Advances in Taxation, Volume 16

CONTENTS LIST OF CONTRIBUTORS vii EDITORIAL BOARD ix AD HOC REVIEWERS xi AIT STATEMENT OF PURPOSE xiii MAIN ARTI...

Author: Thomas M Porcano

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CONTENTS LIST OF CONTRIBUTORS

vii

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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v

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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

123

AN EMPIRICAL INVESTIGATION OF FACTORS INFLUENCING TAX-MOTIVATED INCOME SHIFTING Toby Stock

147

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

viii

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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DONNA D. BOBEK ET AL.

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.

Professional Liability Suits Against Tax Accountants

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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


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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


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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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TED D. ENGLEBRECHT AND TIMOTHY O. BISPING

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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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


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

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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


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Table 2. Classification by Annual Revenue. Total

Arkansas

Louisiana

Mississippi

EHI

Freq.

%

Freq.

%

Freq.

%

Freq.

%

Freq.

%

Annual revenue 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 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

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Table 3. Who Should Pay the Payroll Tax? Who should pay the payroll tax?

Panel A Need not pay if number of employees 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,

An Empirical Investigation of Factors Influencing Tax-Motivated Income Shifting

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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.


175

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.

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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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PAUL D. HUTCHISON AND CRAIG G. WHITE

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:

Academic Tax Articles

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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

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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.


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


195

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.

Export Incentives After Repeal of the Extraterritorial Income Exclusion

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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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ERNEST R. LARKINS

$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., & Mougoué, 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).

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