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The Corporate Profit Base, Tax Sheltering Activity, and the Changing Nature of Employee Compensation

Author

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  • Mihir A. Desai

Abstract

This paper examines the evolution of the corporate profit base and the relationship between book income and tax income for U.S. corporations over last two decades. The paper demonstrates that this relationship has broken down over the 1990s and has broken down in a manner that is consistent with increased sheltering activity. The paper traces the growing discrepancy between book and tax income associated with differential treatments of depreciation, the reporting of foreign source income, and, in particular, the changing nature of employee compensation. For the largest public companies, proceeds from option exercises equaled 27 percent of operating cash flow from 1996 to 2000 and these deductions appear to be fully utilized thereby creating the largest distinction between book and tax income. While the differential treatment of these items has historically accounted fully for the discrepancy between book and tax income, the paper demonstrates that book and tax income have diverged markedly for reasons not associated with these items during the late 1990s. In 1998, more than half of the difference between tax and book income - approximately $154.4 billion or 33.7 percent of tax income - cannot be accounted for by these factors. This paper proceeds to develop and test a model of costly sheltering and demonstrates that the breakdown in the relationship between tax and book income is consistent with increasing levels of sheltering during the late 1990s. These tests also explore an alternative explanation of these results - coincident increased levels of earnings management - and finds that the nature of the breakdown between book and tax income cannot be fully explained by this alternative explanation.

Suggested Citation

  • Mihir A. Desai, 2002. "The Corporate Profit Base, Tax Sheltering Activity, and the Changing Nature of Employee Compensation," NBER Working Papers 8866, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:8866
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    References listed on IDEAS

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    1. Austan Goolsbee, 2000. "What Happens When You Tax the Rich? Evidence from Executive Compensation," Journal of Political Economy, University of Chicago Press, vol. 108(2), pages 352-378, April.
    2. Fudenberg, Drew & Tirole, Jean, 1995. "A Theory of Income and Dividend Smoothing Based on Incumbency Rents," Journal of Political Economy, University of Chicago Press, vol. 103(1), pages 75-93, February.
    3. Alan J. Auerbach & James M. Poterba, 1987. "Why Have Corporate Tax Revenues Declined?," NBER Chapters,in: Tax Policy and the Economy, Volume 1, pages 1-28 National Bureau of Economic Research, Inc.
    4. Brenner, Menachem & Sundaram, Rangarajan K. & Yermack, David, 2000. "Altering the terms of executive stock options," Journal of Financial Economics, Elsevier, vol. 57(1), pages 103-128, July.
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    6. Core, John E. & Guay, Wayne R., 2001. "Stock option plans for non-executive employees," Journal of Financial Economics, Elsevier, vol. 61(2), pages 253-287, August.
    7. Burgstahler, David & Dichev, Ilia, 1997. "Earnings management to avoid earnings decreases and losses," Journal of Accounting and Economics, Elsevier, vol. 24(1), pages 99-126, December.
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    9. Zimmerman, Jerold L., 1983. "Taxes and firm size," Journal of Accounting and Economics, Elsevier, vol. 5(1), pages 119-149, April.
    10. Brian J. Hall & Jeffrey B. Liebman, 2000. "The Taxation of Executive Compensation," NBER Chapters,in: Tax Policy and the Economy, Volume 14, pages 1-44 National Bureau of Economic Research, Inc.
    11. Degeorge, Francois & Patel, Jayendu & Zeckhauser, Richard, 1999. "Earnings Management to Exceed Thresholds," The Journal of Business, University of Chicago Press, vol. 72(1), pages 1-33, January.
    12. Anand Mohan Goel, 2003. "Why Do Firms Smooth Earnings?," The Journal of Business, University of Chicago Press, vol. 76(1), pages 151-192, January.
    13. Huddart, Steven & Lang, Mark, 1996. "Employee stock option exercises an empirical analysis," Journal of Accounting and Economics, Elsevier, vol. 21(1), pages 5-43, February.
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    Citations

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    Cited by:

    1. Mills, Lillian F. & Plesko, George A., 2003. "Bridging the Reporting Gap: A Proposal for More Informative Reconciling of Book and Tax Income," National Tax Journal, National Tax Association;National Tax Journal, vol. 56(4), pages 865-893, December.
    2. Desai, Mihir A. & Hines, James R. Jr., 2002. "Expectations and Expatriations: Tracing the Causes and Consequences of Corporate Inversions," National Tax Journal, National Tax Association;National Tax Journal, vol. 55(3), pages 409-440, September.
    3. Mihir A. Desai, 2003. "The Divergence between Book Income and Tax Income," NBER Chapters,in: Tax Policy and the Economy, Volume 17, pages 169-208 National Bureau of Economic Research, Inc.
    4. Lav, Iris J., 2003. "Piling on Problems: How Federal Policies Affect State Fiscal Conditions," National Tax Journal, National Tax Association;National Tax Journal, vol. 56(3), pages 535-554, September.
    5. Baruch Lev, 2003. "Corporate Earnings: Facts and Fiction," Journal of Economic Perspectives, American Economic Association, vol. 17(2), pages 27-50, Spring.
    6. Inès Bouaziz Daoud & Mohamed Ali Omri, 2011. "Divergences comptabilité - fiscalité, gestion fiscale et gestion des résultats en Tunisie : les nouveaux défis," Post-Print hal-00646800, HAL.
    7. Charles P. Himmelberg & James M. Mahoney & April Bang & Brian Chernoff, 2004. "Recent revisions to corporate profits: what we know and when we knew it," Current Issues in Economics and Finance, Federal Reserve Bank of New York, vol. 10(Mar).
    8. Thomas Dalsgaard, 2005. "U.S. Tax Reform; An Overview of the Current Debate and Policy Options," IMF Working Papers 05/138, International Monetary Fund.
    9. Julie H. Collins & Douglas A. Shackelford, 2003. "Do U.S. Multinationals Face Different Tax Burdens than Other Companies?," NBER Chapters,in: Tax Policy and the Economy, Volume 17, pages 141-168 National Bureau of Economic Research, Inc.

    More about this item

    JEL classification:

    • D33 - Microeconomics - - Distribution - - - Factor Income Distribution
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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