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Article Excerpt
INTRODUCTION
Two opposite trends have recently affected the relationship between the taxable income that companies report to the government and the financial accounting income that they report to investors. In the United States, a "two-book" country in which the two measures are largely independent, the rise of the book-tax gap (i.e., the excess of financial accounting over taxable income), providing suggestive evidence of earnings manipulation and/or tax sheltering, has led to calls for moving towards a one-book system, in which companies generally would have to use the same measure for both purposes (Desai, 2006). Meanwhile, several previously "one-book" members of the European Union (EU), such as Germany, Austria, Belgium, and France, have moved in the two-book direction (Schon, 2005, 116).
One interpretation of these opposite trends would be that the grass is always greener on the other side of the tracks. People on each side of the Atlantic, one might surmise, have a better grasp of their own approach's failings than of those arising under the other approach. Examined more closely, however, the opposite trends reflect complementary and intellectually consistent concerns about the tax-book relationship, rather than contradictory views of a single phenomenon.
American concern about a two-book system relates to the issue of managerial discretion to manipulate the two measures in opposite directions. Managers can more easily both overstate earnings and engage in tax sheltering if neither activity interferes with the other. Thus, proponents of a one-book system argue that "the latitude afforded managers by the dual nature of corporate profit reporting has contributed to the simultaneous degradation" of both measures (Desai, 2006, 171).
By contrast, the EU's movement away from a one-book system reflects concern about political discretion over the definition of income. The countries that decoupled financial reporting from legislatively determined taxable income did so by adopting international financial reporting standards (IFRS), which were promoted as a means of providing investors with better information about company performance, as integrated global capital markets increasingly demand (Haller and Eierle, 2004, 40-41). (1) To this end, IFRS offers two benefits: depoliticization of the process of defining income, and cross-border convergence. The latter, however, is an EU goal in tax policy as well as accounting, reflected in ongoing efforts to reach agreement on a common consolidated corporate tax base (CCCTB). (2) Accounting convergence has gone faster because EU members are considerably more reluctant to cede national political control over the definition of income in the tax realm than the accounting realm. If the EU reaches agreement on a CCCTB, reflecting similar acceptance of income depoliticization in the tax realm, it could easily revisit the one-book versus two-book choice by determining how the CCCTB and IFRS should relate to each other. (3)
Accordingly, the opposite U.S. and EU trends are not intellectually contradictory in substance, and in combination help to illustrate two key points. First, the proper relationship between taxable income and financial accounting income depends in large part on incentive problems at two distinct stages: rule design by the relevant political authorities, and rule application by corporate managers. Second, new multinational institutions such as the International Accounting Standards Board (IASB), established to determine IFRS, or the EU if it develops a widely accepted CCCTB, potentially can affect both the actual and the optimal relationship between the two income measures.
The rest of this paper elaborates on these two points by proceeding as follows. The next section discusses how taxable income and financial accounting income might differ in the absence of the managerial and political incentive problems that affect income measurement. The third and fourth sections discuss the implications of those two sets of problems for the relationship between the rules for measuring the two types of income. The fifth section discusses a recent proposal (from Shaviro (2009a)) for partial integration of the two U.S. measures, while the sixth explores the significance of international convergence with respect to measuring income. The final section offers a brief summary and conclusion.
SIGNIFICANCE OF THE DIFFERENT PURPOSES SERVED BY THE TWO MEASURES
In principal, income is a reasonably coherent economic concept, commonly defined (for individuals) as equaling the market value of one's consumption plus the change in one's net worth during the relevant accounting period (Simons, 1938, 50). One can adapt it to a legal entity, such as a corporation, by substituting distributions to owners for consumption. Use of an income measure in any given setting requires motivation, however, potentially affecting how it is best defined in that setting.
The tax and financial accounting motivations for measuring income differ markedly. Taxable income determines how tax liabilities are distributed between taxpayers, reflecting underlying distributional concepts such as earning ability or ability to pay (Shackelford, Slemrod, and Sallee, 2007, 4). While such concepts logically apply only to individuals, not legal entities, a corporate-level tax on earnings can act as a withholding device, substituting for taxing the earnings directly at the owner level. Financial accounting income, by contrast, provides a discrete informational input to actual and prospective owners of corporate shares who are making ongoing investment decisions regarding whether to buy, hold, or sell such shares at any given market price. Managers and investors often appear to care about the amount reported on the income line even if the exact details of the computation arguably do not affect available information--for example, because a given expense, even if ignored in computing income, is disclosed in footnotes (Walker, 2007, 938).
The chief implications of these distinct functions include the following.
1. For taxable income but not financial accounting income, mismeasurement may not matter if it does not affect the overall taxes imposed on all of the parties to a given transaction. Thus, if corporations and their employees share the same marginal tax rate, it may make no long-term difference whether wages are (1) currently deducted by the company and included by the employee or (2) neither deducted nor included. In the financial accounting setting, by contrast, it is important to measure correctly the corporation's income (net of employee compensation).
2. Multiple jurisdictions, such as countries, typically coordinate their income taxes in order to limit the extent to which cross-border investment, by reason of being duplicatively taxed, is disfavored relative to investment wholly within a single jurisdiction. A jurisdiction may, for example,...
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