Tax Back To the Future: Lessons From the 1986 Book Minimum Tax

To me, the most interesting case for the Inflation Reduction Act’s corporate alternative minimum tax–the 15% levy on financial “book” profits that is controversial with experts, but apparently popular with the public–is that it balances natural incentives against each other.

In rhetoric, the tax hits profitable companies that are getting away with paying low or zero taxes. That implies that financial accounting profit, what’s reported to shareholders, is more accurate and closer to the real economic picture than taxable income as defined by the tax code. That’s intuitive, but as both financial and tax accountants will tell you, it’s also a sometimes misleading way to look at it.

Financial accounting rules are set up to measure something different than what the tax rules measure, and many of the differences are intrinsic to those purposes. Furthermore, Congress has enacted incentives which further widen the gap, but for reasons which legislators have decided are worthy goals.

But there’s another way of looking at it–that financial accounting can serve as an imperfect but sturdy backstop to the tax rules. The tax only kicks in if a company's financial accounting profit is high enough and its tax payments are low enough that its effective tax rate is lower than 15%. Without the min tax, a company has every incentive to reduce taxable income as much as possible. Likewise, companies are under intense pressure from investors to maximize earnings, the profit recorded in financial statements. (Indeed, that’s why companies reduce their taxable income in the first place.) Why not face those incentives off each other, perhaps arriving at a number which is closer to the truth?

Kim Clausing, a tax professor at the University of California at Los Angeles and the former U.S. Treasury Department deputy assistant secretary for tax analysis in the Biden administration, made that case during a webcast held by the Tax Policy Center earlier this month.

“Companies have an incentive to lower their taxable income and they have an incentive to exaggerate their accounting income, in order to please their financial investors,” Clausing said. “And so by having elements of book income in the tax base, you can basically mute both of those incentives. We don't want people being too aggressive in either one of those conventions.”

It’s an interesting theory, but how is it going to work in practice? Maybe the urge to reduce taxes will be so powerful, companies will be willing to sacrifice a bit of their earnings, making everyone lose out. Especially potential investors, who are now faced with less trust-worthy public filings.

This was a principal concern when Congress previously toyed with this idea, as part of the 1986 federal tax overhaul. That bill enacted another version of the same concept, a tax on “business untaxed reported profits,” or BURP–an even worse acronym than the CAMT, or “Camtee” as it’s come to be called. BURP, however, was given a three-year sunset, and it unceremoniously expired in 1990, with few mourning its loss. It was replaced with a more normal AMT concept, which lasted for decades until it was fully repealed by the 2017 Tax Cuts and Jobs Act.

That brief three-year period gave academics an interesting chance to test this theory, however. There have been quite a few studies pouring over the data from those years, to see just how companies responded to these incentives.

The conclusion from most–companies actually did depress their earnings, at least enough that tax management is the likeliest explanation.

“The central conclusion is that the most relevant evidence…suggests a large responsiveness of financial statement income to taxes (and hence, albeit with important caveats, arguably a large deadweight loss),” wrote Dhammika Dharmapala, an economist and law professor at the University of Chicago in a 2020 study.

Michelle Hanlon, a professor of accounting at the Massachusetts Institute of Technology (and a Things of Caesar subscriber!) reviewed the evidence in a 2021 paper.

“The (admittedly limited) prior evidence suggests that conforming book and taxable income, even mildly, generally leads to a behavioral response by companies and less informative earnings,” Hanlon wrote.

There are plenty of other papers, from throughout the 30 years since the BURP died, finding the same conclusion. But there are also some dissenters.

A 2001 paper by three accounting professors critiqued the prior studies, claiming that a lack of adequate control groups and comparisons may have led experts to mistake noise for correlation. And a 2022 paper by Princeton University economics Ph.D. student Jordan Richmond also came to the conclusion that there was no evidence for earnings manipulation. He looked for new comparisons (such as companies under less pressure to boost earnings) and accounted for “mean reversion,” the tendency for returns to gravitate to historical averages over time. Since the new tax itself affects the bottom line regardless of how managers respond, some earnings changes are inevitable–Richmond stated that correcting for these causes the supposed dips to disappear in statistical analysis.

I could go on citing studies for several more pages–if you find this interesting I’d encourage you to follow the links to see for yourself.

Ultimately, despite the voluminous evidence, it’s hard to know what conclusion to draw. Most of it comes from those in financial accounting, who aren’t too happy about the notion of mixing the field with taxes. (From reporting on this, I’ve found that there are surprisingly few who are experts in both fields–something that Treasury is dealing with as we speak.)

“If I am being objective, there is a chance that maybe the accountants that have studied the topic are biased,” Hanlon wrote. “Perhaps we are just subconsciously protecting our turf in a sense.”

I wonder if the three-year sunset in the 1986 law drove corporations to make very different decisions than they would have for a permanent tax regime. A company which fears being subject to the minimum tax could push its profits out a few years, gambling that by then they’d no longer have to worry about it.

The whole experiment was really an inelegant way to kill the proposal during the arduous legislative process for the ‘86 reform bill, while providing its supporters with a little face-saving. From what I can gather, nobody was surprised when it died out.

Hanlon acknowledged that this is an issue, but said it's still worth looking at the results.

"Pushing earnings four years is not trivial," she wrote to me in an email. "And I am not sure how long people expect this one to last either."

Of course, very soon we’ll have much more data to add to the 1987-90 returns. Not just from CAMT, but also from the Organization for Economic Cooperation and Development’s 15% global minimum tax, which also uses financial accounting as a basis. Their system, however, is very different, and uses accounting more as a way to arrive at a common multinational tax base, rather than a backstop.

Either way, the issue of mixing tax and financial accounting is clearly no longer academic. It’s now global and systemic, and will be a feature moving forward no matter what happens. Even if these particular tax regimes are repealed, there are plenty of other examples–including in some regulations from the U.S. Department of the Treasury.

If the tax pressure does affect larger Wall Street or the global stock markets, I suppose we’ll know soon enough. The implications, though, will take much longer to sort out.

Note: The newsletter will be out next week for the Thanksgiving holiday, and will return the week of Nov. 28.

DISCLAIMER: These views are the author's own, and do not reflect those of his current employer or any of its clients. Alex Parker is not an attorney or accountant, and none of this should be construed as tax advice.

LITTLE CAESARS: NEWS BITES FROM THE PAST WEEK

Probably the biggest recent news in the international tax world is the United Kingdom government’s promise to implement the OECD’s Pillar 2 global minimum tax plan, in the Chancellor of the Exchequer’s Autumn Statement. Technically, this isn’t even a change–but it ends weeks of speculation that the new Tory government may back out of the agreement. This could put more pressure on the European Union to move past its impasse and begin implementation themselves, and move the global coalition forward.

The Tax Justice Network, a left-leaning global advocacy group, released a study claiming that governments could recover as much as 25% of the revenue lost through tax evasion by making country-by-country reports public. These are the global blueprints that companies currently have to report to tax authorities privately, as part of the OECD’s 2015 Base Erosion and Profit Shifting plan. Some companies are beginning to voluntarily release these, and Australia recently announced it would require its taxpayers to. It’s taken a back seat to the global min tax agreement implementation recently, but this shows that the CBC reporting is still a focus for reform advocates.

I haven’t had a chance to sift through them yet, but the OECD released comments it's received on some technical aspects of Pillar One, the market-placed digital taxation aspect of the global agreement. As I’ve said before, while the conventional wisdom is that Pillar One is toast, it’s a mistake to ignore it completely.

Have you been following the drama at Twitter as closely as I have? As the site plunges into dysfunction, it’s been reported that Elon Musk’s new regime laid off their entire tax department. If that’s true, it could be quite the problem for a tech giant, which is likely subject to various complex digital taxes around the world that require real-time compliance. Someone’d better attend to that soon!

PUBLIC DOMAIN SUPERHERO OF THE WEEK

Mr. Q, also known as Operative 17, appearing in Green Hornet Comics #11 in 1943. An FBI agent who adopted a superhero persona out of boredom and to get into the field, he uses his knowledge of pyrotechnics to apparently appear and disappear in a cloud of smoke. (The moniker “Operative 17” may be a knockoff of Operator #5, a famed pulp hero who fights off foreign invasions as a Secret Service agent. His novels are sometimes called the “War and Peace of Pulps.”)