (MTRs) below rates otherwise applying to domestic sales. This article provides several case examples illustrating how U.S. exporters can minimize the MTR applicable to export profit. MTRs often depend on the period over which the company expects to absorb its NOL or FTC carryforward, the firm’s discount rate, and, in the case of ICDs, the prevailing T-bill rate. Assuming a 34% corporate tax rate, exporters with NOL (FTC) carryforwards can reduce the MTR on export profit to zero (17%) in some cases. Also, over the range of variables this article examines, the ICD reduces the MTR on export profit to between 34 and 21%. The cases illustrate how NOL and FTC carryforwards and ICDs affect exporters’ MTRs and provide educators with useful tools for discussing the tax aspects of exporting.
Advances in Taxation Advances in Taxation, Volume 16, 201–219 Copyright © 2004 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1058-7497/doi:10.1016/S1058-7497(04)16009-2
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INTRODUCTION For more than three decades, the Internal Revenue Code has contained provisions intended to stimulate U.S. exports. In 1971, Congress created the domestic international sales corporation (DISC), a tax deferral entity that caused U.S. exports to spike upward billions of dollars each year (U.S. Department of the Treasury, 1988). Asserting violations of the General Agreement on Tariffs and Trade, several nations pressured the United States to repeal the DISC. In 1984, Congress replaced the DISC with two new export regimes – the interest-charge domestic international sales corporation (ICD) and foreign sales corporation (FSC). Like the former DISC, the ICD provided a tax deferral benefit but with a few twists. The accumulated deferred tax became subject to an annual interest charge, and the deferral applied only to annual export sales of $10 million. The interest charge and ceiling on benefits shielded the ICD from other nations’ criticism; so, many U.S. exporters still use the ICD to reduce their marginal tax rate (MTR) from selling abroad.1 Primarily benefiting C corporation exporters, the FSC granted an annual exemption equivalent to a 15% tax break. For example, if the marginal U.S. tax rate applicable to domestic earnings was 34%, the MTR for export profit, after considering the FSC exemption, equaled 28.9% [(1–15%) × 34%]. Trumpeting the FSC’s success, the U.S. Department of the Treasury (1997) reported 1992 exports attributable to FSCs totaling $150 billion.2 Such publicly extolled success re-ignited international trade complaints similar to those that plagued the former DISC – especially from the European Union (EU). Reaching a crescendo in the late 1990s, the complaints led to a formal protest before the World Trade Organization (WTO). In 1999, the WTO declared the FSC to be an illegal export subsidy, and an Appellate Body later upheld the decision (WTO, 1999, 2000). In response, Congress repealed the FSC regime in 2000, replacing it with the extraterritorial income exclusion (EIE).3 Interestingly, the EIE’s tax benefits closely mimicked those the FSC provided and also extended the benefits to more taxpayers (e.g. S corporations, partnerships, and individuals). Soon after its enactment, the EU cried foul once more, asserting that the EIE provided a subsidy contingent on export sales the same as the FSC. As a result, the WTO declared the EIE to be an illegal export subsidy, like its predecessor, and a WTO Appellate Body agreed (WTO, 2001, 2002). To avoid trade sanctions, many international tax advisers and policy analysts expect Congress to repeal the EIE in 2004. Given the recent failed attempts of the United States to defend the legitimacy of the FSC and EIE, Congress is unlikely to replace the EIE with another export-based tax incentive.
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Repealing the EIE raises several important questions for U.S. exporters. What tax incentives remain for exporting? What MTR applies to export profit? What strategies should exporters adopt to minimize the MTR from exporting? This article addresses these questions. After a brief review of MTR calculations in the next section, the third section explains and illustrates how exporters calculate MTRs when they have net operating loss carryforwards and graphically portrays MTRs to emphasize salient factors. The fourth and fifth sections provide similar guidance for exporters with excess foreign tax credits and ICDs, respectively. Conclusions appear in the final section.
MEASUREMENT OF MARGINAL TAX RATES Viewing export profit as incremental income, U.S. corporations calculate the MTR for a given year as the present value of incremental taxes from exporting divided by export profit. When selling abroad, the numerator includes only U.S. income taxes; no foreign income tax results since exporting usually occurs without assistance from permanent establishments in foreign jurisdictions. Equation (1) summarizes the MTR calculation from a decision to export in a given year:4 n y Present Value of Incremental Tax y=0 TAXy /(1 + d) = MTR0 = (1) Export Profit in a Given Year PROFIT0 where: TAX = Incremental U.S. income tax from exporting; PROFIT = Incremental (export) profit in a given year (y = 0); d = Discount rate; and y = Year. U.S. corporations not taking advantage of the tax law’s incentives when exporting, especially those with consistent profits, may have explicit MTRs on export profit around 34% (assuming no state or local income tax).5 However, MTRs on export profit can decline significantly for U.S. corporations with: (1) prior year net operating losses; (2) excess foreign tax credits; or (3) export sales qualifying for tax deferral through an ICD. These situations occur frequently, and the following three cases explain how such conditions create export incentives and illustrate the calculation of MTRs in each scenario. U.S. exporters can use the analyses to reasonably estimate MTRs on export profit and maximize after-tax return from exporting. Professors teaching international taxation can use the cases to explain underlying processes in export decisions. Finally, the cases provide opportunities to discuss other aspects of decision-making (e.g. the sensitivity of MTRs to discount rates and expected carryforward years). The cases extend the work of Shevlin (1990), Graham (1996a, b), and Scholes et al. (2002) (which focused primarily on incremental income from domestic transactions)
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by illustrating MTR calculations for a specific type of cross-border transaction (i.e. export sales).
CASE 1: NET OPERATING LOSS CARRYFORWARDS IRC Sec. 172(b)(1) allows taxpayers to carry a net operating loss (NOL) back two and forward 20 years. U.S. companies deduct the loss against profit in carryover years. NOLs can shield profit from either domestic or foreign sources. Thus, export profit avoids current U.S. income tax when exporters have offsetting NOL carryovers. To estimate the MTR from exporting, exporters must determine whether the export profit absorbs NOL carryovers that otherwise would expire unused or, alternatively, that domestic profit would absorb in future years.6 In the former case, the MTR from exporting is zero since no incremental income tax results either now or later. However, if export profit absorbs NOLs that otherwise would offset future domestic profit, a tradeoff occurs. NOLs shield export profit now rather than shielding domestic profit later, and the tax increase from exporting effectively occurs in future years. In this case, the numerator of the MTR formula equals the present value increase in U.S. income tax paid in later years. The further in the future the income tax, the smaller its present value, and the lower the MTR. Table 1 illustrates how a U.S. company with an NOL carryforward calculates its MTR from exporting. Panel A shows the projected results before considering export sales. The company has a $56 NOL carryforward from 2003 and expects annual domestic profit of $6 that should absorb the last of the carryforward during 2013 without exporting. Thus, the company does not expect to pay income tax until 2013. The $56 NOL offsets the expected profit from 2004 through part of 2013 (years 0 through 9) so that domestic profit is nontaxable (i.e. expected taxable income is zero each year through 2012 and only $4 in 2013). The company wants to sell goods abroad (the marginal decision). Panel B displays the financial results assuming that such additional sales occur and export profit is $3 in 2004 (see rightmost boxed region). Export profit accelerates absorption of the NOL carryforward. In 2004, the carryforward shields both $6 of domestic profit and $3 of export profit from taxation. As a result, the company expects to fully absorb the NOL in 2012, rather than 2013, and pay tax on an additional $2 of profit in 2013 and an additional $1 of profit in 2012 (compare the two boxed regions under “Domestic Profit” in Panels A and B). Panel C shows how the company estimates its MTR on the $3 of export profit. The formula’s numerator contains the present value of the increased income
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Table 1. Marginal Tax Rate Example Involving Net Operating Loss Carryforwards.
tax attributable to exporting. Without exporting, the company pays no income tax in 2012 and income tax on $4 in 2013 (see boxed region in Panel A). With exporting, the company pays additional income tax on $1 of profit in 2012 and $2 of profit in 2013 that the NOL carryforward no longer shields. The formula’s denominator includes the $3 of export profit (or incremental income). Assuming a statutory U.S. income tax rate of 34% and discount rate of 5%, the company’s
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Fig. 1. Marginal Tax Rates for U.S. Exporter with Net Operating Loss Carryforward.
MTR on export profit equals 22.3%. When the export profit is larger (smaller) so that it absorbs the NOL carryover sooner (later), domestic profit becomes taxable sooner (later), increasing (decreasing) the MTR. Based on the procedure explained above and assuming a 34% income tax rate, Fig. 1 portrays MTRs (y-axis) for various combinations of discount rates (legend) and the period it takes domestic profit alone to absorb an NOL carryforward (x-axis). The Fig. reveals the combined effect the projected annual domestic profit and existing NOL carryforward have on MTRs. The diagram captures this combined effect as the “Years for Domestic Profit to Absorb Loss Carryforward” along the x-axis (i.e. NOL carryforward divided by expected annual domestic profit). For each discount rate, the MTR declines as the absorption years increase. That is, the larger the NOL carryforward relative to the annual domestic profit, the further into the future any incremental tax resulting from export profit, the smaller the present value of such incremental tax, and the lower the MTR. For example, when a U.S. company expects domestic profit to absorb its NOL carryforward within two years, the MTR ranges between 32.4 and 29.6% for the discount rates shown. However, the MTR is much lower when the expected absorption period is 20 years, ranging between 13.8 and 2.6%. Consistent with the statutory carryforward period mentioned earlier, the MTR declines to zero when the value along the x-axis exceeds 20 years. Figure 1 also shows that discount rates are inversely related to MTRs and that this relationship tends to be greater for longer absorption periods (at least in the earlier years). The discount rate is a relatively small factor when domestic profit is expected to absorb NOLs quickly. For an absorption period of two years, the MTR
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equals 32.4% when the discount rate is 5 and 29.6% when the discount rate is 15% (i.e. only a 2.8 percentage point difference). However, as the period required for domestic profit to absorb the NOL carryforward lengthens, the discount rate tends to have a larger effect on the MTR. For example, assuming a 12-year absorption period, the MTR is 20% when the discount rate is 5% and 7.5% when the discount rate is 15% (i.e. a 12.5 percentage point difference). When export profit absorbs NOL carryforwards that otherwise would expire unused (i.e. after 20 years on the x-axis), the MTR plummets to zero.
CASE 2: EXCESS FOREIGN TAX CREDITS IRC Sec. 901(a) allows U.S. persons to claim a foreign tax credit (FTC) for foreign income taxes they pay.7 However, IRC Sec. 904(a) limits the FTC each year as follows: Foreign source taxable income Limit = × U.S. tax before FTC Worldwide taxable income ≈ Foreign source taxable income × U.S. statutory tax rate (2) When conducting business through permanent establishments in high-tax foreign countries, the limit often restricts how much foreign income tax U.S. companies can claim as an FTC. IRC Sec. 904(c) allows these “excess credits” to be carried back to the two preceding taxable years and, if still unabsorbed, forward to the following five years. When excess credits expire unused, they represent instances of double taxation. Much tax planning occurs to absorb excess credits before they expire since the five-year carryforward period is relatively short. As Eq. (2) suggests, one common tax strategy involves earning foreign source income on which U.S. companies pay little or no foreign income tax. The greater the “excess limit” generated from low-taxed foreign income, the greater the company’s capacity to absorb excess credits carried forward from high-taxed foreign income. Using excess limits to absorb excess credits is a tax strategy known as “cross-crediting.” When U.S. manufacturers export their goods, Reg. Sec. 1.863–3(b)(1) treats half of the profit as U.S. source income and half as foreign source income (i.e. the 50–50 rule). Both the U.S. and foreign portions are currently taxable in the United States. However, the foreign source profit increases the FTC limitation appearing in Eq. (2) without, as mentioned earlier, increasing foreign income tax. If the exporter has excess credits from prior years, the foreign source profit increases the limitation formula, which increases the FTC so that it offsets any U.S income tax otherwise due on the foreign source profit. Thus, the excess expiring
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credits from prior years effectively shield foreign source profit from current U.S. taxation.8 For U.S. manufacturers in the 34% tax bracket, the MTR on export profit can be as low as 17% since: (1) the U.S source half of the profit is taxable while (2) excess credits that otherwise would expire unused shield the foreign source half of the profit from U.S tax.9 The MTR will not be this low if the excess limit from exporting merely accelerates absorption of excess credits being carried forward (i.e. the excess credits would not have expired unused). In this latter case, the current year’s export profit increases future income taxes, and the MTR falls somewhere between 17 and 34%. Table 2 contains an example illustrating this point and shows how to calculate the MTR from exporting. Panel A provides the projected FTC results before the Table 2. Marginal Tax Rate Example Involving Excess Foreign Tax Credit of U.S. Manufacturer.
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taxpayer decides to export. A $180 excess credit resulted in 2003 because the taxpayer earned high-taxed foreign income in that year. To absorb the excess credit, the taxpayer expects a $40 excess limit in each of the following five years, enough to fully absorb the excess credit without exporting. The anticipated excess limit may be the result of tax planning (e.g. shifting business profit to low-tax foreign jurisdictions) or tax law changes (e.g. a decrease in a foreign jurisdiction’s statutory income tax rate). Panel B shows the results assuming the company decides to start selling abroad and earns export profit of $200 in 2004. Under the 50–50 rule, $100 is U.S. source profit and currently taxable. The $100 foreign source profit is subject to tax also but increases the company’s excess limit by $34, which absorbs part of the 2003 excess credit. In effect, the increased FTC offsets the U.S. tax on foreign source profit, resulting in a net wash. Thus, the only tax effect in 2004 from exporting is the U.S. income tax imposed on the $100 U.S. source profit (i.e. FTC of $34 offsets half the $68 U.S. tax on $200 taxable income). However, the 2004 exports cause excess credits to be absorbed in 2004 that the U.S company expected to shield foreign source income in 2008 and, to a lesser degree, 2007. As the boxed regions of Panels A and B show, the 2008 (2007) shield of $20 ($40) that would have resulted without exporting declines to zero ($26). The MTR calculation from exporting appears in Panel C. The numerator’s incremental tax includes the current tax on U.S. source export profit plus the present value of the $20 and $14 additional tax in 2008 and 2007, respectively. The denominator reflects the 2004 export profit. The 31.3% MTR is 2.7 percentage points below the otherwise assumed 34% statutory tax rate. The example in Table 2 involves a situation in which the U.S. company anticipated excess limits in future years that would absorb all excess credits carried forward from 2003. Thus, the export profit (incremental income) simply accelerates use of the tax shield from the 2003 excess credit (i.e. the excess credit shields $34 profit in 2004 rather than $20 profit in 2008 and $14 profit in 2007). If the U.S. company had no other foreign operations that might generate excess limits (i.e. zero excess limit each year from 2004 through 2008 instead of $40) so that it must depend entirely on export profit to absorb the 2003 excess credit, the MTR would decline significantly. Specifically, the tax shield from exporting would not increase 2007 and 2008 taxes so that the numerator’s second and third components (Panel C) disappear. The resulting MTR equals 17% or half the 34% corporate tax rate. Thus, the MTR from exporting when the U.S. taxpayer has excess credits depends on the extent to which the excess credits will expire unused without export sales. Figure 2 depicts the impact on MTRs (y-axis) of discount rates (legend) and the expected years for a company’s excess limits (other than those from
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Fig. 2. Marginal Tax Rates for U.S. Exporter Carrying Forward Excess Foreign Tax Credit.
exporting) to absorb its FTC carryforward (x-axis). Similar to Fig. 1, the “Years for FTC Carryforward to Be Absorbed Without Exporting” on the x-axis captures the combined effect of a firm’s FTC carryforward and its anticipated future excess limits (i.e. FTC carryforward from preceding year divided by expected annual excess limits). The greater the number of years required to absorb an FTC carryforward, the lower the MTR attributable to exporting. When an FTC carryforward can be absorbed in one year without exporting, export sales result in a MTR of 34%, regardless of the discount rate. That is, any portion of excess credit shielding export profit from tax simultaneously exposes an equal amount of non-exporting foreign profit to U.S. taxation. However, when the FTC carryforward is so large relative to the annual anticipated excess limits that the company expects a five-year absorption period, the MTR attributable to export profit equals 31 and 26.7% for discount rates of 5 and 15%, respectively. That is, the MTR drops 3 and 7.3 percentage points, for the respective discount rates, as the absorption period lengthens from one to five years. In effect, the longer absorption period means that the export profit causes non-exporting foreign profit to lose its tax shield in a later period where discounting reduces the present value of the incremental tax and, thus, the MTR. As the figure indicates, when export profit uses a portion of the excess credit shield that otherwise would expire unused (i.e. year 6 on the x-axis), the MTR drops to one-half the statutory tax rate or 17%. Figure 2 also highlights the effect of discount rates on the MTR of firms with FTC carryforwards. Differences in discount rates cause MTRs to differ only a relatively small amount when the excess credit absorption period is short. For a two-year absorption period, the MTR equals 33.2% when the discount rate
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is 5 and 31.8% when the discount rate is 15% (a 1.4 percentage point spread). However, a five-year absorption period causes the respective MTRs to be 31 and 26.7% (a spread of 4.3 percentage points).10
CASE 3: INTEREST-CHARGE DOMESTIC INTERNATIONAL SALES CORPORATION Another option for U.S. exporters is the ICD, an elective, tax deferral arrangement that primarily benefits small to mid-size companies. IRC Sec. 992(a)(1), (d) stipulates that ICDs are domestic corporations meeting the following conditions for the taxable year: Qualified export receipts that are at least 95% of total gross receipts; Qualified export assets that are at least 95% of all assets (measured by adjusted basis at year end); Only one class of outstanding stock with daily par or stated value of $2,500 or more; C corporation other than exempt organization, personal holding company, banking institution, life insurance company, or regulated investment company; and Election to be an ICD in effect. Typically, ICDs have no employees, own no tangible assets, operate only as commission agents, and perform no substantial economic functions. In short, they are “paper entities,” so U.S. exporters find ICDs inexpensive to establish and maintain. IRC Sec. 991 indicates that ICDs are not subject to U.S. income tax. Thus, an ICD’s commission income escapes U.S. tax as long as the ICD does not distribute such earnings to shareholders. Most ICDs allow U.S. exporters to defer approximately 47% of income tax otherwise due.11 However, IRC Sec. 995(b)(1)(E) allows the deferral only for annual export sales up to $10 million; the Code taxes profit attributable to additional exports the same as domestic profit.12 U.S. exporters pay an interest charge on their deferred tax liability at a rate equal to the average annual yield of one-year T-bills, a highly favorable rate when compared to most commercial loans.13 C corporations can deduct the interest charge.14 Figure 3 highlights the various flows and tax results when a U.S. corporation exports through its commission ICD. Table 3 illustrates how U.S. taxpayers determine MTRs on export profit when using ICDs. The example assumes 2004 export profit of $10,000, a 34% statutory rate, a 2% T-bill rate, and liquidation of the ICD at the end of 2014. Panel A shows the allocation of export profit between taxable and nontaxable amounts. The $5,294 taxable portion equals 50% of the $10,000 profit plus, as a deemed
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Fig. 3. Commission ICD Structure.
distribution, 1/17 of the remaining profit. At a 34% tax rate, U.S. income tax payable in 2004 equals $1,800 ($5,294 × 34%). The $4,706 nontaxable portion is the ICD’s $5,000 commission income less 1/17 of the commission that is deemed distributed. When the ICD liquidates in 2014, the $1,600 deferred tax becomes payable ($4,706 × 34%). In the intervening years, a $32 annual interest charge applies to the deferred tax ($1,600 × 2%). Panel B shows the MTR calculation. The numerator contains three factors. The first represents the U.S. income tax payable in 2004, the second equals the present value of the deferred tax payable in 2014, and the third captures the present value of the after-tax interest charge from 2005 through 2014. The 2004 export profit of $10,000 appears in the denominator. At 29.5%, the MTR is significantly lower than the 34% otherwise assumed without an ICD. As Fig. 4 indicates, the MTR from ICD-related exports depends on the deferral period and “spread” between the T-bill rate and the applicable discount rate. As the deferral period increases, the MTR declines. For example, the MTR when the spread is 2% equals 32.1% for a five-year deferral and 28.2% for a 20-year deferral. For other spreads, the inverse relationship between deferral period and MTRs holds also. The greater the spread between the T-bill and discount rates, the lower the MTR. For example, assuming a 20-year deferral period, the MTR equals 28.2
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Table 3. Marginal Tax Rate Example Involving Interest-Charge Domestic International Sales Corporation.a Panel A: Projected Results with ICD Election Year
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Export Profit Taxable
Deferred
$5,294
$4,706
U.S. Tax
Interest
$1,800
1,600
$32 32 32 32 32 32 32 32 32 32
Panel B: Marginal Tax Rate on Export Profit Assuming No Carryforward
MTR =
($5,294 × 34%) + ($4,706 × 34%)/(1 + 0.05)10 y + 10 y=1 ($4,706 × 34% × 2% × (1 − 34%))/(1 + 0.05) $5,294 + $4,706
= 29.5%
Panel C: Marginal Tax Rate on Export Profit Assuming NOL Carryforwardb
MTR =
($5,294 × 34%)/(1 + 0.05)3 + ($4,706 × 34%)/(1 + 0.05)10 y + 10 y=1 ($4,706 × 34% × 2% × (1 − 34%))/(1 + 0.05) $5,294 + $4,706
= 27.0%
Panel D: Marginal Tax Rate on Export Profit Assuming FTC Carryforwardc $2,500 × 34% $4,706 × 34% MTR = ($2,794 × 34%) + + (1 + 0.05)3 (1 + 0.05)10 $4,706 × 34% × 2% × (1 − 34%) + 10 ÷ ($5,294 + $4,706) = 28.3% y=1 y (1 + 0.05) a Assumes
ICD liquidation at end of ten-year time horizon, 34% effective tax rate, 2% T-bill rate, and 5% discount rate. b Assumes ICD’s U.S. parent uses its allocable export profit of $5,294 to absorb an NOL carryforward that otherwise would not have been absorbed until 2007. c Assumes ICD’s U.S. parent uses its allocable export profit from foreign sources of $2,500 to absorb an FTC carryforward that otherwise would not have been absorbed until 2007.
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Fig. 4. Marginal Tax Rates for U.S. Exporter Using Interest-Charge Domestic International Sales Corporation.
and 21.2% when the spread is 2 and 10%, respectively (a seven percentage point difference). The difference is somewhat less for shorter deferral periods. For example, assuming a 10-year deferral period, the MTR equals 30.5 and 24.3% when the spread is 2 and 10%, respectively (a 6.2 percentage point difference). Overall, Fig. 4 suggests that the MTR from ICD-related exports bottoms out around 21%, at least for the range of variables this article examines. The preceding MTR analyses assume sales abroad through commission ICDs when U.S. parent companies do not have NOL carryovers. Exporters with NOL carryforwards can either: (1) apply all export profit against these carryover losses per the illustration in Table 1 or (2) use a commission ICD for export sales. In the latter case, 50% of export profit flows to the ICD as a commission and 3% flows back to the U.S. exporter as a deemed distribution (see Fig. 3).15 Thus, the company defers U.S. tax on 47% of export profit, leaving 53% of export profit to absorb some of the NOL carryforward. In other words, using an ICD does not preclude the exporter from offsetting some of its NOL carryover against the 53% portion of export profit not allocable to the ICD, which further reduces the MTR. Generally, the more years needed for domestic profit to absorb an NOL carryforward (i.e. the further out on the x-axis in Fig. 1), the less likely that using an ICD minimizes the MTR on export profit. Thus, using a commission ICD for export sales in the presence of carryforward NOLs usually makes sense only when the expected NOL absorption period is relatively short. Panel C in Table 3 illustrates how to calculate the MTR on export profit when a U.S. company with an NOL carryforward uses a commission ICD. Except for the initial factor in the numerator, the calculation is identical to the one appearing in Panel B. In Panel C, the profit allocable to the U.S. exporter (i.e. 53% of total
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export profit) is not currently taxable but absorbs part of the NOL carryforward that otherwise would have offset domestic profit in 2007. Thus, using 53% of the export profit to absorb some of the NOL carryover results in income tax in 2007 that otherwise would have been due in 2004, dropping the MTR from 29.5% (Panel B) to 27.0% (Panel C). Finally, U.S. exporters might decide to run export sales through an ICD even when they have excess credits. Often, if excess credits are expected to expire unused, exporters will forgo the ICD benefits in favor of using as much export profit as possible to absorb the expiring credits, resulting in a 17% MTR. However, exporters may choose to use an ICD when they expect to absorb excess credits from other low-taxed foreign income (i.e. non-export profit). When a U.S. parent company uses a commission ICD for exporting, some of the profit allocable to the parent is available to absorb the excess FTC, further reducing the MTR on export profit.16 Of the 53% export profit allocable to the U.S. parent, three percentage points provides no FTC relief since IRC Sec. 904(d)(1)(F) allocates these earnings to a separate FTC limitation basket unavailable for cross-crediting. However, the previously mentioned 50–50 sourcing rule splits the remaining 50 percentage points between U.S. and foreign source income. Thus, 25% of export profit (i.e. 50% allocable under the ICD rules times 50% allocable under the income sourcing rules) can absorb some of the FTC carryover. Panel D in Table 3 demonstrates calculation of the MTR on export profit when a U.S. company with an FTC carryforward uses a commission ICD. The calculation is the same as the one appearing in Panel B except for the numerator’s treatment of the $5,294 allocable to the U.S. parent, which Panel D splits into two factors. The first factor consists of current U.S. tax on $2,794. The second factor equals foreign source export profit of $2,500, which the FTC carryforward shields in 2004, resulting in additional taxable income of $2,500 in a later year (assumed to be 2007 in Panel D). That is, using 25% of the export profit to absorb some of the excess FTC from prior years results in 2007 income tax that otherwise would have been due in 2004. As a result, the MTR drops from 29.5 (Panel B) to 28.3% (Panel D).
CONCLUSION This article guides U.S. exporters in calculating and minimizing the MTR applicable to export profit and provides teachers of international taxation with a set of illustrative cases. With the expected repeal of the EIE, many U.S. companies selling abroad must rethink their tax strategies related to export profit. Firms with
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NOL carryforwards, excess FTC carryforwards, and ICDs can reduce MTRs on export profit below the rates otherwise applicable to domestic sales. Since the ICD involves no significant set-up and maintenance costs and export sales rarely attract foreign income tax, the selection of tax benefits applicable to export sales involves a comparison of MTRs under these three regimes. Firms with NOL carryforwards expected to expire unused can reduce the MTR on export profit to zero. However, when domestic profit is expected to absorb a NOL carryforward before it expires, the MTR on export profit depends on the number of years required for domestic profit alone to absorb the NOL carryforward and the applicable discount rate. The longer the absorption period and the higher the discount rate, the lower the MTR. Companies with FTC carryforwards experience MTRs as low as half the tax rate otherwise applicable to domestic sales. When excess limits from export sales absorb FTC carryforwards that non-export-related profit otherwise would absorb, the MTR depends on the number of years needed to absorb the carryforward without exporting and the discount rate. As with NOL carryforwards, the longer the absorption period and the higher the discount rate, the lower the MTR on export profit. However, the MTR often will be higher than the MTR a firm with NOL carryforwards experiences. Over the range of variables this article examines, the MTR generally lies between 26 and 34% when the carryforward would have been absorbed later through other international activities. U.S. exporters without NOL and FTC carryforwards can reduce MTRs using ICDs. When the spread between a firm’s discount rate and the T-bill rate is large, the MTR can be as low as 21%, given the range of variables examined here. Similarly, U.S. companies with either NOL or FTC carryforwards can choose the ICD benefit for $10 million of its export sales, assuming such choice minimizes its MTR, and use the remaining export profit to absorb some of its carryforwards for a further MTR reduction. Teachers of international taxation can use this article’s illustrative materials to explain tax implications of cross-border sales. The cases can encourage and assist students to delve into various aspects of exporting and enhance understanding of MTRs and their importance in decision-making.
NOTES 1. This article focuses on: (1) the “cash” MTR rather than the “book” MTR under FAS 109; and (2) the explicit MTR under the U.S. federal tax law. 2. Also, Billings et al. (2003) found a positive relationship between the FSC incentive and export sales volume for several product categories.
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3. FSC Repeal and Extraterritorial Income Exclusion Act of 2000, P.L. 106-519, (November 15, 2000). 4. Adopting a more flexible definition that allows incremental profit to vary from $1 focuses on the MTR applicable to a given investment, compensation, or financing decision rather than the MTR for the next $1 of taxable income (i.e. basically no decision). Consistent with this view in a financing context, Graham (1996a, p. 54) indicates that “the true tax rate to gauge the tax advantage of interest deductibility should probably: (i) be an average of future expected MTRs (matching the life of the debt instrument); and (ii) reflect the impact of deducting the total amount of interest and not just one dollar’s worth [emphasis mine].” Further, Rupert and Fischer (1995) solicited MTR estimates from subjects based on incremental income of $1,000. 5. As Shevlin (1990) demonstrates, firms with NOL carryovers in some years often have MTRs differing significantly from the highest statutory tax rate. 6. Considering NOL carryovers when estimating MTRs requires some projection of future taxable income and NOLs. To incorporate the uncertainty characterizing such projections, Shevlin (1990) illustrates how to simulate future income or losses based on prior year results. Graham (1996a) later refined Shevlin’s simulation procedure by considering the effect of investment tax credits and the alternative minimum tax on MTR calculations. In comparison with a benchmark MTR that assumes firm management with “perfect foresight,” Graham (1996b) finds that a simulated MTR is the best proxy for the “true” MTR. Using a benchmark based on tax return data, Plesko (2003) also found a simulated MTR to be the best proxy. In a simpler but intuitively appealing approach, Manzon (1994) uses a firm’s current market value, in effect, to project a future income stream that absorbs NOL carryforwards. Of course, companies may have other ways to take uncertainty into account when projecting income/loss streams (e.g., attaching probabilities to alternative projections). 7. For a detailed explanation of the foreign tax credit and its economic rationale, see Ault and Bradford (1990). 8. For estimated revenue costs and trade effects of the source rules, see U.S. Department of the Treasury (1993). 9. Scholes et al. (2002, p. 282) confirm that the minimum MTR equals half of the U.S. tax rate otherwise applicable. However, the authors do not extend their analysis to situations in which the U.S. exporter uses excess credits that would later be absorbed anyway. As when estimating MTRs given uncertain patterns of future taxable income and NOLs (see Case 1), estimates in the presence of excess credits requires some projection of future FTC results. 10. For U.S. exporters with both NOL and FTC carryovers, the choice of which to absorb with export profit depends on the MTRs calculations illustrated in Tables 1 and 2 and the sample MTR results appearing in Figs 1 and 2. Generally, the choice of which to absorb can be made after the taxable year at issue as long as the selection occurs within the period for which taxpayers can file amended returns. 11. For export profit margins of 8% or more, the combined taxable income method in IRC Sec. 994(a)(2) minimizes the MTR through its allocation of half the export profit to the ICD (usually as commission income). Then, IRC Sec. 995(b)(1)(F)(i) treats 1/17 of the ICD’s allocable income as a deemed distribution, which is currently taxable. Thus, ICDs usually permit deferral approximating 47% of export profit (50% × 16/17). 12. The $10 million annual limitation on export sales qualifying for ICD benefits restricts this regime’s appeal for large exporters. For example, a U.S. company with $50 million of export sales might experience a 25% MTR on sales of $10 million and 35% MTR on the other
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$40 million of sales. Assuming identical profitability across sales, the MTR for all export profit is 33% [(20 × 25%) + (80 × 35%)]. Prop. Reg. Sec. 1.995-8(b)(1) allows the ICD to choose which export sales receive the deferral benefit. So, if profitability differs across sales, U.S. exporters can strategically select transactions with the most export profit for deferral. 13. Revenue Ruling 2003-111, 2003-45 IRB 1009, specifies the base period T-bill rate applicable to the period ending September 30, 2003, as 1.30%. 14. Tedori v. U.S., 211 F.3d 488 (CA-9, 2000). 15. In the context of a foreign sales corporation (FSC), Private Letter Ruling 8911022 confirms that a U.S. parent company does not apportion its NOL carryforward to export profit; thus, the NOL carryforward does not reduce FSC commissions and benefits. The ruling’s rationale should apply similarly under the ICD regime. 16. This analysis assumes that the prior year excess credits result from high-taxed foreign source income and that tax planning, such as shifting profit to low-tax jurisdictions, will generate excess limits to absorb the excess credits before they expire. However, if the excess credits are attributable to the recapture of overall foreign losses under IRC Sec. 904(f), it is likely that the ICD will not be allocated profit, resulting in no ICD deferral benefit.
ACKNOWLEDGMENTS The author wishes to thank Greg Geisler, Ted Kresge, Mike Turgeon, Tom Porcano (editor), and two anonymous reviewers for their helpful insights and suggestions.
REFERENCES Ault, H. J., & Bradford, D. F. (1990). Taxing international income: An analysis of the U.S system and its economic premises. In: A. Razin & J. Slemrod (Eds), Taxation in the Global Economy. Chicago, IL: National Bureau of Economic Research. Billings, B. A., McGill, G. A., & Mougou´e, M. (2003). The effect of export tax incentives on export volume: The DISC/FSC evidence. Advances in Taxation, 15, 1–28. Graham, J. R. (1996a). Debt and the marginal tax rate. Journal of Financial Economics, 41(May), 41–73. Graham, J. R. (1996b). Proxies for the corporate marginal tax rate. Journal of Financial Economics, 42(October), 187–221. Manzon, G. B., Jr. (1994). The role of taxes in early debt retirement. Journal of the American Taxation Association, 16(Spring), 87–100. Plesko, G. A. (2003). An evaluation of alternative measures of corporate tax rates. Journal of Accounting and Economics, 35, 201–226. Rupert, T. J., & Fischer, C. M. (1995). An empirical investigation of taxpayer awareness of marginal tax rates. Journal of the American Taxation Association, 17(Suppl.), 36–59. Scholes, M. S., Wolfson, M. A., Erickson, M., Maydew, E. L., & Shevlin, T. (2002). Taxes and business strategy: A planning approach. Upper Saddle River, NJ: Prentice-Hall. Shevlin, T. (1990). Estimating corporate marginal tax rates with asymmetric tax treatment of gains and losses. Journal of the American Taxation Association, 12(Spring), 51–67. U.S. Department of the Treasury (1988). The operation and effect of the domestic international sales corporation legislation (February).
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U.S. Department of the Treasury (1993). Report to the congress on the sales source rules (January). U.S. Department of the Treasury (1997). The operation and effect of the foreign sales corporation legislation (November). World Trade Organization (1999). WTO Panel Report. United States – tax treatment for “foreign sales corporations” (October 8). World Trade Organization (2000). WTO Appellate Report. United States – tax treatment for “foreign sales corporations” (February 24). World Trade Organization (2001). WTO Panel Report. United States – tax treatment for “foreign sales corporations”: Recourse to Article 21.5 of the DSU by the European Communities (August 20). World Trade Organization (2002). WTO Appellate Report. United States – tax treatment for “foreign sales corporations”: Recourse to Article 21.5 of the DSU by the European Communities (January 14).