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Five things economists and lawyers can learn from accountants: an illustration using the domestic production activities deduction.

Article Excerpt
INTRODUCTION

Accounting is often referred to as the "language of business." In addition to providing a language, it is also akin to a translation program. The corporation uses accounting principles and rules to aggregate all of the year's transactions to a few tables of numbers; the stock analyst studies these few tables of numbers to understand the events and estimate the value of the corporation. When I speak to high school students about accounting as a profession, I relate my experience of enjoying word problems in fourth grade. If one were to place attorneys at the verbal end of the spectrum and economists at the quantitative end of the spectrum, accountants are in the middle, because they need facility in translating words to numbers and numbers to words.

The domestic production activities deduction in the American Job Creation Act (AJCA) of 2004 provides a specific platform to introduce five concepts from financial accounting that lawyers and economists should consider when setting tax policy: book income matters; tax rate changes immediately affect earnings; current tax expense does not generally equal taxes paid; accounting mixes different methods and permits management judgment; and consolidation rules differ for book and tax income, complicating jurisdictional inferences.

This paper provides a brief introduction to these issues and their implications for the production activities deduction and for tax policy debates broadly.

BOOK INCOME MATTERS

In setting tax policy, economists might think that managers of corporations will view alternatives as equivalent if they provide equal present values of after-tax cash flows. Legislators can construct an investment incentive through a statutory rate cut, a credit, a permanent deduction, or an accelerated deduction, and write the law to make any of those structures economically equivalent. However, because different structures have different effects on reported book income, corporations may lobby in favor of one alternative over another.

Only rate decreases, credits and permanent deductions increase book income. Accelerating deductions reduces taxable income but does not change reported total tax expense book income.

Table 1 in the Appendix illustrates why expensing an asset for tax purposes improves cash flow but does not change book income. In brief, total tax expense for book purposes equals the sum of tax owed now (current tax expense) plus tax owed later (deferred tax expense) on book income this period. A tax policy that permits accelerated depreciation (in the extreme, expensing an asset) decreases current tax expense but increases deferred tax expense, leaving total tax expense unchanged. If deferred tax expense were discounted for the time value of money, the accelerated tax benefit would affect book income, but accounting for income taxes does not generally reflect any discounting. (1)

The example of expensing versus depreciating begs the following questions. If the effect on tax expense is so simple, why can't financial statement users observe the cash flow benefit of the tax policy? Are markets so inefficient? The question of whether and in what settings financial reporting "matters" are at the heart of academic research in accounting. Policymakers need to worry about short-run and transition effects. Although markets are reasonably efficient, at least in the long run, evidence is mixed about short-run market efficiency (see Fama (1998), Kothari (2001), and Thaler (1999) for reviews of this literature).

The most obvious short-run effects involve contracts. For example, manager bonuses and debt covenant restrictions are frequently based on reported book income and balance sheet amounts. Such contracts induce preferences for rate decreases, credits or permanent deductions over rapid expensing. Reported details concerning deferred tax expense components do not permit financial statement users to understand easily the benefit of a tax change on a corporation's cash flows. The more complex is the tax change, the less able are analysts (Plumlee, 2003) and other financial statement users to evaluate the effect of the tax change on the corporation. Hence, the mapping of a tax benefit into the corporation's stock price is likely to be less efficient in the short run, especially as the complexity of the tax provision increases. For example, casual inspection of company footnotes shows many firms reporting that the company has not determined the effect of the repeal of extra-territorial income (ETI) exclusion and the enactment of the domestic production activities deduction on the company's financials.

The domestic manufacturing deduction is a new deduction that reduces only taxable income but does not change book expenses. As such, this deduction is a "permanent" item, because pre--tax book income is unchanged, but taxable income is lower. Net book income will increase, however, because current and total tax expense will both be smaller. When the domestic manufacturing deduction was first passed, the Financial Accounting Standards Board (FASB) opined that it was not equivalent to a rate cut (FSP FAS 109-1--Application of FASB Statement No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (December 21, 2004)) and, thus, should only affect tax expense prospectively. As the next section shows, rate cuts have immediate effects on income because they affect existing deferred tax assets and liabilities.

TAX RATE CHANGES AFFECT ACCUMULATED DEFERRED...