The Tax Elasticity of Financial Statement Income: Implications for Current Reform Proposals

There has been growing attention among policymakers and the general public to the taxation of multinational corporations (MNCs) in recent years. This reflects widespread concern about the capacity of the international tax regime – which originated in the 1920s – to accommodate recent developments such as the growth of digital services across borders. In particular, it focuses on what the Organisation for Economic Co-operation and Development (OECD) and the G-20 group of governments have termed “base erosion and profit shifting” by MNCs. Recently, this widespread concern over MNC taxation has been combined with an earlier strand of discussion regarding the divergence between financial statement income (FSI) and taxable income among corporations.

My paper on “The Tax Elasticity of Financial Statement Income: Implications for Current Reform Proposals,” analyzes aspects of current reform proposals that seek to tax MNCs’ FSI as a response to the various concerns highlighted above. It develops a conceptual framework that is grounded in the principles of tax policy design, as well as taking account of the wider financial and business ramifications of these proposals. The paper also discusses the available evidence on the responsiveness of FSI to taxation.

Current international tax reform proposals

1. GloBE and beyond

The ongoing work of the OECD and the G-20 on international tax reform has led to the Global Anti-Base Erosion (GloBE) proposal (also known as the “Pillar Two” proposal). This envisages the use of FSI as the tax base for a global minimum tax on MNCs. The various challenges that led the OECD to contemplate taxing FSI (or “book” income) can be illustrated as follows. Assume an MNC group that consists of a parent in country A and an affiliate in a lower-tax jurisdiction B. The GloBE proposal aims to ensure that the MNC’s income in B is subject to a minimum tax rate. The primary mechanism is an “income inclusion rule” involving the imposition by country A of an additional tax if the MNC’s effective tax rate falls below the GloBE regime’s minimum rate.

However, it is far from straightforward to determine the MNC’s effective tax rate on a global basis and to define the relevant tax base for the global minimum tax. One possibility is to use the tax law of each country to compute the tax base; however, this leads to the problem that country B’s tax law may strategically set a narrow tax base. Another would be to use country A’s tax law to compute the income of all subsidiaries; however, this would entail large compliance costs by requiring complex calculations that the firm would not otherwise need to undertake. The solution mooted by the OECD in a public consultation document issued towards the end of 2019 is to use the consolidated (i.e. worldwide) FSI of the MNC as the tax base for determining the effective tax rate for purposes of the global minimum tax. A more recent draft report that was circulated online – and which, it is believed, will be discussed during OECD and G-20 meetings in October and November – suggests that the OECD continues to maintain its commitment to the taxation of FSI.

Beyond the OECD and G-20 reform efforts, a number of recent US policy proposals also entail the taxation of FSI. For instance, the “Real Corporate Profits Tax” proposed by Senator Warren’s Presidential campaign in April, 2019 would be imposed at a 7% rate on the worldwide consolidated financial income of US-resident corporations.

2. Academic perspectives

Academic researchers in accounting have long been overwhelmingly opposed to any imposition of tax consequences on FSI. The main reasons include the potential reduction in the informativeness of accounting earnings when firms engage in tax-motivated downward earnings management, and the possibility of political pressure on financial accounting standard setting bodies by governments seeking to increase tax revenue. Notwithstanding these concerns, proponents of taxing FSI argue that the political process by which tax law is determined is flawed, in particular by taxpayer lobbying that leads the tax base to be too small. Delegating the determination of the tax base to an independent nongovernmental institution that sets financial accounting standards is thus viewed by proponents as being potentially advantageous. More generally, it seems difficult to rule out on a priori grounds the possibility that the welfare costs of introducing a small distortion to financial accounting reports might be outweighed by welfare gains elsewhere – for instance, from increased tax revenue or from reduced deadweight costs of tax planning.

Whether this is the case is an empirical question that depends on factors such as the responsiveness of FSI to the imposition of a tax – that is, on the tax elasticity of FSI. My recent paper discusses how to conceptualize what evidence might be relevant, and outlines some of the existing evidence. It takes as its starting point the influential literature in public finance on the elasticity of taxable income. This shows that, albeit with some exceptions, under certain conditions the elasticity of taxable income can be used to infer the magnitude of the deadweight loss from taxation.

Profit shifting, earnings management, and deadweight loss

My paper presents a simple model of profit shifting within an MNC that is subject to separate taxation of the income of each affiliate (where taxable income in each country is defined by the tax law of that country). The focus is on the inefficiency that arises because profit shifting requires the employment of tax planners. Tax planners’ output in their best alternative occupation would have been socially valuable; in contrast, their tax planning activity simply generates transfers from the government(s) to the firm. This foregone socially valuable output constitutes a deadweight loss from profit shifting.

The model characterizes the circumstances in which the magnitude of profit shifting can be used to infer the deadweight cost of taxation. The scenario is then modified to represent one in which the tax base is redefined as consolidated (i.e. worldwide) FSI, which is allocated by a formula across countries. The firm no longer has any reason to shift profits across countries, but is able to engage in downward earnings management (for instance, through the use of discretionary accruals) to reduce FSI. Somewhat analogously to the profit shifting context, earnings management requires the employment of financial accountants, whose output in their best alternative occupation would have been socially valuable. Thus, there is a deadweight loss from earnings management, and the model characterizes the circumstances in which the responsiveness of FSI to the tax rate can be used to infer the magnitude of this deadweight cost.

The empirical evidence and its interpretation

The paper then reviews the available empirical evidence. There is a significant literature that estimates the elasticity of corporate income under current arrangements (where the tax base is typically defined by tax law) with respect to the net-of-tax share (i.e. one minus the tax rate, where the tax rate is expressed as a fraction). Representative estimates from this literature are around 0.2 or less. There are no explicit estimates of the corresponding elasticity when the tax base is defined as FSI. However, an episode from the 1980s in the United States can potentially shed some light on this question. The Tax Reform Act of 1986 (TRA86) introduced the corporate Alternative Minimum Tax (AMT), which for tax years 1987-1989 involved what was known as the Book Income Adjustment (BIA) or Business Untaxed Reported Profit (BURP) adjustment. This entailed that firms facing the AMT were required to add 50% of FSI to their taxable income in determining their tax base for AMT purposes. There is a substantial accounting literature from the 1990s that analyzes earnings management of FSI in response to the BIA.  An implied elasticity derived from these studies is much larger than that for income defined under tax law, in the range of about 1.4 to 2.1 with respect to the net-of-tax share.

This difference suggests a much larger elasticity – and hence, under certain assumptions, a much larger deadweight cost of taxation – when FSI is used as the tax base. One possible interpretation is that downward earnings management of FSI is relatively unconstrained by financial accounting rules, while downward management of taxable income is quite strongly constrained by tax law.

Further evidence is needed

Of course, there are many caveats with respect to the estimates inferred from studies of the BIA. Within the accounting literature, significant questions have been raised about the robustness of the results to alternative empirical approaches. The results may also reflect short-run responses (although there are also several reasons why they may underestimate the responsiveness of FSI to taxes). These limitations underline the need for further evidence on this question before policymakers proceed with proposals to tax FSI, especially in view of the consensus among scholars in financial accounting that the effects on earnings management would potentially be large.

Even if the elasticity of FSI with respect to taxes is large, there are circumstances in which this would not necessarily imply a large deadweight cost. If that is the case however, then it would be quite difficult to maintain that a large magnitude of profit shifting implies a large deadweight cost from profit shifting (as discussed above, the nature of the deadweight costs associated with tax planning and earnings management are fairly closely analogous). This would tend to undermine the case for initiatives – such as the GloBE proposal – to address base erosion and profit shifting (at least on efficiency grounds). My paper thus concludes that the challenge for proponents of current proposals to tax FSI is to produce evidence showing a small and precisely estimated impact of taxes on FSI, or to explain why a large elasticity of FSI is not relevant for assessing the normative desirability of these proposals (without thereby also undermining the case for addressing profit shifting).

Further comments on the OECD’s multilateral solution

The wider context of international tax reform is one in which the OECD and G-20 appear to be continuing with their efforts to secure a multilateral agreement based on the GloBE proposal, despite (or perhaps spurred by) the current pandemic and associated crisis. The OECD portrays its ongoing multilateral process as the only alternative to the specter of widespread uncoordinated actions by different governments, in particular the unilateral imposition of Digital Services Taxes (DSTs) and similar measures. A DST is a gross receipts tax imposed by a country on advertising revenues derived by (domestic and foreign) digital platform firms from advertising directed at consumers resident in that country. DSTs have been proposed or recently enacted in a number of major countries, eliciting a hostile reaction from the US authorities. Some scholars have expressed concerns that unilateral DSTs may undermine the OECD’s multilateral process that promises a more comprehensive approach to reforming the taxation of MNCs, and that some DSTs may give the appearance of disproportionately targeting US-based firms. However, a more positive scholarly view has also emerged, analogizing DSTs to resource rent taxes on mining activities that are a well-established element of the global tax landscape.

My paper is not, of course, intended to resolve the issue of whether the world would be better off under the OECD’s proposed multilateral solution or under the status quo augmented by unilateral DSTs. However, the conceptual framework that it develops and the empirical evidence that it reviews suggest that – even if the OECD’s multilateral solution proves to be diplomatically feasible – there may be significant efficiency costs associated with the GloBE proposal’s taxation of financial statement income.

Dhammika Dharmapala is Julius Kreeger Professor of Law in The University of Chicago Law School.

This post is adapted from his paper, “The Tax Elasticity of Financial Statement Income: Implications for Current Reform Proposals,” available on SSRN.

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