LIST OF CONTRIBUTORS Susan B . Anders
Department of Accounting, St. Bonaventure University, USA
Christine C. Bauman
School of Business Administration, University of Wisconsin-Milwaukee, USA
B. Anthony Billings
Department of Accounting, Wayne State University, USA
Tonya K. Flesher
Patterson School of Accountancy, University of Mississippi, USA
Sharon K. Ford
Department of Accountancy and Computer Information Systems, Delta State University, USA
Anna C. Fowler
Department of Accounting, University of Texas-Austin, USA
Gregory G. Geisler
Department of Accounting and Information Systems, University of Missouri-St . Louis, USA
Daryl M. Guffey
School of Accountancy and Legal Studies, Clemson University, USA
Philip J. Harmelink
Department of Accounting, University of New Orleans, USA
Peggy A . Hite
Department of Accounting and Information Systems, Indiana University, USA
Angela L . J. Hwang
Department of Accounting and Finance, Eastern Michigan University, USA Vii
LIST OF CONTRIBUTOR
Ernest R. Larkins
School of Accountancy, Georgia State University, USA
Daniel P. Murphy
Department of Acounting and Business Law, University of Tennessee, USA
Buagu Musazi
Department of Accounting, Virginia State University, USA
Claire Y Nash
Department of Accounting, Christian Brothers University, USA
Elizabeth Plummer
Department of Accounting, Southern Methodist University, USA
Dan L . Schisler
Department of Accounting, East Carolina University, USA
Douglas K. Schneider
Department of Accounting, East Carolina University, USA
Morris H. Stocks
Patterson School of Accountancy, University of Mississippi, USA
William M. VanDenburgh
Department of Accounting, Louisiana State University, USA
Ann Boyd Watts
Department of Accounting and Business Law, University of Tennessee, USA
W. Mark Wilder
Patterson School of Accountancy, University of Mississippi, 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 Ted D . Englebrecht Louisiana Tech University, USA Philip J . Harmelink University of New Orleans, USA D . John Hasseldine University of Nottingham, England Peggy A . Hite Indiana University-Bloomington, USA Beth B . Kern Indiana University-South Bend, USA
Daniel P . Murphy University of Tennessee, USA Charles E . Price Auburn University, USA William A. Raabe Capital University, USA Michael L . Roberts University of Alabama, USA David Ryan Temple University, USA Dan L. Schisler East Carolina University, USA Toby Stock Ohio University, USA
AD HOC REVIEWERS Richard C . Hatfield Drexel University, USA
Cherie J . O'Neil Colorado State University, USA
Herbert G . Hunt California State University, USA
Patrick J . Wilkie George Mason University, USA
Janet A . Meade University of Houston, USA
STATEMENT OF PURPOSE 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 is also 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 : porcantm@muohio .ed u See http ://www.jaipress .com / for Guidelines and additional information regarding manuscript submissions . Professor Thomas M . Porcano Series Editor
AN EMPIRICAL ANALYSIS OF THE EFFECT OF THE EARNED INCOME TAX CREDIT ON WORK EFFORT Susan B . Anders
ABSTRACT The purpose of this study is to further the examination of the effectiveness of the earned income tax credit (EITC) in meeting one of Congress' major objectives for the credit : increasing work incentives . Economic theory predicts a potential work incentive in the phase-in range of the credit and a potential work disincentive in the phase-out range . This study utilizes empirical analysis of individual tax return data to evaluate EITC participants' and comparable non-participants' wage income cross-sectionally and over time for indications of statistically significant changes . Observations are grouped into income classifications based on the income ranges of the credit : phase-in, plateau, and phase-out . The wages for EITC participants, as well as for non-participants, increased significantly over selected time windows during the 1979 to 1990 time period. Wage growth .for both participants and non-participants was greater in the phase-in range than in the phase-out range- The potential existence of significant differences in income growth between participants and non-participants is only indicated for the time period of the mid-1980s, before the major increase in the credit post-1986. Contrary to theory, the current study estimates a potential disincentive in the mid-1980s in
Advances in Taxation, Volume 14, pages 1-35 . Copyright 0 2002 by Elsevier Science Ltd . All rights of reproduction in any form reserved . ISBN : 0-7623-0889-3
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SUSAN B . ANDERS
the phase-in range, as well as the phase-out range. However, after the post-1986 increase in the credit, the differences between the participants and non-participants are no longer statistically significant and a potential disincentive cannot be inferred.
INTRODUCTION The EITC was first enacted in 1975 to : (1) reduce the burden of the Social Security tax for the working poor, (2) increase the progressivity of the tax system overall, and (3) increase the incentives of low-income individuals to work (Pechman, 1987, pp . 112-113) . The EITC has become the major government support for many low-income families . The Congressional Budget Office (CBO, 2000) estimates for the years 2000 and 2001 predict federal government spending outlays for the EITC will exceed those for family support programs .' Estimated expenditures for 2000 are $23 billion for family support and $25 billion for EITC . For 2001, they are $29 billion for family support and $30 billion for EITC (CBO, 2000) . Welfare reforms that emphasize work requirements over guaranteed entitlements also have increased the importance of, and expenditures on, the ETTC 2 Welfare to work alternatives now place time limits on the receipt of transfer payments . Additionally, as further encouragement for work while receiving assistance, the receipt of EITC refunds no longer reduces transfer payment amounts . The EITC is a refundable credit, which means that eligible taxpayers may receive refunds if the amount of the credit exceeds their tax liability . Appendix A details the historical participation in the credit and average credit amounts from 1975 through 1998 . For 1998, approximately $27 billion was paid out in refunds and 83% of the claimants received a refund (Gish, 2001, p . 4) . Although the EITC has been in existence for more than 25 years, it is still the subject of some controversy, and changes to the credit are regularly proposed by supporters and opponents alike . The Economic Growth and Tax Relief Reconciliation Act of 2001 increases the beginning and ending points of the phase-out range of the EITC for married couples filing joint returns . Also in 2001, the Senate is considering a bill (S . 685) that would expand the credit for families with three or more children . On the other hand, a bill has been proposed in the House of Representatives (H . R . 1652) that would repeal the credit for taxpayers without children and reduce the amount of the credit for those still eligible . The current study adds to the literature examining the impact of tax incentives on the labor supply . Previous studies have examined the effect of a
An Empirical Analysis of the Effect of the Earned Income Tax Credit
3
Negative Income Tax (NIT) on the hours worked by a treatment group, who received a guaranteed grant, versus a control group, who received no grant (Robins, 1985, GAO, 1993) . Other studies have applied parameter estimates from NIT experiments to examine labor supply response, in terms of changes in hours worked or changes in earnings, to changes in the EITC (GAO, 1993 ; Holtzblatt et al ., 1994) . Further studies have simulated the effects of increases or decreases in the credit rate (and phase-out rate) on a "treatment group" only (Browning, 1995) . The most recent empirical studies utilize household survey data to compare changes in employment rates or hours worked by single women (Eissa & Liebman, 1996 ; Meyer & Rosenbaum, 1999 ; Ellwood, 2000) and married couples (Eissa & Hoynes, 1998) with and without children . These studies focus on differences between potential beneficiaries and non-beneficiaries that may be related to the expansion of the EITC, and are discussed in more detail in the literature review section of the paper . This study contributes to a better understanding of the EITC by expanding the research method and by utilizing data from actual filed tax returns, rather than self-reported survey data . Using tax return data focuses the issue on whether the people who actually did claim the credit, rather than those who may have been eligible, were better off .' Additionally, widening the examination from single mothers to all actual claimants is important because of the purported "marriage penalty" effects on low-income married couples whose combined low incomes place them in or above the phase-out range . This study does not address compliance issues (i .e . whether or not taxpayers were eligible for the credit) . 4 Using a different data source provides the opportunity to triangulate the results of this study with other studies . For example, if the results of this study are similar to the simulation or household survey studies, confidence in all of the studies can be increased. On the other hand, if the results of the current study differ from prior studies, the need for additional research could be indicated . This study examines the growth or decline in wages (in constant dollars) over nine time windows which cover the time period 1979 through 1990, for a "treatment group" (i .e . EITC participants) and a "control group" (i .e . non-participants) . The chosen time windows take into account various changes in the credit during that time period . However, the focus is on differences between participants and non-participants that may be associated with an overriding incentive or disincentive of the EITC . This study also expands upon previous empirical studies by separating the tax returns into income groups based on the income ranges of the credit . The
4
SUSAN B . ANDERS
appearance of growth or decline in wages is examined separately for the phase-in, plateau, and phase-out income ranges . Examining the ranges separately is important because of the predicted differing effects on labor supply for each range (described below), which have been the source of much of the controversy surrounding the EITC . EITC participants are facing an upper limit on earnings that reduces their hourly wages in the phase-out range . If the EITC creates a disincentive to work, then participants in the phase-out income range would be expected to have a flatter distribution of earnings over time than non-participants in the phase-out income range . On the other hand, for participants in the phase-in range, the distribution of earnings over time would be expected to be steeper than for non-participants . Comparing the growth rates in earnings of EITC participants and non-participants with similar beginning levels of income allows the examination of differences in growth patterns that may indicate potential incentives or disincentives from the credit . The results of this study do not provide support for the idea that the EITC program influences the work efforts of recipients . In contrast to prior simulation studies, the results indicate that EITC participants exhibited positive wage growth (in constant dollars) in all income ranges, suggesting either that they worked more hours over time, or were more productive, or both . However, wage growth was significantly higher for EITC participants in the phase-in range, where the work incentive is positive, than for participants in the phase-out range, where the work incentive is negative . Importantly, the same pattern of wage growth is also exhibited by low-income workers who did not receive the EITC . This is in contrast to the results of previous empirical studies, which generally report an increased labor measure only for potential beneficiaries and not for potential nonbeneficiaries . The possible existence of significant differences in income growth between participants and non-participants is only indicated for the time period of the mid-1980s, before the major increase in the credit post-1986 . Contrary to theory, the current study estimates a potential disincentive in the mid-1980s in the phase-in range, as well as the phaseout range . However, after the post-1986 increase in the credit, the differences between the participants and non-participants are no longer statistically significant. The remainder of this article is organized as follows . First, the economic theory behind potential disincentives is briefly summarized . Second, a review of the related literature is presented . Third, the research design is developed . Finally, the results are presented, along with a discussion of the limitations of the study and suggestions for future research .
An Empirical Analysis of the Effect of the Earned Income Tax Credit
5
LITERATURE REVIEW Although the earned income tax credit is intended to provide an incentive for low-income taxpayers to work, some theoretical literature suggests that the credit may actually reduce work incentives . The effect on labor supply may depend on whether the taxpayer's income is in the "phase-in," "plateau," or "phase-out" ranges (Scholz, 1994 ; JCT, 1995) . In the "phase-in" range, the amount of credit increases as the taxpayer's earned income increases, so the credit acts as an earnings subsidy (Browning, 1995) . In the "plateau" range, the EITC acts as a lump-sum transfer since the amount of the credit is constant at the maximum amount, with no increase (or decrease) for additional earnings (Browning, 1995) . In the "phase-out" range, taxpayers lose a percentage of the credit for each additional dollar earned, similar to a negative income tax (Browning, 1995) . The operations of the "phase-in," "plateau," and "phase-out" ranges for the years of this study are depicted graphically in Fig . 1 . The overall effect of the EITC on work effort can be separated into a "substitution effect" and an "income effect ." The substitution effect derives from : (1) a positive credit rate, which increases the net wage, versus ; (2) an increase in the marginal tax rate (i.e. phase-out of the credit) which decreases the net wage (Browning, 1995) . In the phase-in range, the substitution effect provides a positive incentive to increase labor supply, because the higher after-tax wage makes leisure more expensive, and individuals may substitute work for leisure (Scholz, 1994 ; JCT, 1995) . In the "plateau" range, there is no substitution effect, since the credit does not increase or decrease . However, in the "phase-out" range, the decreasing after-tax wage makes leisure relatively less expensive, and individuals may choose to substitute leisure for work (Browning, 1995) . The "income effect" describes the potential for individuals to choose to work fewer hours, since their disposable money incomes have increased with receipt of the transfer (credit) (Scholz, 1994) . The negative direction of the income effect holds across all income ranges of the EITC . In the "phase-in" range, the substitution and income effects are in opposition to each other (JCT, 1995), although the positive substitution effect is expected to dominate the negative income effect and result in a net increase in the labor supply (Holtzblatt et al ., 1993 ; Scholz, 1994) . The income effect operates unopposed in the "plateau" range, although the strength of its effect is not clear (Holtzblatt et al ., 1994) . In the "phase-out" range, the substitution effect would be expected to reinforce the income effect for a net reduction in labor supply (JCT, 1995 ; Browning, 1995) . The theoretical development of the EITC has grown out of discussions of the negative income tax (NIT) . However, there are important differences
6
SUSAN B . ANDERS
1979 through 1984 : Maximum Credit $500 Phaseoat
Phasem 10% ooo~l $5,000 $0
s6,000
1985 through 1986 : Maximum Credit $550
1987 : Maximum Credit $851
Fig . 1 .
Earned Income Tax Credit Ranges .
$10,000
An Empirical Analysis of the Ellect of the Earned Income Tax Credit
7
between the EITC and an NIT (Alstott, 1994, p . 609 ; Cataldo, 1995, p. 59) . The NIT provides a guaranteed level of income, subsidizing individuals for the difference between their own incomes (which may be zero) and a minimum amount of income that is guaranteed to all individuals . The NIT subsidy decreases as the individual's own income increases . Thus, an NIT neither requires nor rewards work effort . In contrast, the EITC provides a wage subsidy as a percentage of earnings, which increases as taxpayers' earnings increase . The potential income effects and substitution effects associated with the NIT also apply to the EITC . However, analysis of the EITC cannot transfer directly from the NIT because the structure of the EITC is more complex . The EITC provides potential incentives as well as disincentives, due to the use of a phase-in range, plateau range, and phase-out range of income . The structure of the NIT utilizes only a phase-out range for determining the stipend . Thus, while it does not encourage participants to work, it may well discourage additional work for participants who are in the phase-out range . Prior studies on the effectiveness of the EITC in encouraging low-income individuals to work have produced disparate results . Simulation studies utilizing NIT estimates have supported the economic theory that taxpayers are discouraged from working in the plateau and phase-out ranges of the credit . On the other hand, empirical studies using household survey data have reported that potential beneficiaries of the credit increased their labor supply in comparison to potential non-beneficiaries . These studies are summarized in Tables 1 through 3 as follows . Simulation and empirical studies that have examined changes in hours worked are summarized in Table 1 . Simulation and modeling studies that analyzed changes in earnings are summarized in Table 2 . An empirical study that addressed changes in employment rates is summarized in Table 3 . The U .S . Department of Health and Human Services conducted four NIT experiments between 1968 and 1982 (Robins, 1985, pp . 567-568) . Some simulation studies of the effectiveness of the EITC utilized estimates from the largest and most comprehensive of the four experiments, sometimes referred to as the "Seattle/Denver" experiments, which were conducted between 1971 and 1977 . A treatment group received a guaranteed grant subject to a 50% or 70% phase-out based on income level . A control group received no grant (GAO, 1993) . Labor supply responses in terms of relative changes in hours worked by the treatment group are summarized in Panel A of Table 1, and indicate that husbands would reduce their hours worked by 12 .5%, wives by 23 .4%, and single heads of household by 20 .7% . The Government Accounting Office (1993) simulated the effects of the EITC on labor supply utilizing estimates of changes in hours worked by participants
8 Table 1 .
SUSAN B . ANDERS Summary of Labor Supply Responses : Changes in Hours Worked .
Panel A NIT experiments (GAO, 1993) GAO simulation (1993) Eissa and Liebman (1996) With children Without children Previously in workforce Eissa and Hoynes (1998) With 2 children With I child Without children Meyer and Rosenbaum (1999) With children Without children Panel B GAO simulation (1993)
Husbands -12 .5% -1 .5%
Wives -23.4% -6.5%
Single Head of Household -20 .7% -0 .3% +1 .9% None None
+0 .3% -0 .6% -1 .3%
-2.6% -0.1% +1 .7% +6 .0% -1 .0%
Phase-in +4.1%
Plateau -2 .6%
Phase-out -4 .3%
Overall -2 .1%
in the Seattle/Denver NIT experiments . Regression coefficient estimates of income and substitution effects from the NIT experiments were applied to estimate the labor supply response of low-income workers to the 1988 EITC . The results are summarized in Panel A of Table 1, and indicate that husbands would reduce their hours worked by 1 .5%, wives by 6.5%, and single heads of household by 20 .7% . If analyzed by income ranges of the EITC, as shown in Panel B of Table 1, hours worked increased 4 .1% in the phase-in range, but fell 2 .1% overall . Holtzblatt, McCubbin and Gillette (1994) also simulated the response of eligible workers to changes in the EITC in OBRA90 and OBRA93, using parameters estimated in the Seattle/Denver NIT experiments to determine the change in aggregate labor supply of eligible wage earners already in the workforce . In response to the changes in OBRA90, overall gross earnings fell by 1 .7%, and in response to OBRA93, overall earnings fell an additional 0 .7% . The effects on earnings by credit range are summarized in Table 2 . Browning (1995) modeled the effects of the EITC on labor supply with particular emphasis on the phase-out range . He estimated income and substitution effects at different levels of earnings, utilizing wage elasticities of labor supply and income elasticities from prior studies . Browning calculated that families in the upper end of the phase-out range would reduce earnings (and therefore labor supply) by 0 .73% .
9
An Empirical Analysis of the Effect of the Earned Income Tax Credit Table 2 .
Summary of Labor Supply Responses : Changes in Earnings . Phase-in
Holtzblatt et al. simulation (1994) OBRA90 OBRA93 Browning model (1995)
+1 .1% +1 .6%
Plateau
1 .6%
Phase-out
-2.0%
Overall
-L7% -0 .7%
0 .73%
Several recent studies have utilized data from the Current Population Survey (CPS), which is a monthly self-reported household survey conducted by the Bureau of the Census . The CPS data are collected by personal and telephone interviews of a recurring sample of 60,000 households . The studies utilizing CPS data analyzed changes in hours worked or employment rate, by populations that would potentially benefit from the credit, as an indication of the work incentive effects of the EITC . Eissa and Liebman (1996) utilized data from the March CPS to examine changes in the labor supply of single women with children, following the TRA86 expansions of the EITC . They compared the change in labor supply of single women with children, who were eligible for the EITC, to the change in labor supply of single women without children, who were not eligible for the EITC . They found that single women with children, who were not previously in the workforce, increased their labor force participation by 1 .9% . In contrast, they found no significant change in the number of hours worked by single women with children who were already in the workforce or by single women without children . Eissa and Hoynes (1998) utilized CPS data from 1985 to 1997 to compare labor supply responses of married couples with children and similar married couples without children, during a period of major expansions in the EITC . As summarized in Panel A of Table 1, they found that married men with children increased their labor supply (in terms of hours worked) relative to married men without children . In contrast, married women with children were more likely to decrease labor force participation . Meyer and Rosenbaum (1999) analyzed CPS data from 1985 to 1997 to examine the effect of several social programs (including EITC) on the labor supply of single mothers in comparison to single women without children . They estimated that the EITC was responsible for over 60% of the increase in employment rates of single mothers during the full 1984 to 1996 period . During the 1992 to 1996 period, however, the EITC explained only 37% of the increase in single mothers' employment rates .
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SUSAN B . ANDERS
Table 3.
Summary of Labor Supply Responses : Changes in Employment Rates .
Ellwood (2000)
First Quartile
Second Quartile
Third Quartile
Fourth Quartile
Median earnings (1998) Women with children Unmarried Married Women without children Unmarried/married
$11,0110°
$15,000h
$20,000,
$30,100`
+21% +5%
+13% +11%
+8% +8%
+4% +6%
-1%/-2%
Notes: (a) Similar to plateau range ; (b) Similar to phase-out range; (c) Beyond phase-out range .
Ellwood (2000) utilized CPS data from 1975 to 1999 to separate women into four equal skill/wage groups . As summarized in Table 3, the employment rates for both married and unmarried women with children increased between 1986 and 1999 in all four wage groups. The greatest increase in employment occurred in the first quartile for unmarried women and in the second quartile for married women . There was no growth in employment for married or unmarried women without children . The current study contributes to the analysis of the work incentive effects of the EITC by using data from actual tax returns and by examining income growth in the different income ranges of the credit, which are predicted to have different incentive/disincentive effects . Using tax return data focuses the issue on whether the people who did claim the credit, rather than those who may have been eligible, were better off . Additionally, widening the examination from single mothers to all actual claimants is important because of the purported "marriage penalty" effects on low-income married couples.
RESEARCH DESIGN This study utilizes empirical analysis of actual individual income tax return data to evaluate EITC participants' and comparable non-participants' wages (in constant dollars) over time for indications of statistically significant increases or decreases . The wages of participants and a comparable sample of nonparticipants also are compared cross-sectionally for evidence of a statistically significant difference between the two groups over time . Comparisons are made over different time windows to take into account the expansion of credit eligibility and the increasing number of claimants between 1979 and 1990 .
An Empirical Analysis of the Effect of the Earned Income Tax Credit
II
Economic theory predicts a potential work incentive in the phase-in range and a potential work disincentive in the phase-out range, which calls for separate analyses by each income classification . This study examines a potential association between income growth (or decline) and the theoretical incentives (or disincentives) of the EITC . As an archival study, cause and effect between the credit and growth (or decline) in income cannot be inferred, and no implication of a causal relationship is intended . However, the use of panel data in this study may provide for the control of some omitted confounding variables if they are constant over time . If the EITC is effective in accomplishing the congressional objective of inducing low-income individuals to earn wages (or self-employment income), the incomes of EITC claimants would increase over a period of time as they enter the work force and develop work skills and experience . "Income" can obviously be defined by many different variables, and combinations of variables, in the tax return data . As a practical matter, the income variables chosen must be important to the EITC concept of income . Wages are used in this study as a proxy for "income," as approximately 93% of EITC claimants reported wages on their tax returns . Wage income also represented approximately 93% of total EITC earnings (IRS, Statistics of Income, 1975-1994) . Self-employment income is also eligible earned income for purposes of calculating the EITC . Out of all EITC claimants, approximately 15% reported self-employment earnings, although the amount of self-employment income accounted for only 7% of total EITC earnings (IRS, Statistics of Income, 1975-1994) . Net self-employment income also is examined as a subsidiary aspect of this study, although in the interest of simplicity, the following discussion focuses on wage income .'
Method
Means tests and regression analysis are used to examine the possible effectiveness of the EITC in encouraging low-income individuals to work . Comparisons of wages (in constant dollars) are made for the same taxpayers between a base year and a later year . Wage growth (decline) is analyzed separately for participants and non-participants . The two groups are then compared for indications of statistically significant differences . The means for wages for the same EITC recipients and a comparable group of the same non-recipients are calculated for each tax year, adjusted for inflation to 1990 dollars, and analyzed for differences over time (between the base year and a later year) . The means are analyzed for differences over time
12
SUSAN B . ANDERS
Table 4. Tax Year 1979-1984 1985-1986 1987 1988 1989 1990
EITC Credit Ranges for 1979 through 1990 .
Credit Rate
Maximum Phase-in Income
Plateau Range
Phase-out Range
Phase-out Rate
10% 11% 14% 14% 14% 14%
$5,000 $5,000 $6,080 $6,240 $6,500 $6,810
$5,001-6,000 $5,001-6,500 $6,081-6,920 $6,241-9,840 $6,501-10,240 $6,811-10,730
$6,001-10,000 $6,501-11,000 $6,921-15,432 $9,841-18,576 $10,241-19,340 $10,731-20,264
12 .5% 12,22% 10% 10% 10% 10%
for all participants and all non-participants over the entire income range, and separately for each credit range group . The comparisons are made over nine different time windows to take into account the expansion of credit eligibility and the increasing number of claimants between 1979 and 1990 . The EITC credit ranges for 1979 through 1990 are detailed in Table 4 . The base years chosen are 1979, 1983, and 1987 . 1979 is the first year available in the data set and is the closest to 1975, the year of inception of the EITC . As the first year available . 1979 also provides the largest time span between a base year and a later year. 1983 was chosen as the second base year as it is approximately mid-way through the nine-year period during which the maximum credit was constant . This was also the period during which inflation was eroding the value of the EITC . The average credit was at its lowest point during the period of 1982 through 1984, as detailed in Appendix A . 1983 was chosen over 1982 or 1984 because of a reduction of the number of tax returns available in the data for 1982 and 1984, due to cost saving measures on the part of the Internal Revenue Service . 1987 was chosen for the third base year as the first major increase since the inception of the credit took effect in 1987 . The percentage of tax returns claiming the credit increased more than two percentage points from 1986, and the dollar value of the credit also increased . The credit was also indexed for inflation beginning in 1987 . The base years were linked to the next year following the base year and also to the later years of 1983, 1987, and 1990 . For example, the same 1979 taxpayers were linked to 1980, to 1983, to 1987, and to 1990 . The years 1983 and 1987 were chosen as later years for the same reasons discussed above, and also to provide for equal multiples of four-year periods . 1990 was chosen as the final base year as it is the last year available in the data set . The time windows are summarized in Table 5 .
An Empirical Analysis of the Effect of the Earned Income Tax Credit Table 5. Window
Time Period
1 2
1979 to 1980 1979 to 1983
3
1979 to 1987
4 5
1979 to 1990 1983 to 1984
6
1983 to 1987
7 8
1983 to 1990 1987 to 1988
9
1987 to 1990
13
Time Windows . Description
The first year available in this data set is 1979. The credit rate and income ranges were constant over this time period, although taxpayers were adversely affected by rising inflation. The first major increase in the credit and income ranges occurred in 1987, as indexing for inflation was incorporated. The last year currently available in this data set is 1990 . Base year 1983 is approximately midway between base year 1979 and the first major increase in the credit in 1987 . The credit rate and income ranges were moderately increased by the 1984 and 1986 tax acts, although probably not sufficiently to offset inflation . The last year currently available in this data set is 1990 . The first major increase in the credit and income ranges occurred in 1987, as indexing for inflation was incorporated. The credit and income ranges were steadily increased during this period . The last year currently available in this data set is 1990.
If the EITC is associated with work incentives, we would expect to find differential rates of growth in earnings over time of taxpayers who claim the credit and those who do not. This result would be expected whether the credit has a positive or negative association with work incentives . To analyze differences over time, the changes in incomes of EITC participants and non-participants are compared over the nine time windows using regression analyses . Data
The data set is selected from the IRS Panel of Individual Income Tax Returns provided by the University of Michigan Center for Tax Policy 6 The data are compiled by tax year and consist of actual individual income tax returns . They currently are available for 1979 through 1990 . The tax returns included in the IRS Panel of Individual Income Tax Returns were selected by a stratified random sample of tax returns filed each year to produce reliable estimates of the entire population of individual income tax returns (Slemrod, 1990) . Each year contains a subset of tax returns from a panel of taxpayers whose tax returns are included year after year, and therefore, can be followed through the study . The percentage of tax returns claiming the EITC in the IRS Panel of Individual
14
SUSAN B . ANDERS Table 6.
IRS Panel of Individual Income Tax Returns . Tax Reurns Claiming the EITC .
Tax Year
Number of Returns in Sample
Returns in Sample with EITC
Percentage of Sample with EITC
Percentage of All Returns with EITC
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990
45,141 46,214 46,670 9,235 19,120 9,762 20,202 10,120 21,191 21,656 22,352 22,683
3,480 3,460 3,242 595 1,234 554 1,270 590 1,714 2,153 2,348 2,500
7 .71% 7 .49% 6 .95% 6 .43% 6 .45% 5 .68% 6 .29% 5 .83% 8 .09% 9 .94% 10 .50% 11 .02%
7 .70% 7 .41% 7 .04% 6.71% 6.51% 5 .65% 6.38% 5 .99% 8 .23% 9 .96% 10.43% 11 .04%
Income Tax Returns for 1979 through 1990 is representative of the percentage of the total population of tax returns claiming the EITC in those years, and is summarized in Table 6 . The data set used for this study contains variables taken directly from tax returns, as well as some amounts calculated by the IRS . The data are ideal for examining many tax policy issues, particularly when the constructs under analysis can be operationalized with tax return information. The data set does not permit the analysis of demographic factors, however, nor does it include economic and sociological data, such as participation in welfare programs, that are not reported on individual tax returns . Sample Selection From the panel data, all tax returns with EITC were selected for the participant group in each year to be examined . Tax returns were deleted if the returns were filed for the wrong year (e.g . 1978 tax returns filed with 1979 tax returns) . In addition, tax returns where the taxpayers were over the age of 65, or were claimedd as dependents on another return (i .e . children under 18), were deleted since these individuals are not the focus of the incentive policies of the EITC . Tax returns with negative adjusted gross incomes were deleted to make the results more interpretable and to eliminate tax returns with investment losses in excess of earned income. In order to limit the analyses in this study to those
An Empirical Analysis of the Effect of the Earned Income Tar Credit
15
individuals who might appropriately be considered persistent "working poor," tax returns with changes in income of greater than plus or minus $20,000 were deleted from the samples for both the means tests and regression analyses . A non-participant group is used for comparison with EITC participants . The data set is as comparable as possible to the participant group, at least in terms of base year income levels (before EITC) and sources of income . The non-participant group was created by deleting, from the complete sample, those tax returns claiming the EITC . In addition to the adjustments mentioned in the prior paragraphs, tax returns with no earned income or with adjusted gross income in excess of the EITC ceiling were also deleted . Taxpayers who should have claimed the credit, but did not claim it, were properly included in the nonparticipant group, since they did not benefit from the credit .' Thus, the income patterns of the two groups are relatively similar, as portrayed in Fig . 2 . In order to increase the comparability of the participant and non-participant groups, both groups were further reduced by eliminating tax returns with interest income, dividend income, and capital gains or losses . Although low-income taxpayers may legitimately have investment income, Congress indicated its desire to limit EITC eligibility to taxpayers without significant investment income by placing a cap on interest income (in the years following the study period) . Taxpayers with itemized deductions were also deleted to reduce the samples to taxpayers in comparable standard deduction (zero bracket amount) positions .
$12,000 $10,000 $8,000 -
9
5
$6,000
-
$4,000
-
$2,000
-
79
Non-participants
80
81
82
83
84
85
86
87
Year Fig. 2 .
Average Base Year Wages in 1990 Dollars .
88
89
90
16
SUSAN B . ANDERS
Taxpayers who were employed in the base year, but who retired before or during the later comparison year, are outside the scope of policy incentives . These individuals experience a decrease in earned income that is not potentially influenced by EITC policy . In order to control for this situation, observations where the taxpayer is 65 or older in the later comparison year were deleted for both means tests and regression analyses . Another potential source of change in income that is outside the scope of the EITC is a change in marital (or filing) status . In the regression analyses, change in marital status is included as a control variable . For the means tests, observations where the taxpayer's marital (filing) status differed between the base year and the later comparison year were deleted to control for change in marital status . Table 7 details the final sample selection of participants for the means tests and regression analyses . Table 8 details the final sample of comparable non-participants . The EITC participant and non-participant groups were further separated into sub-groups based on the portion of the credit range into which their incomes fall in the base years . For example, in 1979, the phase-in group consists of those with incomes up to $5,000 . The plateau group consists of those with incomes between $5,001 and $6,000 . The phase-out group consists of those with incomes between $6,001 and $10,000 . The EITC credit ranges for 1979 through 1990 are detailed in Table 4 . Hypotheses The first hypothesis compares the mean wages for EITC participants in a base year to the mean wages for the same taxpayers in a later year . If the credit encourages additional work effort among participants, this should be evidenced by increased wages over time . The comparison is made through a paired t-test of the difference between the later year and base year . The first hypothesis (in the null form) is : HI : There is no difference in the means (in constant dollars) of EITC claimants' wages for a base year (e.g . 1979) and a later year (e .g . 1980) . Different results should be observed depending on whether taxpayers are in the phase-in, plateau, or phase-out ranges . Examining wage growth (or decline) in the separate ranges precludes the possibility of disincentives offsetting incentives in the overall picture . The second hypothesis compares the mean growth (or decline) in wages for EITC participants in the phase-in, plateau, and phase-out ranges, between the base year and a later year.
An Empirical Analysis of the Effect of the Earned Income Tax Credit 0
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SUSAN B . ANDERS
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An Empirical Analysis of the Effect of the Earned Income Tax Credit
19
H2 : There is no difference in the means (in constant dollars) of EITC claimants' wages between the base year and a later year for participants in the phase-in, plateau, and phase-out ranges . If the EITC provides an incentive or disincentive to eligible low-income workers, it should have no influence on the non-participants who did not benefit from the credit . A foundational test of non-participants is needed to provide a basic comparison . The third hypothesis also tests for differences in the change in means between the phase-in, plateau, and phase-out ranges . H3A : There is no difference in the means (in constant dollars) of nonparticipants' wages for a base year and a later year . H3B : There is no difference in the means (in constant dollars) of nonparticipants' wages between the base year and a later year for non-participants in the phase-in, plateau, and phase-out ranges . According to economic theory, we would expect to see more growth in wages for participants than non-participants in the phase-in range . We also might expect less growth for participants than non-participants in the phase-out range (and also potentially in the plateau range) . H4: There is no difference in the change in means of participants' and nonparticipants' wages in the phase-in, plateau, and phase-out ranges . If the EITC is associated with work incentives, we would expect to find differential rates of growth in earnings over time of taxpayers who claim the credit and those who do not . This result would be expected whether the credit has a positive or negative association with work incentives . To analyze differences over time, the incomes of EITC participants and non-participants are compared at fixed intervals over time. The fifth hypothesis is tested for differences in income growth over time using regression analysis . H5 : There is no difference over time in the wages of EITC participants and non-participants (in constant dollars) .
RESULTS Hypothesis One
The first hypothesis asks whether taxpayers who receive the EITC in the "base year" exhibit significant wage growth in subsequent years, as would be expected if the credit encourages recipients to work more hours . Consistent with
20
SUSAN B . ANDERS
expectations, participants' wage income increased significantly over all nine time windows . Statistically significant increases were exhibited by all three income groups (phase-in, plateau, and phase-out) in each time frame analyzed, as reported in Table 9 . These results are in contrast to prior simulation studies, which predict decreases in the plateau and phase-out ranges . Hypothesis Two The results reported in Table 9 also provide support for expected differences between the phase-in, plateau, and phase-out ranges . In the phase-in range of the EITC, the credit increases with wages, thus providing an incentive for participants to earn more . In the phase-out range, in contrast, the credit decreases with wages, reducing the marginal benefits of additional earnings . Accordingly, hypothesis two suggests that wage growth should be higher for EITC participants with base year incomes in the phase-in range relative to their counterparts with base year incomes in the phase-out range . Similarly, wage growth should be higher for participants in the phase-in range than in the plateau range, where the credit is unaffected by additional compensation . As indicated in Table 9, the results are consistent with expectations . For all time periods studied, wage growth was significantly higher for EITC participants in the phase-in range than for those in either of the other income groups . No significant differences were observed between the plateau and phase-out income groups . Hypothesis Three While the results to this point imply that the EITC may have a positive impact on the work effort of participants, analysis of the results for hypothesis three gives cause to question this conclusion . The null hypothesis that nonparticipants' wages would not reflect growth over time is rejected . In contrast to prior studies, non-participants' wage income increased significantly over all nine time windows . The null hypothesis that non-participants' wages would not reflect differences in growth between the phase-in, plateau, and phase-out ranges is also rejected . For all time periods studied, wage growth was higher for non-participants in the phase-in group than for those in the plateau and phase-out groups . As indicated in Table 10, the same growth patterns seen for participants are exhibited by non-participants with comparable base year levels of income . In contrast to participants, wage growth for non-participants in the plateau range was significantly higher than for those in the phase-out range . This may
21
An Empirical Analysis of the Effect of the Earned Income Tax Credit
Table 9. Hl : Wages (Yr 1) = Later Year
Participants' Results . All Groups
Phase-in
Plateau
Phase-out
1979 to 1980: Sample size 2,030 Mean change in wages $758* 112 : Phase-in = Plateau and Phase-in=Phase-out
626 $1,876*
263 $620** *(l)
1,141 $177 n.s . *(2)
1979 to 1983 : Sample size 636 Mean change in wages $2,200* H2 : Phase-in =Plateau and Phase-in = Phase-out
189 $3,611*
76 $1,746**
374 $1,575* *(2)
503 1979 to 1987 : Sample size Mean change in wages $3,276* 112 : Phase-in = Plateau and Phase-in = Phase-out
**(1) 151
55
297
$4,464*
$2,312** ***(1)
$2,850**(2)
1979 to 1990: Sample size 445 Mean change in wages $3,498* H2 : Phase-in = Plateau and Phase-in = Phase-out
137 $4,683*
51 $2,084** **(1)
257 $3,146* **(2)
1983 to 1984 : Sample size 307 Mean change in wages $1,762* 112- Phase-in = Plateau and Phase-in = Phase-out
110 $3,365*
35 $954 n .s . *(1)
162 $849** *(2)
1983 to 1987 : Sample size 479 Mean change in wages $3,837* 112 : Phase-in =Plateau and Phase-in = Phase-out
168 $5,054*
51 $3,211* **(1)
260 $3,174* *(2)
1983 to 1990 : Sample size 400 Mean change in wages $4,022* 112 : Phase-in = Plateau and Phase-in = Phase-out
131 $5,581*
45 $4,584* n .s .(1)
224 $2,999* *(2)
1987 to 1988: Sample size Mean change in wages
247 $2,445*
54 $L953* n .s . (I)
626 $595* *(2)
200 $4,062*
51 $1,856** **(1)
517 $1,209* *(2)
927 $1,167*
112 : Phase-in = Plateau and Phase-in = Phase-out 1987 to 1990 : Sample size 768 Mean change in wages $1,995* H2 : Phase-in = Plateau and Phase-in = Phase-out
Notes : *p<0 .01, **p<0 .05, ***p<0 .10, n .s . = not significant (1) Phase-in compared to plateau (2) Phase-in compared to phase-out
be a result of the larger sample size of non-participants than participants . The greater income growth for non-participants in the plateau range versus the phase-out range appears to be reflected in the means tests between participants and non-participants, but not in the regression analysis .
22
SUSAN B . ANDERS Table 10.
H3A :
Wages (Yr 1) = Later Year
Non-participants' Results . All Groups
Phase-in
Plateau
Phase-out
1979 to 1980 : Sample size 6,878 Mean change in wages $1,338* H3B: Phase-in = Plateau and Phase-in = Phase-out
4,022
657
$2,145*
$677*
1979 to 1983 : Sample size 1,781 Mean change in wages $3,467 H3B: Phase-in = Plateau and Phase-in = Phase-out
1,085
162
534
$5,085*
$2,035*
$613**
*(1)
*(2)
1979 to 1987 : Sample size 1,168 Mean change in wages $5,444* H3B: Phase-in = Plateau and Phase-in = Phase-out
688
ill
369
$7,095*
$4,596*
$2,622*
*(1)
*(2)
1979 to 1990 : Sample size 989 $5,200* Mean change in wages H3B: Phase-in = Plateau and Phase-in = Phase-out
556
97
336
$7,060*
$4,420*
$2,349*
*(1)
*(2)
to 1984 : Sample size 964 Mean change in wages $2,536* H3B: Phase-in = Plateau and Phase-in = Phase-out
574
90
300
$3,366*
$2,242*
$1,038*
**(1)
*(2)
1,366 1983 to 1987 : Sample size $5,411* Mean change in wages H3B : Phase-in = Plateau and Phase-in = Phase-out
854
113
399
$6,347*
$5,238*
$3,455*
**(1)
*(2)
1,008 1983 to 1990 : Sample size $5,907* Mean change in wages H3B: Phase-in = Plateau and Phase-in = Phase-out
599
91
318
$7,333*
$5,024*
$3,475*
*(1)
*(2)
1,846 1987 to 1988 : Sample size $1,525* Mean change in wages H3B: Phase-in = Plateau and Phase-in = Phase-out
694
130
1,022
$2,556*
$2,011*
$762*
n .s . (1)
*(2)
1,471 1987 to 1990 : Sample size $2,810* Mean change in wages H3B : Phase-in = Plateau and Phase-in = Phase-out
566
101
804
$4,699*
$3,463*
$1,397*
**(1)
*(2)
1983
Notes :
* p < 0.01, ** p < 0 .05, ***p < 0 .10,
*(1)
2,199 $58
n .s .
*(2)
n .s . = not significant
(1) Phase-in compared to plateau (2) Phase-in compared to phase-out
Hypothesis Four A stronger test of the relationship between the EITC and participants' work efforts is provided by comparison of the rates of wage growth of participants
An Empirical Analysis of the Effect of the Earned Income Tax Credit
23
versus non-participants with comparable base year income . Overall wage growth was significantly higher for non-participants in all nine time windows . This may be a result of the larger sample size of non-participants than participants . However, an analysis by the separate income groups (phase-in, plateau, and phase-out) reflects a general lack of significant differences in the directions predicted by theory . Thus, the null hypothesis that participants' and nonparticipants' wage growth is not significantly different is not rejected . As summarized in Table 11, these results suggest that the EITC appears to have had no measurable impact on work efforts, at least in the intended directions . Indeed, wage growth during this period was higher for taxpayers in the phase-in group who did not claim the credit than for those who did . The higher wage growth for non-participants in the phase-in and plateau ranges generally occurs in the time windows during which the credit was stagnant and being eroded by inflation . For the time windows beginning in 1987, after the major increase in the credit post-1986, non-participant wage growth was still higher, but not statistically different from participants . Wage growth was higher for participants than non-participants in the phase-out range for the time windows with 1979 as the base year, although only 1979 to 1983 was significant. For the time windows beginning in 1983 and 1987, wage growth for participants and non-participants in the phase-out range are not statistically distinguishable . Analysis of variance results are similar to the t-tests results and are not reported . These results are in marked contrast to those reported by studies utilizing CPS data (see Table 1), which report increases in the employment measures for potential EITC beneficiaries, but not for non-beneficiaries . In the current study, the importance of a separate analysis by income group can be seen in a lack of significant differences between participants and non-participants, with comparable base year wages, for many time windows . Where statistically significant differences do appear, they do not necessarily work in the directions predicted by economic theory . One reason may be slightly lower base year wages (in the phase-in range) reported by non-participants, revealed by descriptive analysis, providing them with greater growth potential . Alternatively, the results may reflect differences in family circumstances ; during the study period, EITC participants had children while nonparticipants did not . As a result, non-participants potentially may have more flexibility in working more hours to increase their earnings . Additionally, the stagnant income ranges in the years through 1986 (see Table 4) may have created disincentives, or may have forced former participants into the non-participant category if their wages increased even moderately to keep up with inflation .
24
SUSAN B . ANDERS Table 11 .
114: Participants' Change in Wages = Non-participants'
Change in Wages .
All Groups
Growth in Wages Plateau Phase-in
Phase-out
1979 to 1980 : Participants Non-participants Difference
$758 $1,337 *
$1,876 $2,147 n.s .
$620 $677 n .s .
$177 $58 n .s .
1979 to 1983 : Participants Non-participants Difference
$2,200 $3,467 *
$3,610 $5,085 *
$1,746 $2,035 n .s .
$1,575 $613 **
1979 to 1987 : Participants Non-participants Difference
$3,276 $5,444 *
$4,465 $7,095 *
$2,312 $4,596 ***
$2,849 $2,622 n .s .
1979 to 1990 Participants Non-participants Difference
$3,498 $5,200 *
$4,683 $7,060 *
$2,084 $4,420 ***
$3,146 $2,348 n .s .
1983 to 1984 : Participants Non-participants Difference
$1,762 $2,536 **
$3,365 $3,366 n.s.
$954 $2,242 n .s .
$849 $1,037 n .s .
1983 to 1987 : Participants Non-participants Difference
$3,837 $5,411 *
$5,054 $6,347 **
$3,211 $5,238 ***
$3,174 $3,455 n .s .
1983 to 1990 : Participants Non-participants Difference
$4,023 $5,907 *
$5,581 $7,333 *
$4,584 $5,024 n .s .
$2,999 $3,475 n .s .
1987 to 1988 : Participants Non-participants Difference
$1,167 $1,525 ***
$2,445 $2,556 n .s .
$1,954 $2,011 n .s .
$595 $762 n .s .
1987 to 1990 : Participants Non-participants Difference
$1,995 $2,810 **
$4,062 $4,699 n .s .
$1,856 $3,463 u .s .
$1,208 $1,397 n .s .
Notes: * p < 0.01, **p < 0 .05, ***p < 0.10, n .s .=not significant ; where participants' mean
compared to non-participant mean .
An Empirical Analysis of the Effect of the Earned Income Tax Credit
25
Hypothesis Five Regression analysis is used to test the fifth hypothesis, which posits that EITC participants will exhibit greater wage growth over time than non-participants . The regression model takes the following form in order to control for variables known to impact earnings potential : WAGES,
-WAGES a+(3 I WAGES,+(32 M1+(3 3 M2+
R, M3 + (35 ADEP + (3 6 EITC, + (3,WAGES * EITC, + where : t=base year (e .g . 1979), t+n = test year (e .g . 1980), Ml =change in marital (filing) status from married to single (not married), M2 = change in marital (filing) status from single (not married) to married, M3 = marital (filing) status is single (not married) in both years, XDEP=change in number of dependent children, and EITC, = categorical (0,1) variable representing participation in the EITC program in the base year . Separate regression models are estimated for the phase-in, plateau, and phase-out income groups . In this model, change in wages is stipulated to be a function of beginning wages, change in marital status (if any), change in the number of dependents, and participation in the EITC program . The intercept represents change in wages for non-participants after controlling for these factors . The model controls for differences in the beginning wage level, since that variable proxies both for beginning labor market skills and the potential for wage growth . As such, the coefficient on (3, represents rate of growth . Change in marital status is expected to be positively correlated with wage growth . Taxpayers getting married generally should exhibit positive wage growth after combining two spouses' earnings . In contrast, divorce would be expected to reduce wage growth for most taxpayers . Similarly, an increase in the number of dependents would be expected to decrease wage growth for single parents, as the flexibility to work additional hours conflicts with additional child care commitments . It may decrease growth for married taxpayers, as well, if one spouse curtails labor force participation to stay at home and care for the additional children . The primary focus of the model is the EITC variable, which represents the greater or lesser wage growth for participants . The model also includes an
26
SUSAN B . ANDERS
interaction term to capture any interaction between EITC participation and base year wages, which represents the marginal rate of growth for participants . Coefficients on both variables are expected to be positive and significant if the credit is associated with a higher rate of growth in earnings for EITC participants . Table 12 summarizes the estimates from the regression model for growth in income over time . For growth in wages, the coefficient for claiming the EITC in the base year of the comparison shows indications of statistical significance for the 1979 to 1987, 1983 to 1987, and 1983 to 1990 time windows, for the phase-in group . In correspondence to the means test for hypothesis four, the wage growth was higher (in the phase-in range) for non-participants versus participants, which is opposite to the direction predicted by theory . Wage growth for participants in the phase-in range does not exceed that for non-participants until the 1979 to 1990 and 1987 to 1990 time windows ; however, the EITC coefficients are not statistically significant . For most of the phase-in range time windows, the combined dummy and interaction terms reflect a net reduction in the marginal rate of wage growth in comparison to non-participants . This corresponds with the t-tests under hypothesis four and may be reflective of the high inflation in the general economy that occurred during the 1980s before the credit rate and income ranges were adjusted for inflation . However, the rate coefficient is only significant for the 1987 to 1990 phase-in range . The comparison of wage growth between participants and non-participants in the plateau range indicates, in contrast to the means tests in hypothesis four, no significant differences in any of the time windows . Analysis of the phase-out range reveals that wage growth was lower for participants than for non-participants, as predicted by theory, in the 1979 to 1990 time window ; however, the difference is not significant . The only time windows with significant differences for the 1983 base year are 1983 to 1984 and 1983 to 1990 . For the two time windows for the 1987 base year, that occur entirely after the major increases in the credit in 1986, the negative EITC coefficient is not significant. In the overview, the regression analyses seems to reflect potential disincentives of the EITC in the phase-in range, contrary to the predictions of economic theory, for the time windows beginning in 1983 and linked to 1987 and 1990 . The differences in wage growth in the plateau range are not significant . The differences in the phase-out range are only significant for the 1983 base years . The base years beginning in 1979 and 1987 generally do not reflect significant differences . Thus, the null hypothesis that participants' and non-participants' wage growth is not significantly different over time is not rejected .
An Empirical Analysis
of the
P
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27
Effect of the Earned Income Tax Credit
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28
SUSAN B . ANDERS
The existence of a potential disincentive appears to be most evident for the time windows beginning in 1983 . The significant differences in wage growth between participants and non-participants are not reflected in the 1987 base year analyses . This could be the result of many different factors, but it is possible that the post-1986 increases in the credit produced a small "incentive" that served to offset the disincentives that appeared in the 1983 base year time windows . An alternative no-intercept model was developed utilizing six dummy variables to separately represent participants and non-participants in each of the income ranges . The six dummy variables, representing amount of wage growth, generally were significant for each of the time windows . Tests of linear combinations of coefficients, comparing participants and non-participants, were significant at the p = 0 .10 level only for exactly the same time windows and income ranges discussed above . The results are similar to the simpler model discussed above, and are therefore not presented . Self-Employment Income All of the analyses performed on the wage variable were duplicated for net self-employment income . Earnings from self-employment would seem to offer the greatest potential for manipulation . Taxpayers could be influenced by two contrasting objectives : (1) maximize self-employment income reported in order to maximize the EITC, versus; (2) minimize self-employment income in order to minimize self-employment and income tax liabilities . The current study does not provide any substantive insights into selfemployment income . Overall, the net increases or decreases in self-employment income were fairly small in dollar amounts . Most comparisons were not statistically significant on either the complete sample, or on a sample reduced to only those tax returns with self-employment income . Selected results are presented in Appendix B . The regression analysis does indicate a potential disincentive in the phase-out range of the credit for the 1987 to 1988 and 1987 to 1990 time windows, following the major increase in the credit . Further examination of self-employment income is a topic for future research. A different approach may be required to analyze self-employment income . Limitations The tax return data do not include economic and sociological data that are not reported on individual tax returns . The data set does not permit the analysis of
An Empirical Analysis of the Effect of the Earned Income Tax Credit
29
demographic factors, such as geographical variations in demand for workers, the locality, and the health of the worker, which may influence income. These factors may have been randomized out to the extent that growth in income varies across the sample of tax returns . Subdivisions of the sample into credit range groups also may provide a surrogate approach to addressing differences between unskilled and skilled workers, as well as between new workers and those who already have been in the workforce . Another potentially important omitted variable that is not available in the tax return data is the potential receipt of transfer payments . Eligibility for transfer payments decreases as the taxpayer's earned income increases, which could provide a disincentive to work . As mentioned above, the receipt of an EITC refund is no longer counted in a welfare recipient's earned income, which may mitigate some of the conflict between working and eligibility for transfer benefits . Great care has been taken to create a non-participant group from the data set that is as comparable as possible to the participant group, at least in terms of base year income levels . However, some dissimilarities probably still exist between the two groups that are in some part responsible for differences in income growth . Divergence may exist between the two groups regarding stage of the working life cycle, education, receipt of transfer payments, and earning potential . These demographic factors are not available on archival tax return data and therefore cannot be analyzed from this data set . Based on descriptive statistics, non-participants, as a group, appear to be similar to participants, as a group ; however, they are not individually matched by common characteristics, which could affect the results . The differences in sample sizes between the participants and non-participants also may affect the analyses . Finally, the results of this study are only potentially generalizable for the taxpayers included in the samples - specifically, those without interest income, dividend income, capital gains and losses, or itemized deductions . Utilizing different sample selection criteria may generate different results from those reported in the current study .
FUTURE RESEARCH The results of the current study, including those that run contrary to theory and prior research, demonstrate the need for future research into issues raised by the debate surrounding the EITC . An examination of whether participants remain in their original income ranges, migrate out of the phase-in and plateau ranges into the phase-out range, or migrate back and forth, would provide greater insight into the behaviors and circumstances of low-income individuals, and
30
SUSAN B . ANDERS
could have potential tax policy implications . The construction of the samples may impact the results of any analysis of the EITC . Future research could attempt a more exact matching of the treatment and control groups by pairing individual taxpayers based on characteristics such as state of residence, the presence of interest, dividend, or capital gain income, and the use of the standard deduction or itemization . Further research also could address self-employment income by comparing taxpayers with self-employment income only to those with wages or wages and self-employment income . Finally, participants and non-participants could be individually matched .
SUMMARY AND CONCLUSIONS The purpose of this study is to examine the effectiveness of the earned income tax credit (EITC) in meeting Congress' objective of increasing the participation of low-income taxpayers in the workforce through the use of an economic incentive . Although the credit is intended to provide an incentive for low-income taxpayers to work, some theoretical literature suggests that the credit may actually reduce work incentives, because in the "phase-out" range taxpayers lose a percentage of the credit for each additional dollar earned . Recent empirical studies utilizing household survey data have concluded that increases in employment rates or hours worked by individuals eligible for the credit indicate positive work incentive effects . The current study uses individual tax return data to compare the changes in wages over time for taxpayers who actually claimed the EITC (participants) and taxpayers who did not (non-participants) . Prior empirical studies have found increases in their labor measurement for potential beneficiaries only . This study reveals that incomes for both groups are found to have increased significantly over the selected time windows during the 1979 to 1990 time period . Income growth for both participants and non-participants was also greater in the phase-in range than in the phase-out range . The potential existence of significant differences in income growth between participants and non-participants is only indicated for the time period of the mid-1980s, before the major increase in the credit post-1986 . The current study estimates a potential disincentive in the phase-in range for that time period, which is contrary to theory. However, after the post-1986 increase in the credit, the differences between the participants and non-participants are no longer statistically significant . Theoretical literature suggests a disincentive effect in the phase-out range of the credit, which is only borne out by the regression analysis of this study for the mid-1980s time period . The differences in income growth between
An Empirical Analysis of the Effect of the Earned Income Tax Credit
31
participants and non-participants in the phase-out range generally are not statistically significant in the means tests, and in the regression analysis after the post-1986 credit increase . In contrast to previous simulation studies which estimate reductions in hours worked or in earnings in the plateau and phase-out ranges, an association of the credit with a disincentive in the phase-out range after 1986 cannot be inferred from this study . In summary, income growth patterns for taxpayers who claimed the EITC and those who did not were very similar for 1979 through 1990, which could indicate that the EITC did not have significant incentive or disincentive effects during that period . A potential disincentive appears in both the phase-in and phase-out ranges, contrary to theory, in the mid-1980s . After major increases in the credit in 1986, there are no longer significant differences between taxpayers who claimed the credit and those who did not . This could be the result of many different factors, but it is possible that the post-1986 increases in the credit produced a small "incentive" that served to offset the disincentives that appeared prior to 1987 .
NOTES 1. Family support programs include Temporary Assistance for Needy Families, Family Support, Emergency Assistance, Child Care Entitlements to States, Children's Research and Technical Assistance, and Child Support Enforcement . 2 . Specifically, the Personal Responsibility and Work Opportunity Reconciliation Act (PRWORA) of 1996 replaced Aid to Families with Dependent Children (AFDC) with Temporary Assistance to Needy Families (TANF) . 3 . Under complex eligibility requirements, mothers with children may or may not have been eligible for the EITC . 4 . This study does not address the interaction of the EITC and the "marriage penalty," but instead refers the reader to Counts and White (1999) and Lav (1999) . Liebman (2000) discusses EITC compliance problems, which are generally due to the complexity of filing status and eligible child requirements . Many low-income taxpayers who were ineligible pre-1990 would have met the liberalized post-1990 requirements . 5 . All analyses performed on wages are also performed on self-employment income . Overall, the results for self-employment earnings generally do not reflect statistically significant differences, or any discemable pattern . The statistically significant results are included in Appendix B . The remainder of the paper will focus on wage income, with the caveat that self-employment income warrants further study . 6 . This data source is also referred to as the IRS Statistics of Income (SOI) Panel of Individual Returns . 7 . The number of tax returns was reduced after 1981 due to budget constraints . 8 . The participation rate in the EITC has been high relative to other low-income programs (Scholz, 1990, p . 5) . Using private data compiled by the Census Bureau matched with Survey of Income and Program Participation data, Scholz (1994, pp . 64-65) estimates that the participation rate in 1990 was 80 to 86% . Scholz (1994, p . 79) finds
32
SUSAN B . ANDERS
that non-participation by eligible individuals is correlated with those who are entitled to a smaller credit, have higher self-employment income, live in states without income taxes, work as household employees, and have higher levels of education . Non-participation does not appear to be correlated with lack of knowledge about ETT C .
ACKNOWLEDGMENTS This paper
is
based on the author's dissertation at Texas Tech University . The
author wishes to thank her dissertation chairperson, Robert Ricketts, and committee members : Ronald Bremer, Mary Sue Gately, and Thomas Steinmeier . The author also would like to thank Carol Fischer, David Hulse, members
of
the St . Bonaventure University research colloquiums, the editor, and two
anonymous reviewers .
REFERENCES Alstott, A . L . (1994) . The Earned Income Tax Credit and Some Fundamental Institutional Dilemmas of Tax-Transfer Integration . National Tax Journal, 47(September), 609-619 . Browning, E . K . (1995) . Effects of the Earned Income Tax Credit on Income and Welfare . National Tax Journal, 48(March), 23-43 . Cataldo, A . J . II. (1995). The Earned Income Credit: Historical Predecessors and Contemporary Evolution. Accounting Historians Journal, 22(June), 57-79 . Congressional Budget Office (CBO) . (2000) . Federal Spending on the Elderly and Children (Other Documents) . http ://www .cbo.go v Counts, R. W ., & White, C . G . (1999) . Accounting Professors Look at Marriage Penalty `Fix' and Lower Income Families . Tax Notes (May 17), 1063-1070 . Eissa, N ., & Liebman, J . B . (1996). Labor Supply Response to the Earned Income Tax Credit . Quarterly Journal of Economics, 91(May), 605-637 . Eissa, N., & Hoynes, H . W . (1998) . The Earned Income Credit and the Labor Supply of Married Couples . National Bureau of Economic Research, Working Paper 6856 . Ellwood, D. T . (2000). The Impact of the Earned Income Tax Credit and Social Policy Reforms on Work, Marriage, and Living Arrangements . National Tax Journal, 53(December), 1063-1105 . Gish, M . (2001). The Earned Income Tax Credit: Current Issues and Benefit Amounts . Congressional Research Service Report to Congress (2001ARD 112-3), May 13, 2001 . Holtzblatt, J ., McCubbin, J ., & Gillette, R . (1994). Promoting Work Through the EITC . National Tax Journal, 47 (September), 591-607 . Joint Committee on Taxation (JCT) . (1995) . A Staff Description of Present Law and Issues Relating to Earned Income Tax Credit (JCX-27-95), June 14, 1995 . Lav, I . J . (1999) . Extending Marriage Penalty Relief to Working Poor and Near Poor Families . Center on Budget Policy and Priorities (June 10). http .://www, cbpr.org Liebman, J . B . (2000). Who Are the Ineligible EITC Recipients? National Tax Journal, 53 (December), 1165-1185 . Meyer, B . D ., & Rosenbaum, D . T. (1999) . Welfare, the Earned Income Tax Credit, and the Labor Supply of Single Mothers . National Bureau of Economic Research, Working Paper 7363 .
An Empirical Analysis of the Effect
of the
Earned Income Tax Credit
33
Pechman, J . (1987) . Federal Tax Policy . Washington, D .C . : The Brookings Institution . Robins, P . K. (1985) . A Comparison of the Labor Supply Findings from the Four Negative Income Tax Experiments. The Journal of Human Resources, 20(4), 567-582. Scholz, J. K . (1990). The Participation Rate of the Earned Income Tax Credit . Institute for Research on Poverty Discussion Paper No. 928-90, 1-33 . Scholz, J . K . (1994) . The Earned Income Tax Credit : Participation, Compliance, and Anti-poverty Effectiveness . National Tax Journal, 47(March), 63-87 . Slemrod, J. (1990) . Notes on the 1979-1986 panel of individual income tax returns . Mimeo (July 18) . U .S . General Accounting Office (GAO) . (1993) . Earned Income Tax Credit : Design and Administration Could Be Improved . (GAO/GGD-93-145), Washington, D .C . U .S . Internal Revenue Service (IRS) . (1975-1996) . Statistics of Income, Individual Income Tax Returns. Washington, D .C . : Government Printing Office.
APPENDIX A: HISTORICAL DATA Tax Year
Total No . of Returns
Number with EITC
Percentage with ETTC
Total$EITC (thousands)
Average Avg . Credit Min . Wage Credit (2000 $) (2000 $)
82,229,332 1975 1976 84,670,389 1977 86,634,640 1978 89,771,551 1979 92,694,302 1980 93,902,469 1981 95,396,123 1982 95,337,432 96,321,310 1983 1984 99,438,708 1985 101,660,287 1986 103,045,170 1987 106,996,270 1988 109,708,280 1989 112,135,673 1990 113,717,138 1991 114,730,123 1992 113,604,503 1993 114,601,819 1994 115,943,131 1995 118,218,327 1996 120,351,208 1997 122,421,991 1998 124,770,662
6,214,533 6,472,633 5,626,938 5,191,834 7,134,756 6,953,621 6,717,177 6,395,032 6,274,532 5,615,085 6,483,291 6,180,259 8,801,288 10,925,590 11,695,876 12,554,681 13 .664,555 14,096,575 15,117,389 19,017,357 19,334,397 19,463,836 19,391,179 19,704,707
7 .56% 7.64% 6.50% 5 .78% 7 .70% 7 .41% 7 .04% 6.71% 6.51% 5 .65% 6 .38% 5 .99% 8.23% 9.96% 10 .43% 11 .04% 11 .91% 12.41% 13 .19% 16 .40% 16 .35% 16.17% 15 .84% 15 .79%
$1,249,962 $1,294,830 $1,126,555 $1,048,303 $2,051,945 $1,985,996 $1,911,632 $1,775,339 $1,793,766 $1,635,644 $2,087,655 $2,007,050 $3,930,528 $5,896,447 $6,595,387 $7,542,230 $11,104,993 $13,027,917 $15,536,762 $21,105,158 $25,995,575 $28,825,258 $30,388,532 $31,591,789
$201 $200 $200 $202 $288 $286 $285 $278 $286 $291 $322 $324 $446 $540 $564 $600 $813 $924 $1,028 $1,110 $1,345 $1,481 $1,567 $1,603
Adapted from Internal Revenue Service Statistics of Income . Relative value of minimum wage data is from Bureau of Labor Statistics .
$643 $605 $568 $534 $683 $598 $540 $496 $494 $482 $515 $509 $676 $786 $783 $79t $1,028 $1,134 $1,225 $1,290 $1,520 $1,625 $1,681 $1,720
$6 .72 $6.96 $6.54 $7.00 $6.88 $6 .48 $6.35 $5 .98 $5 .79 $5 .55 $5 .36 $5 .26 $5 .08 $4.88 $4.65 $5 .01 $5 .37 $5 .22 $5 .06 $4.94 $4 .80 $5 .21 $5 .53 $5.44
34
SUSAN B . ANDERS
APPENDIX B : ANALYSIS OF SELF-EMPLOYMENT INCOME Table Bl .
H4 : Participants' Change in Self-Employment Earnings = Non-participants' Change
All Groups
Growth in Self-Employment Earnings Phase-in Plateau Phase-out
1979 to 1983 : Participants Non-participants Difference
($43) $124 **
($64) $90 n .s .
$312 ($88) n .s .
$102 $257 **
1979 to 1990 : Participants Non-participants Difference
($69) $308 **
($144) $402 **
($202) ($60) n .s .
($3) $258 n.s.
Notes. * p < 0 .01, ** p < 0.05, *** p < 0.10, n.s. = not significant ; where participants' mean
compared to non-participants' mean .
See also Table B2 on next page .
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35
THE EXPANDED TAXPAYER CONFIDENTIALITY PRIVILEGE : A REVIEW AND ASSESSMENT OF IRC SECTION 7525 Christine C . Bauman and Anna C . Fowler
ABSTRACT For taxpayer communications made after July 21, 1998, IRC Section 7525 extends a confidentiality privilege to tax advice furnished in non-criminal proceedings by certified public accountants and other federally authorized tax practitioners to the extent such communication would be privileged if it took place between a taxpayer and an attorney . However, subsequent to the enactment of the statute, concerns have been raised about the scope and usefulness of the accountant-client privilege . This article presents an examination of the historical development, statutory provisions, and limitations of IRC Section 7525 . It also evaluates, through the use of survey responses, the impact of the privilege on the accounting profession . This study is valuable because it is one of the first to examine the confidentiality privilege by using feedback (via a survey) from the accounting profession .
Advances in Taxation, Volume 14, pages 37-64 . Copyright O 2002 by Elsevier Science Ltd . All rights of reproduction in any form reserved . ISBN : 0-7623-0889-3 37
38
CHRISTINE C . BAUMAN AND ANNA C . FOWLER
INTRODUCTION The Internal Revenue Service (IRS) Restructuring and Reform Act of 1998 (RRA, 1998) added IRC Section 7525 (Confidentiality Privilege) to provide uniform confidentiality protection to all taxpayers, regardless of the professional affiliation of their tax advisor .' This section creates a new taxpayer confidentiality privilege for communications with "federally authorized tax practitioners (FATPs)" - certified public accountants (CPAs), attorneys, enrolled agents, and enrolled actuaries - with respect to the rendering of tax advice . In essence, the Confidentiality Privilege extends the common law attorney-client privilege to CPAs and other FATPs, but only with respect to tax advice . Subsequent to the enactment of the Confidentiality Privilege, concerns have been raised about the scope and usefulness of the privilege . The purpose of this study is to examine the historical development and statutory provisions of IRC Section 7525 and to assess, through the use of survey responses, the impact of the Confidentiality Privilege on the accounting profession . This study is valuable because it is one of the first to examine how the Confidentiality Privilege has affected practice by using feedback (via a survey) from accounting practitioners . Gaining feedback is especially relevant because of the importance to the AICPA of this statutory change . The first section of the article provides background information on the Confidentiality Privilege . The next section contains a description of the attorneyclient privilege, an understanding of which is essential for comprehending the Confidentiality Privilege . The third section contains a discussion of the implications for the accounting profession . The fourth section provides an overview of other implications of the Privilege . The next section of the article contains a presentation of the results of a survey conducted to assess the impact of the Confidentiality Privilege on the accounting profession and to learn about practitioners' experiences with the Privilege . The final section offers conclusions .
BACKGROUND Historical Development Prior to the 1998 legislation, Federal confidentiality protection did not exist for tax communications between accountants and their clients . Two Supreme Court cases addressed this issue . In Couch v . United States, 409 U .S . 322 (1973), the Supreme Court held that an accountant-client privilege is not recognized by Federal law. In United States v . Arthur Young & Co., 465 U.S . 805 (1984), the
The Expanded Taxpayer Confidentiality Privilege
39
Court reversed the Second Circuit's conclusion that the work-product privilege prevented the IRS from obtaining a CPA's tax accrual workpapers . The Court refused to extend confidentiality protections, citing principally the differences in the roles legal counsel and auditors play . It also concluded that in light of
Couch, the Second Circuit's creation of a work-product privilege was misplaced . Subsequent to the Arthur Young & Co . decision, the AICPA helped form a coalition that sponsored legislation to create an accountant-client privilege in tax matters before the IRS . The AICPA wanted to "level the playing field" so taxpayers would be able to engage an accountant to represent them in tax planning and before the IRS with the same expectation of confidentiality as taxpayers that hire a lawyer to provide tax services . The AICPA argued that small taxpayers and small businesses (as well as large taxpayers) might find it duplicative, expensive, and time consuming to engage lawyers solely to gain protection for their communications (Friedman & Mendelson, 1996) . In a 1999 interview, attorney Pamela F . Olson concurred that the Confidentiality Privilege evolved from the AICPA's lobbying efforts subsequent to the Arthur Young & Co . decision (August, 1999) . She further stated that after the Arthur Young & Co . case, the IRS declined to grant accountants an administrative privilege similar to the attorney-client privilege . The IRS agreed, however, to request accountants' tax accrual workpapers only in "unusual circumstances" in which the examining agent obtained approval from the Chief of the IRS's Examination Division . As a result of disparate treatment of lawyers and CPAs with respect to communications, the AICPA sought legislative remedies . According to Mendelson et al . (1998), because most taxpayers are represented before the IRS by CPAs and enrolled agents, "taxpayer privacy interests dictated a need for CPAs and their clients to seek confidential protection similar to the attorney-client privilege ." The rules governing tax practice before the IRS in Treasury Department Circular No . 230 grant parity to CPAs, lawyers, and enrolled agents practicing before the Service . Therefore, the AICPA believed that all groups (not just attorneys) should enjoy privileged communication with clients . In 1996, an AICPA working group expressed concern about financial status audit techniques the IRS employed to identify unreported income (Raymon et al ., 1996) . The techniques included requesting taxpayers to complete a form on which they listed their estimated personal and family expenses . The AICPA provided guidance to CPAs who had clients undergoing a financial status audit . Suggestions included advising the client about the lack of a CPA-client privilege.
40
CHRISTINE C . BAUMAN AND ANNA C . FOWLER
In testimony to Congress concerning the proposed legislation for the Confidentiality Privilege (Section 3411 of H . R . 2676), the AICPA indicated that advisors become privy to much private information about their clients in the course of arriving at recommendations. Clients expect privacy and confidentiality in discussing tax matters with their advisors . In the case of individual clients, CPAs may learn information about clients' lifestyle, family relationships, and habits . For business clients, information may include trade secrets and competitive factors, among other information . The recommendations or tax advice given to clients may be based in part on such private information . The AICPA's position was that as a matter of public policy, a taxpayer has the right to expect that if he selects a tax advisor who can practice before the IRS, all information the advisor obtains regarding the taxpayer's tax matters will be granted the same level of privacy protection, no matter in which profession his advisor practices (AICPA, 1997) . The Confidentiality Privilege has received negative comments, including being described as both limited and vague . In addition, because it does not apply in the criminal area, it has been "hypothesized" that the IRS may tend to classify more investigations as criminal so that IRC Section 7525 will not apply (Geer, 1999) . Law professor Louis F . Lobenhofer conjectures the Privilege "probably does more harm than good ." Among the problems about which he expressed concerns are inadvertently waiving the privilege by failing to take appropriate measures to protect it (Lobenhofer, 1999) . For example, Lobenhofer observes the largest accounting firms will face severe conflicts between the obligation of their tax advisors to keep the confidences of their corporate clients and the obligation of their accountants who audit publicly held corporations to disclose the material transactions of their clients . In the Senate Debate on RRA 98 (H . R . 2676) on July 8, 1998, Senator Moynihan, (Dem . NY) indicated that "the expansion of the privilege of confidentiality to tax advice furnished by accountants is certain to cause confusion and lead to additional litigation with the IRS . Since the privilege does not apply to communications regarding tax shelters, the privilege grants a right that most taxpayers will never be eligible to assert, and many will be surprised to learn about its limitations ." Former Treasury Secretary Rubin (1998), in his letter expressing the Treasury's views on the major issues of the IRS restructuring bills, indicated that : the Administration believes that creating a new evidentiary privilege for communications between accountants and other tax advisors . . . and their clients would be unwise and unwarranted . The Department of Justice and the Federal Bureau of Investigation view the creation of this privilege as an impediment to the prosecution and investigation of fraud matters,
The Expanded Taxpayer Confidentiality Privilege
41
and the existence of the privilege will inhibit the investigation of the types of civil tax matters that often lead to criminal tax referrals . In addition, this proposal could also dramatically increase the courts' burden with summons-related and fact-intensive litigation over whether the privilege applies . . . . The Administration strongly urges Congress to strike the provision . . . and to request a study of the accountant-client privilege provision to determine the potential impact on law enforcement . Statutory Provisions For taxpayer communications made after July 21, 1998 (the enactment date of RRA, 1998), IRC Section 7525 extends a confidentiality privilege to tax advice furnished by FATPs in non-criminal proceedings to the extent such communication would be privileged if it were between a taxpayer and an attorney .4 IRC Section 7525(a)(3)(B) defines tax advice as "advice given by an individual with respect to a matter which is within the scope of the individual's authority to practice," as defined in Federal regulations under section 330 of Title 31, United States Code . Section 10 .2(e) of Treasury Department Circular No . 230 defines practice before the IRS as "all matters connected with a presentation to the IRS or any of its officers or employees relating to a client's rights, privileges, or liabilities under laws or regulations administered by the IRS . Such presentations include preparing and filing necessary documents, corresponding and communicating with the IRS, and representing a client at conferences, hearings, and meetings ." In a last minute change, Congress added language that removed confidentiality protection for written communications related to the promotion of corporate tax shelters . According to IRC Section 7525(b), the Confidentiality Privilege does not apply to "any written communication between a FATP and a director, shareholder, officer or employee, agent, or representative of a corporation in connection with the promotion of the direct or indirect participation of such corporation in any tax shelter (as defined in IRC Section 6662(d)(2)(C)(iii)) ." In this context, a tax shelter is any partnership, entity, plan, or arrangement a significant purpose of which is the avoidance or evasion of income tax . Tax shelters that are required to be registered as confidential corporate tax shelter arrangements under IRC Section 6111(d) definitely fall within the scope of the tax shelter exception . Because of the broad, subjective "a significant purpose" language, it is difficult to know exactly which written communications will be ineligible for the privilege . In the Conference Committee Report (H . R . Conf. Rep . No . 105-599), Conferees indicated that they understood that the promotion of tax shelters was not part of a routine relationship between a practitioner and a client . Therefore, they did not anticipate that the tax shelter limitation would adversely affect such routine relationships .'
42
CHRISTINE C . BAUMAN AND ANNA C. FOWLER
According to MacDonald (1998), ambiguities concerning the scope of the tax shelter carve out sparked "widespread confusion" among the Big Five accounting and consulting firms in 1998 . At that time, some of the accounting firms complained to Congress about the provision . Senator Connie Mack (R., FL.), apparently sympathizing with their concerns, stated, "the entire purpose of the taxpayer confidentiality act is to protect taxpayers and the advice they receive from their tax advisors . Because `tax shelter' is defined so broadly in the bill, we must make sure that tax-shelter exception is clarified so it does not minimize the benefit to the taxpayer ." 6 To date, however, clarification has not happened . Because of the relative newness of IRC Section 7525, little case law has evolved to interpret its language . However, on April 15, 1999, the Seventh Circuit in Frederick, 182 F3d 496, commented in dicta on the Confidentiality Privilege . In Frederick, the advisor (both a lawyer and accountant) provided legal representation to, and prepared the tax returns of, his clients and their company . The IRS summonsed numerous documents, most of which Frederick created in connection with the tax return preparation . Judge Posner ruled that dual-purpose documents (i .e . documents prepared for use in preparing tax returns and for use in litigation) are not protected . He elaborated that while the case occurred prior to the effective date of IRC Section 7525, the section would have had no effect on the Court's analysis in the case . Judge Posner made it clear that tax return preparation, whether by attorneys or accountants, is not protected communication . He also held that IRC Section 7525 "does not protect work product," and that "[n]othing in the new statute . . . suggests that . . . non-lawyer practitioners are entitled to privilege when they are doing other than lawyers' work . . . ." I He discussed services provided in connection with an IRS audit and stated that a tax advisor who is assisting with interpreting the statute or case law is performing lawyer's work. On the other hand, merely verifying the accuracy of a return in an IRS audit is "accountant's work" regardless of whether performed by an attorney or accountant . Many argue that if other courts follow the Seventh Circuit's conclusion, IRC Section 7525 will provide only a limited benefit to taxpayers and accountants (Schnee, 2000) . According to John D . Piper, National Director of Appeals in 1998, IRC Section 7525 contains significant interpretative issues . However, Piper notes that the Confidentiality Privilege rarely applies in the appeals process . The Privilege is more likely to be asserted during examination of a return because the examination function involves findings of facts and provides for summonsing authority for the IRS .' About 40 states recognize some form of accountant-client privilege, which they do not restrict to the tax arena . IRC Section 7525, on the other hand, does
The Expanded Taxpayer Confidentiality Privilege
43
not afford confidentiality protection to advice on state and local tax matters . Thus, the accountant-client privilege is not uniform for Federal versus state and local contexts . Other Confidentiality Privileges The "work-product doctrine," which can be asserted by any professional, also can maintain confidentiality for a client." Rule 26(b)(3) of the Federal Rules of Civil Procedure codifies the work-product doctrine for documents prepared by an attorney or other representative "in anticipation of litigation or for trial ." The work-product doctrine, however, does not apply to protect an accountant's tax accrual workpapers prepared during a financial statement audit . United States v. Arthur Young & Co ., 465 U .S . 805 (1984) . Communications to and from an accountant are subject to the attorney-client privilege if the client's attorney or in-house counsel engages the accountant to assist in providing legal services for the client. United States v. Kovel, 296 F .2d 918 (2d Cir ., 1961) . In tax practice, the attorney and accountant can enter into a Kovel agreement describing the scope of the accountant's role and clarifying that the accountant is under the direction of the attorney .
ATTORNEY-CLIENT PRIVILEGE In order to understand the Confidentiality Privilege of IRC Section 7525, an appreciation of the rules, procedures and limitations of the attorney-client privilege is necessary because the Confidentiality Privilege is based upon this common law protection . The attorney-client privilege applies to confidential communications between attorneys and their clients and is intended to encourage "full and frank communication between attorneys and their clients and thereby promote broader public interests in the observance of law and the administration of justice ." Swidler & Berlin v . United States, 66 U .S .L. W . 4538 (S . Ct ., 1998), quoting Upjohn Co . v. United States, 449 U .S . 383 (1981) . The privilege belongs to the client, but the attorney can assert it on the client's behalf. Several requirements must be met for the privilege to apply . The client must make written or oral communications for the purpose of obtaining legal advice or services and make the communications in confidence ."' To preserve the attorney-client privilege, an attorney is forbidden from disclosing (without client approval) confidential communications obtained from the client in the course of professional consultations ." Either a voluntary or an inadvertent act can waive the attorney-client privilege . For example, disclosure of the privileged information (by the client
44
CHRISTINE C . BAUMAN AND ANNA C . FOWLER
or the attorney) to a third party, such as a financial institution, may constitute a waiver of the attorney-client privilege . The courts have reached mixed decisions about whether disclosure outside a selective group of close advisors constitutes a total waiver of the privilege .' According to Padwe et al . (1998), for tax advice to be considered legal advice, it generally must include "a communication applying the Internal Revenue Code to specific client facts to render an opinion ." For purposes of the attorney-client privilege, tax advice - as distinguished from tax preparation - generally qualifies as legal advice . Tax advice includes "tax planning memoranda, oral and written communications involving legal risk assessments, and analyses of whether an item is capital or ordinary, should be amortized or deducted, or similar issues ." Padwe et al . caution that not all "tax services" qualify as tax advice . For example, tax return preparation is not legal advice, and not covered by the Privilege, even if an attorney prepares the return . This is a very important point because the scope of IRC Section 7525 extends only to communications that would have been protected by the attorney client privilege, had an attorney sent or received the communications . The recent Pomerantz case illustrates well the subtlety of the scope of the attorney client privilege . G. Pomerantz, DC Fla ., 2001 U .S . Dist . LEXIS 7591, Case No . 00-6777-CIV-MOORE, May 22, 2001 . In Pomerantz the government sought various records from two accounting firms retained by the attorney . The court held that certain general ledgers were prepared at the direction of the attorney for his use in divorce litigation and were protected . On the other hand, a tax return and supporting analysis of deposits were held not associated with the divorce case and not protected . Other records were pro-forma amended tax returns that were not filed but rather were prepared by a different accountant at the direction of the divorce lawyer to assist him in determining the client's income for the divorce proceeding . The court held that these items were protected by the attorney client privilege .
IMPLICATIONS FOR THE ACCOUNTING PROFESSION Shortly after the enactment of IRC Section 7525, practitioners suggested that uncertainty exists within both the public and private sector about the bounds of the Confidentiality Privilege . It is unclear, for example, exactly what constitutes tax advice and what types of documents are protected . To date, no Treasury Regulations, either proposed or temporary, offer guidance . To assist tax practitioners in maintaining the Confidentiality Privilege, several commentators (Lobenhofer, 1999 ; Mendelson et al ., 1998) have offered tax
The Expanded Taxpayer Confidentiality Privilege
45
practice suggestions and encouraged practitioners to change office procedures . Appendix A offers a summary of procedures they recommended . Among the suggestions are preparing a separate engagement letter for tax matters within the scope of the Confidentiality Privilege . In its Tax Practice Guides, the AICPA has included a sample "confidentiality privilege engagement letter," which is included as Appendix B . The sample letter describes the privilege and cautions the client about waiving the privilege . Prior to the tabulation and reporting of our survey results, very little was known about the extent to which accounting firms have changed their office procedures as a result of the Confidentiality Privilege . According to Armstrong (1999), some accountants use tax planning letters that bear the stamped cautionary message : "Privileged and confidential tax advice under section 7525 ." They also educate their clients about the privilege. One of the tax managers interviewed by Armstrong stated that accounting firms are keeping privileged communications in separate files from other client correspondence . According to one interviewee, "if you mix your privileged tax advice with all of the other correspondence, you may have inadvertently waived privilege by making it available to a third party or non-certified tax practitioner ." Armstrong cautions about the need to take safeguards to protect the privilege . According to Hamilton (1998), Phil Brand, director of IRS tax controversy services for KPMG Peat Marwick LLP, stated at the annual UCLA Tax Controversy Institute that firms are handling the privilege "very gingerly ." He indicated that KPMG is not making the Confidentiality Privilege "a major marketing ploy" for the firm but stated that KPMG would try to use the privilege to advantage during an IRS examination . He noted, however, that KPMG functions as an accounting firm . He further commented that "because of the uncertainty about how the privilege applies in many situations, if it looked as though the case were entering criminal territory, they would err on the side of being conservative and work this process through a law firm ." As a result, Brand concluded that, in reality, "the privilege is sort of a mixed blessing ."
OTHER IMPLICATIONS OF THE CONFIDENTIALITY PRIVILEGE Auditor Independence The Security and Exchange Commission's (SEC's) Proposed Rule (section III.D .I .b .xi) issued in 1999, and still in place during the time of our survey, indicated that it would not affect tax-related services provided by auditors to their audit clients . The SEC's Proposed Rule stated, "Tax services are unique,
46
CHRISTINE C. BAUMAN AND ANNA C . FOWLER
not only because there are detailed tax laws that must be consistently applied, but also because the IRS has discretion to audit any tax return." The Proposed Rule elaborated that the SEC does not think that the requirement of an independent audit is thwarted when an accountant renders "traditional tax preparation services to an audit client or an affiliate of an audit client ." The language "traditional tax preparation services" is worrisome ; tax practitioners became concerned that tax-planning services could be viewed differently from tax preparation services . Because of the controversy over the independence issue, our survey addressed the issue in the context of tax services . On September 18, 2000, SEC Chairman Arthur Levitt indicated that the Proposed Rule does not restrict tax compliance and planning services, nor does the proposed rule restrict general business advice . Nevertheless, the AICPA was still concerned that although the SEC stated that its proposed rule "would not affect tax-related services" provided to audit clients, it would ban acting as an advocate for an audit client . According to the AICPA, the rule reserves to the SEC authority to prohibit the provision of whatever non-audit services it considers to constitute a "mutuality of interest" with, or "advocacy" for, an audit client using a "facts and circumstances," appearance-based catch all . Because of this catch-all approach, accounting firms would have no basis for predicting whether the SEC would challenge a particular non-audit service, such as appearing before the IRS as an advocate for an audit client (AICPA, 2000) . In November 2000, the SEC issued a final rule "Revision of the Commission's Auditor Independence Requirements" effective February 5, 2001 (17 CFR Parts 210 and 240) that alters independence requirements for accounting firms that audit SEC registrants . The rule sets forth general principles concerning when an auditor is not independent . The final rules include more lenient positions for audit firms providing tax-related services to audit clients . The SEC retained the language regarding advocacy work, but moved the advocacy language to a preliminary note in the rule and designated it as one of four principles to consider in evaluating independence . These changes provide no guidance on the specific types of tax advocacy that might lead to impairment of independence . On January 16, 2001, the SEC released interpretative guidance in a question and answer format ( www .sec .gov/info/accountants/audindep/audinfa q . Into) . The answers provided to question 15 (concerning whether the restrictions on the independent accountant providing legal services to an audit client apply only to litigation services) seem to indicate that traditional litigation support engagements where the CPA's work becomes part of the attorney's work product should not cause independence problems . This position supports the use of Kovel agreements . For a complete discussion see Purcell and Lifson (2001) .
The Expanded Taxpayer Confidentiality Privilege
47
Multidisciplinary Practices
According to some commentators, the Confidentiality Privilege is "the product of pressure from accounting firms that have long desired an accountant-client privilege so that they can take over the tax work that is currently being performed by lawyers" (Rice, 1998) . Others would argue accountants want to increase their collaboration with lawyers (Huefner & Kellogg, 1999) . The Proposed Rule provides that an accountant fails the independence test "if the accountant provides any service to the audit client or its affiliates, that, in the jurisdiction in which the service is provided, may be provided only by someone licensed to practice law ." In 1999, the SEC staff wrote to the American Bar Association (ABA) and its Commission on Multidisciplinary Practices (ABA Commission) and argued that auditor independence is impaired when a firm provides both audit and legal services to a client that must file audited financial statements with the SEC . In its final report in July 2000, the ABA Commission adopted the SEC's viewpoint that it is incompatible for a single firm to provide both legal and attest services for a client . After two years of research and debate, the ABA voted in July 2000 to reject a proposal that would have allowed lawyers to form multidisciplinary practices (MDPs) . As part of that vote, the ABA discharged the ABA Commission, thereby signaling the finality of its decision concerning MDPs . The main arguments against MDPs are that such practices would make it difficult to avoid conflicts of interest and to preserve client confidentiality . It could be argued that IRC Section 7525 represented one step toward addressing the client confidentiality issue, an important part of the MDP debate .
SURVEY RESULTS In order to assess the impact of IRC Section 7525 on the accounting profession, a survey of tax professionals and educators was conducted . The survey instrument (see Appendix C) was completed by tax professionals and educators attending four professional accounting conferences . The conferences include the 2000 AICPA National Conference on Federal Taxes, the 2000 Pennsylvania Institute of Certified Public Accountants (PICPA) Accounting Educators Conference, the 63rd Annual Tax Conference of the Wisconsin Institute of Certified Public Accountants (WICPA), and the 2001 Western Pennsylvania Tax Conference sponsored by the PICPA . The first page of the survey instrument is designed to gain general insights regarding client service matters, limitations of the Confidentiality Privilege, practice changes, marketing initiatives, multidisciplinary practice issues, and
48
CHRISTINE C . BAUMAN AND ANNA C . FOWLER
auditor independence concerns . The top section of page two of the survey requests input about the number of times that the practitioners have asserted the Confidentiality Privilege in financial status audits as well as other tax audits . Questions are also posed to quantify the approximate number of times the work-product doctrine agreement and Kovel arrangement have been used. The bottom section of page two of the survey is designed to obtain information about changes in office administration, client communication, training, and billing . The last page of the survey gathers demographic information . The survey closes by soliciting open-ended comments about the Confidentiality Privilege . Response rates (Panel A) and demographic information (Panel B) are presented in Table 1 . The results for the two PICPA conferences are combined in the tables . The overall response rate for the four conferences is 5 .60% . Because 75% of the respondents are associated with accounting firms and Section 7525 extends a privilege earlier available to attorneys to CPAs (and other FATPs), results are reported only for persons in accounting practice . Of the respondents, 86% have over 15 years of experience in the tax area . Although participants in the AICPA conference were from a variety of jurisdictions, 34% of the respondents were from the Third Circuit (which includes Pennsylvania) and the Seventh Circuit (which includes Wisconsin) . As reported in Table 1, 73% of the respondents are associated with local CPA firms and 65% have partner status . Table 2 summarizes responses regarding the technical issues associated with IRC Section 7525 . Most respondents are neutral as to whether Section 7525 has enhanced their ability to service clients (47 .73% - question 1) or allowed practice growth (59 .09% - question 2) . Only 9 .09% answered that the addition of the section has helped them to "grow their practice ." Interesting opposing views exist as to whether the scope of the Confidentiality Privilege is limited due to its inapplicability to written communication in connection with the promotion of participation in any tax shelter (question 3) . About 43% of the respondents either agree or strongly agree that the Confidentiality Privilege has been limited because of this provision and will apply infrequently in their practice . On the other hand, 25% of respondents either disagree or strongly disagree that the tax shelter limitation provision in Section 7525 has diminished the Confidentiality Privilege . No particular group accounted for the responses in either extreme . Perhaps the 25% who responded this way do not believe that their own corporate clients tend to be involved with tax shelters (despite the broad definition of tax shelter) . For question number five, approximately 20% of the respondents indicate that they have changed office practices subsequent to the enactment of the Confidentiality Privilege . The results for question six show less than 20% describe the Confidentiality Privilege in firm brochures and other firm literature .
49
The Expanded Taxpayer Confidentiality Privilege Table 1 .
Survey Results - Descriptive Statistics .
Panel A : Response Rates Industry
AICPA
PICPA
WICPA
Total
Accounting Law Industry, Government, Education
15 5 3
14 4 0
15 2 2
44 11 5
Total
23
IS
19
60
450 5 .11%
323 5 .57%
299 6.35%
1,072 5 .60%
Number of Attendees Response Rate
Panel B : Descriptive Statistics (Respondents with Accounting Affiliation Only) Demographic Information AICPA PICPA WICPA Total Work Experience 0-15 years 16-20 years 21-25 years 26-30 years 30+ years Judicial Circuit First Second Third Fourth or Dist . of Col . Sixth Seventh Ninth Eleventh Accounting Firm Type Big 5 Regional Local Partner Status Yes No
0 6
2
1 5
1 1 4 4
2 14 2 2 15
0 3 12
I 9
15 0
6 8
6 11 6 9 12
13 .64 25 .00 13 .64 20 .45 27 .27
2 1 15 2 2 16 3
4 .55 2 .27 34 .09 4 .55 4 .55 36 .36 6 .52 6 .82
1
8
10 32
4 .55 22 .73 72 .72
29 15
65 .91 34 .09
A hypothetical question (number 7) regarding multidisciplinary practices (MDPs) was included in the survey . Interestingly, about 43% of the respondents agreed that the Confidentiality Privilege would become more valuable if MDPs are authorized in the United States . Only 14% of respondents disagreed with the statement .
50
CHRISTINE C . BAUMAN AND ANNA C . FOWLER
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52
CHRISTINE C . BAUMAN AND ANNA C . FOWLER
The respondents were evenly divided in question eight about a perceived conflict between the advocacy role of the tax advisor protected under the Confidentiality Privilege and the advocacy role being discussed in the SEC's focus on auditor independence . Approximately 30% of the accounting respondents perceived a conflict while 30% did not perceive a conflict . The responses for the first three questions from the second page of the survey, summarized in Table 3, indicate that few practitioners (less that 7%) in the sample have asserted the new Confidentiality Privilege in any of the three scenarios listed (financial status audits, Information Document Requests, and other tax audit contexts) . The scant use could be due in part to declining audit rates in general . On the other hand, almost 41 % of the respondents have asserted the long-standing Work Product doctrine at least once during their career (question 4) ; the number of times exerted ranges from 1 to 15 . The responses to questions five through seven indicate that some staff training about the Confidentiality Privilege is occurring, but very little. The responses to questions eight are very revealing . Over half of the respondents prefer to be retained and work under the direction of the client's legal counsel to establish the confidentiality privilege for clients . The number of times respondents have used this arrangement ranged from 1 to 12 times . The responses reported in Table 4 examine how accountants have implemented the provisions of Section 7525 in terms of office practices . The most widely-used practice, as shown in question four, is that over 60% of the respondents prepare separate engagement letters for tax preparation versus other engagements (such as tax planning) . Approximately 32% (question 1) of the respondents maintain separate files for tax preparation versus tax planning, risk assessment, and tax research documents . Less than 20% of the respondents mark documents as "privileged" (question 2), explain the privilege to clients (question 3), identify in engagement letters when the privilege does or does not apply (question 5), explicitly discuss the privilege with clients (question 6), or provide separate billing statements for charges related to privileged matters (question 7) . Several respondents with an accounting firm affiliation offered detailed comments about the Confidentiality Privilege . These comments are summarized in Table 5 . One comment indicates that the law is too young to have resulted in changes at a small firm . Another comment offers a detailed analysis about the privilege in Florida . Although responses from persons in law practice are not included in the reported results, several written responses from respondents with a law firm affiliation are noteworthy . One respondent wrote, "The playing field should not be leveled . CPA's should not be practicing law . If you want the traditional
53
The Expanded Taxpayer Confidentiality Privilege
Survey Results - Practice Issues (N=44-Accounting Affiliation Only) .
Table 3.
Yes
of Total Responses No Response No
Range No . of Times
Question
6 .82
84.09
9 .09
2
I . At the request of my client, I have exerted the Confidentiality Privilege of Section 7525 in financial status ("lifestyle") audits .
2 .27
88 .64
9 .09
No Response
2 . At the request of my client, I have exerted the Confidentiality Privilege of Section 7525 to refuse IRS Information Document Requests (tDRs) .
2 .27
88 .64
9 .09
No Response
3 . At the request of my client, I have exerted the Confidentiality Privilege of Section 7525 in other tax audit contexts .
40 .91
56.82
2.27
1-15
36 .36
59 .09
4 .55
I-4
5 . 1 have provided my staff - both audit and tax - with continuing education regarding the scope of the Confidentiality Privilege .
13 .64
79.55
6.82
1-3
6 . 1 have provided only my tax staff with continuing education regarding the scope of the Confidentiality Privilege .
25 .00
72.73
2 .27
2-20+
7 . 1 have provided my clients with information regarding the scope of the Confidentiality Privilege .
54 .55
40 .91
4.55
1-12
8 . To establish the confidentiality privilege for my clients, I prefer to be retained and work under the direction of my client's legal counsel .
20 .45
79.55
0 .00
I-10
9. Subsequent to the Arthur Young Supreme Court case, the IRS has requested audit or tax accrual workpapers from me/my firm.
4 . 1 have exerted the Work-Product doctrine (protection of documents prepared "in anticipation of litigation," not necessarily by an attorney) during my career .
54
CHRISTINE C . BAUMAN AND ANNA C . FOWLER
Survey Results - Implementation Issues (N = 44 - Accounting Affiliation Only) .
Table 4.
Yes
% of Total Responses No No Response
Question
31 .82
63.64
4.55
1 . Separate files are maintained for tax preparation versus tax planning, risk assessment, and tax research documents.
18 .18
81.82
0 .00
2. All documents and files not associated directly with the tax return are marked "privileged" or something similar.
13 .64
84.09
2.27
3 . My clients are provided a full explanation of the Confidentiality Privilege, and only if my client so requests are separate files maintained and marked "privileged ."
61 .36
38 .64
0.00
4 . Separate engagement letters are sent for tax preparation versus other engagements (such as tax planning) .
11 .36
84.09
4.55
5 . All engagement letters reference the Confidentiality Privilege as to when it does or does not apply .
4.55
95 .45
0.00
6 . In meeting with prospective clients, the Confidentiality Privilege is explicitly discussed .
13 .64
84 .09
0 .00
7 . Billing statements separately list charges for tax advice under the Confidentiality Privilege from charges for other client services .
Table 5.
Comments from Respondents with Accounting Affiliation .
• The State of Florida has a privilege law for accountants which I have seen used in cases that I was an expert witness in for the FDIC . I have drafted a similar law for State of [name of state deleted] using the Florida law. It has been approved by all committees but our executive committee refuses to introduce the bill as they fear attorneys will lobby against the bill . The attorneys I work for in these legal cases would like their expert witnesses to have privilege . I do not see privilege as a means for an accountant performing an attorney's function . We have a much more valuable role of preparing expert reports, surviving the depositions, testifying in court, and clearly explaining to the Judge the complex issues so that he can make an informed decision.
• The law is too young to have implemented changes for a small firm . • IRS does not recognize Section 7525 for financial status audits!
The Expanded Taxpayer Confidentiality Privilege
55
privilege you should go to law school and pass the bar . Many of us are now dual practitioners ." Another attorney writes "As an attorney, I try to engage all clients under legal representation to avoid problems the IRS Confidentiality Privilege can create ."
CONCLUSIONS It is premature to conclude whether the accountant-client privilege has proved valuable to CPAs . Based upon the survey responses, the accounting practitioner respondents have not made major changes to their office practices and procedures in response to the new Confidentiality Privilege . In addition, they are not asserting the Privilege often . Moreover, the majority do not believe that the addition of this statutory provision has enhanced their firm's ability to "grow its practice" by leveling the playing field between accountants and attorneys . In contrast to the respondents, CPAs, in general, may have made more modifications to their office practices and procedures and may believe that the new Privilege has proven beneficial for their firm . The responses from the profession are consistent with informal discussions with IRS representatives . The IRS has seldom experienced an assertion of the Confidentiality Privilege . On occasion, the National office of the IRS has received inquiries from IRS field agents about how the Privilege applies . In most cases, attempts to use the Privilege have related to years prior to the effective date of Section 7525 . Most attempts to make use of the Privilege have involved Kovel arrangements, not situations arguably addressed by Section 7525 . Future regulatory guidance, judicial decisions, and perhaps even SEC rules will shape the scope of the Confidentiality Privilege . Guidance is needed from the Treasury to clarify the meaning of the language "tax advice" or "communications." For example, does the Confidentiality Privilege apply to personal discussions, letters, memoranda, notes, reports, interpretations, opinions, mental processes, thoughts, and tax positions? A legal panel points out that every element of the Confidentiality Privilege is ripe for interpretive dispute (Stratton, 1998) . Because of the exclusion for written communications regarding corporate tax shelters, there is concern over the potentially narrow scope of the privilege, given the broad, subjective statutory definition of tax shelters . Critics of the Confidentiality Privilege argue that because the provision applies just to non-criminal proceedings before the IRS, IRC Section 7525 may encourage the IRS to increase criminal investigations and proceedings and its
56
CHRISTINE C . BAUMAN AND ANNA C. FOWLER
use of third-party summonses . Others argue that malpractice suits against accountants will rise . These contentions offer avenues for future research .
NOTES 1 . Public Law 105-206. 2 . At time of quote, Pamela F . Olson was a partner in the Washington, D . C . office of Skadden Arps Slate Meagher & Flom LLP . Ms . Olson was formerly Special Assistant to the Chief Counsel, Internal Revenue Service and currently is Deputy Assistant Secretary of the Treasury for Tax Policy . 3 . See Mendelson et al . (1998) . Mr. Mendelson was a member of the AICPA Tax Division Responsibilities in Tax Practice Committee, and chaired the AICPA Executive Committee working group on parity in tax practice before the IRS . 4 . The Confidentiality Privilege cannot be used to prevent disclosure to any body other than the IRS . Thus, the ability of the Securities and Exchange Commission and other regulatory agencies to compel information in an administrative or court proceeding remains unchanged by the provisions of IRC Section 7525 . 5 . When the corporate tax shelter provision was added to the legislation, Olivia Kirtley (then Chair of the AICPA Board of Directors) commented that she had hoped for more in the taxpayer confidentiality privilege and thought it unfortunate that taxpayers have to worry about confidentiality (Koreto, 1998) . 6 . Quote included in Wall Street Journal article by MacDonald, July 16, 1998 . 7 . The Supreme Court denied certiorari in Frederick on February 22, 2000 . 120 S. Ct. 1157 . 8 . See IRS Memorandum dated September 29, 1998, Department of the Treasury, Internal Revenue Service . 9 . See United States v. Adlman, 134 F .3d 1194 (2d Cir., 1998) (Adlman 11) ; Hodges, Grant & Kaufman v. United States, 768 F.2d 719 (5th Cir., 1985). 10 . See United States v . American Telephone & Telegraph, 86 F . R . D . 603, 612 (D . D . C ., 1979) and Fisher v . United States, 425 U .S . 391 (1976) . 11 . See United States v. Schwimmer, 892 F.2d 237 (2d Cir ., 1989), cent. denied, 112 S . Ct. 55 (1991) . 12 . See United States v. Massachusetts Institute of Technology, 129 F .3d 681 (1st Cir ., 1997), Diversified Indus ., Inc. v . Meredith, 572 F.2d 596 (8th Cir ., 1978).
ACKNOWLEDGMENTS The authors gratefully acknowledge the cooperation of the American Institute of Certified Public Accountants (AICPA), the Pennsylvania Institute of Certified Public Accountants, and the Wisconsin Institute of Certified Public Accountants in allowing and facilitating distribution of our research survey . The authors thank leaders within the AICPA's Tax Division for their helpful comments on the survey instrument. In addition, the authors express appreciation to the participants in the legal papers session at the 2001 American Taxation Association Mid-year Meeting for their questions and suggestions .
The Expanded Taxpayer Confidentiality Privilege
57
REFERENCES American Institute of Certified Public Accountants (2000) . Highlights of the SEC's proposed rule governing auditor independence, http ://www .aicpa.org/belt/sec/sumtnary .htm. American Institute of Certified Public Accountants (1997) . Planned testimony before the national commission on restructuring the IRS . Tax Division Newsletter (February), 7. Armstrong, D . (1999) . New accountant-client privilege not a cure all, but a good start . Care must be taken so as not to inadvertently void confidentiality . Milwaukee Journal Sentinel (October 24), 3. August, J . D. (1999) . Jerald David August interviews Pamela F. Olson: Extension of confidential communications privilege to tax practitioners . Business Entities (September/October), 34 . Friedman, R . E., & Mendelson, D . L . (1996) . The need for CPA-client privilege in federal tax matters . The Tar Adviser (March) . 154-157 . Geer, C . T . (1999). How much can you tell your accountant? Fortune (Much 15), 212 . Hamilton, A . (1998) . IRS official suggests open forum on accountant-client privilege . Tax Notes (November 9), 686. Huefner, R . J ., & Kellogg, S . (1999) . Balancing the interests of both professions - Attorneys and CPAs : cooperation or confrontation'? The CPA Journal, (June) . Koreto, R . J . (1998). A yea to unify . Journal of Accountancy (December), 74-75 . Levitt. A. L . (2000) . Speech by SEC Chairman Levitt - "A profession at the crossroads" at the National Association of State Boards of Accountancy, Boston, Massachusetts (September 1 9) . Lobenhofer, L . F . (1999) . The new tax practitioner privilege : limited privilege and significant disruption . Tax Notes ( June 14), 1619 . MacDonald, E. (1998) . Congress is seeking added protection from IRS for firms . Wall Street Journal (July 16), C15 . Mendelson, D . L ., Herskovitz, D . L., & Einhorn, A . R . (1998) . The new CPA-client confidentiality privilege. The Tax Adviser (October), 676-683 . Padwe, G . W., Ely, M . H., & Friedman, R . E. (1998) . The AICPA experts' taxpayer confidentiality privilege videocourse . Course code 353500. Purcell, T ., & Lifson, D . (2001) . Auditor independence and tax practitioners . Journal of Accountancy, New York, (June), 71-74 . Raymon, J . L ., Coustan, H . L ., Knight, M . J ., Mendelson, D . L., & Primoff, W . M . (AICPA Financial Status Audit Working Group) . (1996) . What should CPAs do? Journal of Accountancy (May), 45-47 . Rice, P . R . (1998). The tax practitioner privilege: a sheep in wolf's clothing . Tax Practice & Controversies (August 10), 172 . Rubin, R . (1998) . Letter to Ways and Means Committee Chairman Archer and attached Summary of Treasury Views on Major Issues in IRS Restructuring Bills (June 2) . Schnee, E . J . (2000) . Accountant/client privilege. Journal of Accountancy (March), 78 . Securities and Exchange Commission (2000) . Revision of the Commission's Auditor Independence Requirements, Proposed Rule, 65 Fed . Reg. 43, 148 . Stratton, S . (1998) . ALI-ABA panel points out problems, pitfalls of tax adviser privilege . Tax Notes (November 9), 684. Treasury Department Circular No . 230. Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, and Appraisers before the Internal Revenue Service : Title 31 Code of Federal Regulations, Subtitle A, Part 10, revised as of July 1, 1994.
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CHRISTINE C . BAUMAN AND ANNA C . FOWLER
APPENDIX A Tax Practice Suggestions for Maintaining Confidentiality Privilege
• Maintain a separate, secure client tax file that contains all tax advice documents for access and retention by the client and make separate arrangements for computerized information that may be privileged .
• Maintain dual file systems for privileged and non-privileged communications . • Label files, databases, and tax advice documents as "Privileged and Confidential Tax Advice Under IRC Section 7525 and Work-Product Doctrine ." This includes incoming items from clients, outgoing items to clients, fax cover sheets and email .
• Prepare a separate engagement letter addressing tax matters covered by the Confidentiality Privilege .
• Advise clients to notify you if the IRS requests information from them . • Counsel clients and office staff about the scope of the Confidentiality Privilege and provide guidance on who can assert the Confidentiality Privilege and how it can be waived (voluntarily or inadvertently) .
• Bill for tax advice in a separate billing statement . • Include language in employment agreements with office staff that requires them to keep client information confidential .
• Take precautions to preserve confidentiality . For example, be sure that no nonclients are in the room when consulting with clients .
• Obtain confidentiality agreements and emphasize the responsibility to maintain confidentiality in exit interviews with staff leaving the firm . Sources : Both of the articles below recommend the tax practice suggestions noted above . 1 . Lobenhofer, L. F . (1999) . The new tax practitioner privilege : limited privilege and significant disruption . Tax Notes (June 14), 1619 . 2 . Mendelson, D . L ., Herskovitz, D . L., & Einhom, A . R . (1998) . The new CPA-client confidentiality privilege . The Tax Adviser (October), 676-683 .
The Expanded Taxpayer Confidentiality Privilege
59
APPENDIX B CONFIDENTIALITY PRIVILEGE ENGAGEMENT LETTER Dear Client : The Internal Revenue Code, as amended by the Internal Revenue Service Restructuring and Reform Act of 1998, provides for CPA-client privileged communications for tax advice provided to you . In order to ensure that all communications resulting from tax advice is under the privilege umbrella of the Act, we are asking you to confirm the following arrangements : We will provide tax advice as needed or requested to meet specific objectives or generally to meet long-term tax related goals and objectives . You have the right to review and/or be supplied with copies of any and all tax planning or research memos and workpapers prepared by our firm related to such tax advice . Tax advice includes, but is not limited to, the following :
• Researching the income tax reporting of a particular transaction . We will review these situations with you and resolve issues in your favor whenever possible . • Providing business tax and consulting to you, throughout 2001, for consideration in making tax related decisions . • Providing services related to the expected outcome of future tax decisions . Privileged tax advice does not include communications associated with the preparation of tax returns, tax accrual workpapers associated with a financial audit or other financial statement engagement, or in providing general business or accounting recommendations or, other non-tax engagements . You may assert the confidentiality privilege in any non-criminal tax matter before the Internal Revenue Service or any proceeding in Federal Court brought by or against the United States . We will not disclose any advice provided under the scope of this engagement letter to the Internal Revenue Service or third parties unless you provide us written consent to do so . Any disclosure of confidential information by you or us to the IRS or third parties may cause the Confidentiality Privilege to be waived . Caution must be taken by both parties to not inadvertently waive the privilege.
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You should notify us of any requests by the Internal Revenue Service for information about any tax advice or tax advice documents provided by us to you . If you advise us to assert the Confidentiality Privilege on your behalf you agree to hold **FIRM NAME** harmless and indemnify us for any attorney fees and any other costs and expenses (including penalties) incurred by us in defending the confidential communication. Very truly yours, Accepted By : Title : Date : Source :
AICPA Tax Practice Guides 2000 .
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APPENDIX C Survey Regarding LRC Section 7525, Confidentiality Privilege November 2000 Dear Conference Participant : As you recall, 1998 legislation added IRC Section 7525 to provide a new privilege of confidentiality (Confidentiality Privilege) to certain communications between CPAs and other Federally authorized tax practitioners and their clients . Professors Christine C . Bauman (University of Wisconsin-Milwaukee) and Anna C . Fowler (University of Texas at Austin) are conducting the survey on the attached pages to assess the impact of the Confidentiality Privilege on the accounting profession and practitioners' experiences with the new Code section . Both Dr . Bauman and Dr . Fowler teach tax research, practice and procedures in graduate tax programs . Participants in this survey are tax professionals or educators who are expected to have a professional interest in, and insights about, this issue and who registered for the conference . The results of the survey will be reported in a study that critically analyzes the impact of this recent legislation . Participation in this survey is voluntary ; if you participate (and we hope you will), you may decide not to answer certain questions . A decision not to participate will not affect your current or future relationships with the University of Wisconsin-Milwaukee or the University of Texas at Austin . Your responses will be kept confidential and used for research purposes only . No one, not even the researchers, will be able to link your responses with your name . You may keep a copy of this cover letter . If you have questions about this survey or its findings, you may communicate with one or both of us at : cbauman@uwm .edu or anna.fowler@bus .utexas .ed u . The survey should take approximately 10 minutes to complete . If some of the questions do not apply to you because you are not in public accounting, please leave them blank . We thank you in advance for your time and assistance . Please turn in your completed surve forms to the Re istration Desk. Sincerely,
Christine C . Bauman and Anna C . Fowler
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CHRISTINE C . BAUMAN AND ANNA C . FOWLER Survey Regarding LRC Section 7525, Confidentiality Privilege November; 2000
Instructions: Please answer the following questions by circling the letter that best describes your opinion, SA for strongly agree, A_ for agree, N for neutral, D for disagree, SD for strongly disagree, and N1Q for no opinion . Please circle your response .
SA A
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The enactment of Section 7525 (Confidentiality Privilege) has enhanced my/my firm's ability to serve clients . The enactment of Section 7525 has enhanced my/my firm's ability to "grow its practice" by leveling the playing field between accountants and attorneys . Due to the provision that Section 7525 does not apply to written communication in connection with the promotion of participation in any tax shelter, I believe the scope of the privilege is greatly limited and, thus, will apply infrequently in the part of my practice dealing with corporate clients. (Tax shelter is defined as "a partnership or other entity, any investment plan or arrangement, or any other plan or arrangement, if a significant purpose of such Partnership . . . is the avoidance or evasion of Federal income tax .") Prior to July 22, 1998 (the effective date of Section 7525), some of my clients were the subject of financial status ("lifestyle") audits, and if the Confidentiality Privilege had been available, I would have exercised the privilege in many of these audits. Subsequent to the enactment of the Confidentiality Privilege, I (my firm) have changed office practices and procedures. The Confidentiality Privilege is described in my fin's brochures and other fin literature . If multidisciplinary practices (viewed here as the same firm providing both CPA and legal services) are authorized in the United States, having the Confidentiality Privilege will become more valuable. I do not perceive a conflict between the advocacy role of the tax advisor protected under the Confidentiality Privilege and the advocacy role being discussed in the SEC's focus on auditor independence .
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Instructions: For each of the following statements, please answer yes or no and fill in the blanks concerning number of times . If, however, some of the questions do not apply to you because you are not in public accounting, please leave them blank . Yes No At the request of my client, I have exerted the Confidentiality Approx, no . of times Privilege of Section 7525 in financial status ("lifestyle") audits . Yes No At the request of my client, I have exerted the Confidentiality Approx, no. of times Privilege of Section 7525 to refuse IRS Information Document Requests (IDRs) . Yes - No _ At the request of my client, I have exerted the Confidentiality Approx . no . of times Privilege of Section 7525 in other tax audit contexts. Yes No I have exerted the Work-Product doctrine (protection of documents Approx. no . of times prepared "in anticipation of litigation," not necessarily by an attorney) during my career. Yes No _ I have provided my staff - both audit and tax - with continuing Approx . no, of times education regarding the scope of the Confidentiality Privilege . Yes - No _ I have provided only my tax staff with continuing education Approx . no . of times regarding the scope of the Confidentiality Privilege . Yes - No I have provided my clients with information regarding the scope Approx . no . of times of the Confidentiality Privilege . Yes No To establish the confidentiality privilege for my clients, I prefer Approx . no . of times to be retained and work under the direction of my client's legal counsel . Yes , No Subsequent to the Arthur Young Supreme Court case, the IRS Approx . no . of times has requested audit or tax accrual workpapers from me/my firm.
Instructions: For each of the following statements, please answer yes or no based upon your firm's office practices subsequent to the enactment of Section 7525, Confidentiality Privilege . Yes No Separate files are maintained for tax preparation versus tax planning, risk assessment, and tax research documents . Yes No ^ All documents and files not associated directly with the tax return are marked "privileged" or something similar. Yes No _ My clients are provided a full explanation of the Confidentiality Privilege, and only if my client so requests are separate files maintained and marked "privileged ." Yes No Separate engagement letters are sent for tax preparation versus other engagements (such as tax planning) . Yes No _ All engagement letters reference the Confidentiality Privilege as to when it does or does not apply . Yes - No In meeting with prospective clients, the Confidentiality Privilege is explicitly discussed. Yes No _ Billing statements separately list charges for tax advice under the Confidentiality Privilege from charges for other client services .
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Demographic Information : Please complete the following ; use check marks and enter numbers where called for . Response 1 . Number of years of work experience in the fields of accounting and/or law . 2 . My primary office is located in : First Circuit (ME, MA, NH, PR, RI) Second Circuit (CT, NY, VT) Third Circuit (DE, NJ, PA, VI) Fourth Circuit (MD, NC, SC, VA, WV) QR D. C . Circuit Fifth Circuit (LA, MS, TX) Sixth Circuit (KY, MI, OH, TN) Seventh Circuit (IL, IN, WI) Eighth Circuit (AR, IA, MN, MO, NE, ND, SD) Ninth Circuit (AK, AZ, CA, Guam, HI, ID, MT, NV, OR, WA) Tenth Circuit (CO, KS, NM, OK, UT, WY) Eleventh Circuit (AL, FL, GA) 3 . I am affiliated with a : Big 5 Accounting Firm National Accounting Firm National Law Firm Regional Accounting Firm (number of employees ) Regional Law Firm (number of employees ) Local Accounting Firm (number of employees _, Local Law Firm (number of employees ) Industry, Government or Educational Institution 4 . If you work for a public accounting or law firm, please indicate whether you are a partner . YES NO Comments: Please offer any comments about the Confidentiality Privilege .
Thank you very much for your participation!!! Please return your completed surveys to the REGISTRATION DESK .
THE EFFECT OF INSTRUCTIONAL STRATEGY AND COGNITIVE LEVEL OF DEVELOPMENT ON TAX KNOWLEDGE AND APPLICATION Sharon K . Ford and Tonya K . Flesher
ABSTRACT The purpose of this study was to evaluate the effectiveness of instructional strategies on how students learn and apply tax knowledge . Accounting students participated in an experiment to determine whether the choice of a procedural or conceptual instructional method enhanced the students' ability to solve problems . Further, the effect of cognitive level of development and success in answering questions was investigated . Results show that the method of instruction was instrumental in solving routine problems but not in solving novel problems . Students with a high (formal) level of cognitive development were better able to solve both routine and novel problems than students of medium (transitional) and low (concrete) cognitive development .
INTRODUCTION Accounting education has been criticized for its emphasis on passing the CPA exam rather than on preparing students to develop the skills necessary for professional practice (Bedford Committee, 1986) . Although a thorough Advances in Taxation, Volume 14, pages 65-84 . Copyright © 2002 by Elsevier Science Ltd. All rights of reproduction in any form reserved. ISBN : 0-7623-0889-3 65
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knowledge of laws and concepts is important, the current emphasis on accounting education stresses the need for critical thinking and reasoning skills, the ability to apply knowledge to real-world problems, and creativity in analyzing and solving problems (The Accounting Education Change Commission, 1990 ; Perspectives paper, 1989) . The AICPA board of examiners plans to hold question-writer workshops to develop questions on the CPA exams that emphasize higher level skills, such as critical thinking, and technology (Booker et al ., 1998) . The question of how these capabilities should be developed and nourished has not been clearly defined nor universally accepted . These concerns are especially important in the area of tax education because the laws are extensive, are changed frequently and are often vague or inconclusive .
THEORY Typically, tax courses have been designed to cover extensive amounts of material and the lecture method is the most efficient means by which to teach laws and concepts . This method tends to focus on learning the laws and finding the correct answers to problems that are closely related to the material and examples presented during class (Hite & Parry, 1993) . When educators dispense knowledge primarily through lectures, the result is that many students do not develop higher-order-thinking skills (Young, 1992) . However, educators are often reluctant to change their teaching methods . May et al . (1995) found that only 44% of educators surveyed agree that the traditional approach (textbook-centered, rule-intensive, lecture/problem-solving) should not survive as the primaryinstructional method in accounting courses . The lecture method of instruction fits well with the learning style of accounting students who generally prefer a well-structured environment . Wolk and Cates (1994) used Kirton's Adaptor-Innovator Theory (Kirton, 1976) to compare the problem-solving style of accounting students to that of other business students. The majority (77%) of accounting majors tested were adaptors (prefer structured, well-established situations ; concentrate on resolving problems rather than finding them ; and conform to the rules) . Geary and Rooney (1993) used the Myers-Briggs Type Indicator to assess four bi-polar dimensions of psychological type . According to this assessment, the majority (71 .5%) of accounting students are sensate, rather than intuitive, thinkers (prefer facts, patterns, rules, and procedures that emphasize highly-structured problems with specific solutions) . Personality studies show that accountants tend to prefer ordered, systematic manipulation of data and tend to avoid ambiguous,
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exploratory or unstructured situations (Tuckman & Orefice, 1973 ; Holland, 1973 ; Aranya et al ., 1978 ; Amernic et al ., 1979) . These studies show that, in general, accounting students are reluctant to accept a low-structured approach to learning ; yet, today's tax professionals need more than knowledge of the laws. Educators need to provide opportunities for students to become intuitive thinkers (focus on new possibilities and unstructured problems, understand reality through abstractions and complex formulations) so they can develop the necessary skills for the successful resolution of complex unstructured problems (Geary & Rooney, 1993) . In response to the teaching objectives promulgated by the Accounting Education Change Commission (1990), textbook authors have incorporated a more conceptual approach to teaching taxes as an alternative to the traditional rule-based method . The authors also include thought-provoking questions and problems to encourage students to use critical thinking skills . Teaching techniques should promote the skills necessary for students to acquire, retain, recall, and apply tax knowledge in a variety of situations . In practice, issues and solutions rarely are well defined or well structured, and the laws do not cover all possible circumstances . In ambiguous areas, the tax professional must identify the facts and issues and then rely on laws, legal precedent, and judgment to arrive at an appropriate solution . Reasoning is a key ingredient in this process . Students who possess a thorough knowledge of tax laws, planning strategies, and problem-solving skills are better prepared to cope with a variety of situations . The means by which students organize tax information for retention and recall is a key element in determining which instructional strategy will be most effective (Limberg et al ., 1995) . They found that the procedural approach is successful in learning rules or tax laws, but the conceptual approach is preferred in situations where judgment skills are needed . Anderson et al . (1989) found that the ability to apply laws was enhanced by using an examples approach, but the use of cases and concepts was superior in factor identification . This study includes two instructional methods - procedural and conceptual . The first treatment featured a procedural method in which examples were provided to illustrate tax laws . The second treatment followed a conceptual method in which court cases were discussed and the court's reasoning was provided . For this study, routine questions are defined as structured questions that deal with a knowledge base gleaned through instruction of tax laws in which examples are presented and problems can be solved with this knowledge . Since routine problems should be resolved by following the laws (which were
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identical to both groups), there should be no significant difference between the two treatment groups in the number of routine problems solved correctly . The first hypothesis (stated in the null form) was used to determine whether the method of instruction had an effect on the successful resolution of routine problems . Hypothesis 1 : There is no statistically significant difference between treatment levels in the mean number of correct responses to routine questions . Teaching/instructional cases provide opportunities for students to share ideas and provide insight into the rationale supporting various arguments . Use of hypothetical case studies can help students identify the facts of the case, the issues involved and the applicable Code sections . Actual court case studies are particularly useful in analyzing real-world situations because the laws must be interpreted in light of the existing situation . Court cases are used extensively in law schools and Subotnik (1987) suggests that accounting students would be better equipped to deal with atypical situations if they learned to focus more on interpretation of the laws rather than on technical aspects . Analysis of court cases can be used to determine the appropriate tax law and legal precedent to apply when there are no clearly defined rules . A tax debate (Schnee, 1980), journal entries (Fry & Fry, 1988), mental models (Marchant et al ., 1989), student-generated elaboration (Schadewald & Limberg, 1990 ; Hermanson, 1994), the falsification theory (Hite & Parry, Jr ., 1993), and pictorial models (Schadewald & Limberg, 1992) are other approaches that have been successful in promoting conceptual skills . If students understand the logic behind the interpretation of the laws in court decisions, then they should be able to apply the concepts to similar situations . Since students in treatment group two were given more detailed information about the issues and reasoning involved in the cases, they should perform better than the students in treatment group one who were given the solution but no explanation . For this study, novel questions are unstructured questions that deal with new or unique types of situations in which the tax laws do not specifically address the issue . Hypothesis 2 (stated in the null form) was developed to test whether there is a difference in the procedural and conceptual methods of instruction in the resolution of novel problems . Hypothesis 2 : Students in treatment two (court cases) will correctly solve more novel problems than students in treatment one (examples) . One challenge facing educators is to implement a learning environment that will emphasize the development and use of cognitive skills to enable students to interpret and analyze tax laws in various situations . Cognitive level of
The Effect of Instructional Strategy and Cognitive Level of Development
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development for this study is represented by three categories : (1) concrete thinkers require strategies and techniques that provide clear examples and concrete experiences to structure their thinking and to achieve understanding ; (2) transitional thinkers use a systematic approach to a problem with some use of abstractions and inferences but the performance is quite inconsistent; and (3) formal thinkers can draw inferences, can hypothesize, predict, and can generalize from their experiences to formulate general rules or principles . They can reconstruct their knowledge when new situations are encountered (Arlin, 1987) . Students' cognitive level of development is a key to the choice of an appropriate strategy because the students will not perform well if the method of instruction is beyond their cognitive ability (Reilly & Lewis, 1983) . For example, if the instruction method requires formal reasoning skills but the student is a concrete thinker, the student will have difficulty grasping the concept (Arlin, 1987) . The degree of structure in the learning environment has a significant impact on the ability of students to develop the skills they need to perform their duties as tax professionals . Hunter and Hunter (1984) stated that cognitive abilities are the single best predictor of job performance because they allow for innovation in novel situations . Memorization of tax laws limits students in the application of the laws. If students understand the concepts underlying the laws and can use critical thinking to analyze and interpret the laws, then they should be able to apply tax laws to numerous situations that vary from the stated laws . Bloom (1956) classified cognitive skills in a sequence of steps from the lowest level to the highest level of development. Higher-order-thinking skills consist of analysis, synthesis, and evaluation . Segovia and Bloom (1988) believe that these skills must be developed in an unstructured environment . Inhelder and Piaget (1958) identified four sequential stages of developmental thinking in children and adolescents, and the highest level of cognitive development (formal operational) should occur during adolescence . Most college students should have reached the highest level of cognitive development, but if educators fail to provide a learning environment conducive to cognitive growth, students may not rise above the lower levels of development . Cognitive ability will continue to develop as long as there is support and challenge in the environment (Hatfield & Hatfield, 1992 ; Revsine, 1970) . Shute (1979) found that there are certain thinking skills (formal operations) that are qualitatively different from those defined as intelligence . This conclusion supported the work of Perry (1970), who found that university students in the same year with comparable intelligence were at different points along the conceptual level continuum .
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Sander and Reding (1993) used the Arlin Test of Formal Reasoning (Arlin, 1984) to measure the cognitive abilities of entry-level accountants . They found that 96 .6% scored at the formal-operational (highest) level . This suggests that accounting graduates have the cognitive abilities needed for active learning even though they may not be required to use their abilities in accounting courses . According to Amernic and Beechy (1984), Tuckman and Orefice (1973), and Shute (1979), students of high cognitive ability perform better than students of low cognitive ability on novel questions, but students tend to perform equally well on routine questions regardless of their cognitive or conceptual level. The following hypotheses (stated in the null form) were tested to obtain evidence as to the effect of cognitive development on the ability to solve routine and novel questions . Hypothesis 3 : There is no statistically significant relationship between cognitive level of development and treatment level for the number of routine questions answered correctly . Hypothesis 4 : There is no statistically significant relationship between cognitive level of development and treatment level for the number of novel questions answered correctly .
RESEARCH METHOD Subjects A total of 214 volunteer students participated in the experiment from six colleges and universities located in Mississippi, Missouri, Texas, and Wyoming . Two schools are private and four are public . Participating students were accounting majors that included 20 graduate students, 105 seniors, 86 juniors, and three sophomores . Materials and Procedures The test items included three components and required approximately 50 minutes for completion . The cognitive test was completed first . The test used was the Arlin Test of Formal Reasoning (ATFR) . This test includes 32 multiple-choice questions, and each question has four response options . The ATFR was designed to assess the thinking skills or the processes by which an answer was obtained . This test is applicable to adults and can be administered easily in large group settings . The second item included a brief pretest and an experimentation packet consisting of general depreciation rules, a treatment, and
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a posttest . The third handout contained a request for demographic information, an answer sheet for the cognitive test, and an answer sheet for the pretest and posttest . Demographic information requested included age, gender, year in school, grade point average, grade in the first upper-division Financial Accounting course (Intermediate Accounting I in most universities), and ACT or SAT score . A pretest was given to all subjects to determine their level of pretreatment knowledge of depreciation and to assess pretreatment equivalence of the students in the treatment groups . Students had some prior knowledge of depreciation from introductory accounting courses and should have been familiar with the financial accounting rules regarding depreciation . The pretest consisted of a narrative describing a general business situation . Four multiple-choice questions were presented : two questions required knowledge of general depreciation rules and two questions required reasoning ability . Experiment
The first part of the experiment included a written narrative explaining the general tax laws for depreciation and reasons for the laws . The description included the general concepts underlying depreciation and several instances of specific laws regarding tax deductibility . The narrative was identical for both treatment levels . The second part of the experiment concerned the learning experience (treatment) through information presented in two different formats (examples and court cases) . The information provided in the treatments was issue specific for three different situations in which depreciation may or may not be allowed . The concepts were applicable to related topics . The information provided in the treatments contained facts from actual court cases (see Appendix A for a listing of court cases) . The cases for the treatments and the scenarios were selected from a large pool of cases involving depreciation . The cases chosen for inclusion in this experiment involved situations in which the solution was not readily apparent from preexisting knowledge because the general tax laws, as such, did not specifically address the issues involved . There were gray areas for which the laws could be interpreted in different ways . Subjects were randomly assigned to one of two treatment levels . Treatment level one had written information using the procedural approach in the form of examples that illustrated specific depreciation laws and their application . The three examples were contained on one page . Following a presentation of the facts, a statement was made that indicated whether depreciation was or was not
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allowed, and a brief explanation was provided . Treatment level two was given written information using the conceptual approach presented in the form of court cases . The facts presented in the examples and court cases were identical . The court cases also included identification and discussion of the issues that were directly involved, the opinion of the court, and the reason for the court's decision . By analyzing the logic and legal interpretation used in court cases, students should be able to transfer the concepts to similar situations . The court cases were presented on two pages . Copies of the two treatments are available at http ://home .olemiss .edu/actonya/recent .htm . The third part of the experiment was a posttest that included four scenarios, and each scenario contained two descriptive situations . Using information from actual court cases prevented any bias from entering into the facts, and students had an opportunity to study and evaluate real-world situations . Each scenario included three multiple-choice questions and each question had four response options . The response options were based on the arguments posed by the Internal Revenue Service and by the taxpayer to the extent possible . In several instances, considerations expressed by the judge were used as response options . If a sufficient number of arguments was not presented in a court case, then response options were included that were appropriate for the topic . The questions required knowledge of the tax laws that were presented in the general depreciation information and the ability to apply concepts to a variety of tax contexts in which reasoning and judgment were necessary to interpret the laws . Although college students cannot be expected to fully understand the intricate nature of the tax laws or the many possibilities that exist in court arguments, the challenge facing them was to interpret their knowledge of the laws to justify their choice of answer . Computation of dollar amounts was not required . There were 12 questions in the posttest - six routine and six novel . As discussed earlier, routine questions are defined as structured questions that deal with a knowledge base gained through instruction of tax laws in which examples are presented and problems can be solved with this knowledge. Novel questions are unstructured questions that deal with new or different types of situations in which the tax laws do not specifically address the issue in question . The question structures appeared randomly throughout the post-test scenarios . Each correct answer was coded as one and each incorrect answer was coded as zero . The correct answer was the one that was in conformity with the decision of the court. Each correct answer was worth one point . Two scores were recorded for each subject : the first score was the total number of correct answers (0 to 6) for the routine questions and the second score was the total number of correct answers (0 to 6) for the novel questions .
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Variables
This experiment included five variables for hypothesis testing . The two dependent variables were the number of routine questions answered correctly (routine score) and the number of novel questions answered correctly (novel score) . The independent variables were treatment level, question structure, and cognitive level of development . Treatment level one employed a procedural (examples) instructional strategy and treatment level two employed a conceptual (court cases) instructional strategy . Treatment level was the only variable manipulated .
RESULTS A one-way ANOVA (not reported) was used to test for statistically significant differences between the two treatment levels based on the pretest . The results of the pretest showed that students in treatment one performed slightly better than students in treatment two on all of the pretest questions, but the difference was not significant . Additional comparisons were made for each of the demographic variables, and for the different universities involved . No significant differences were found in any of these comparisons . Hypothesis I states that there is no statistically significant difference between treatment levels for the number of routine questions answered correctly . Table I contains the one-way ANOVA used as the statistical test . The results show Table 1 .
Effect of Instructional Strategy Routine Score - Hypothesis 1 .
A . Mean and Standard Deviation for routine score:
ROUTINE B . ANOVA Results : Source
SS
Treatment I Mean SD
Treatment 2 Mean SD
3 .10
3 .65 1 .31
1 .41
df
Main Effect TREATMENT Explained Residual
392 .08
1 l 1 212
Total
408 .35
213
16 .27 16 .27 16 .27
Note: * = significant at p < 0 .05 .
MS
F
16 .27 16 .27 16 .27 1 .85
8 .80 8 .80 8 .80
1 .92
Prob . > F 0 .003 0 .003* 0 .003
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SHARON K. FORD AND TONYA K. FLESHER
that there was a statistically significant difference (p = 0 .003) between treatment levels for total correct responses to routine questions . The mean number of correct responses for treatment one was 3 .10 and the mean number of correct responses for treatment two was 3 .65 . Students in treatment two (court cases) performed significantly better than students in treatment one even though both levels had identical information regarding the basic laws . Thus, Hypothesis 1 was not supported . Results of Hypothesis I revealed that the method of instruction had a significant effect for solving routine questions . The additional information included with the court cases, with a more detailed discussion of the issues and the court's decision, may have provided insight that supplemented the students' knowledge of the general laws for solving routine problems . Since students in treatment two were given information about the issues considered by the court and the logic used to determine a conclusion, they may have noticed the similarities between the court case and the given problem . Students in treatment one relied solely on their knowledge of the laws and their interpretation of the brief example that was provided . It may have been more difficult for them to transfer that knowledge to a similar situation . Hypothesis 2 predicts that students in treatment two (court cases) would perform significantly better than students in treatment one (examples) in solving novel problems . Treatment two students had access to more detailed information in the experiment regarding the issues involved and the reasoning for the court's decision ; thus, they would be able to transfer the logic and concepts to similar situations . A one-way ANOVA was used as the statistical test for Hypothesis 2 and the results are presented in Table 2 . The mean number of correct responses to novel questions for treatment one was 2 .22 and the mean number of correct responses for treatment two was 2 .12 . There was no statistically significant difference (p = 0 .571) between treatment levels for correct responses to novel questions . Surprisingly, the students in treatment one outperformed the students in treatment two . Therefore, the results do not support Hypothesis 2 . The results relative to Hypothesis 2 were a complete surprise . Students in treatment two should have performed better than students in treatment one on novel questions since they were exposed to a discussion of the issues involved and the reasons for the court's decision . Instead, students in treatment one correctly solved a larger mean number of novel problems . One possible explanation is that students lack experience in rule interpretation and in analyzing court cases and they may not be able to find the connection between issues and reasoning in complex situations . The second possible explanation is that the students in treatment one had a higher level of cognitive ability and were better able to resolve unstructured
The Effect
of Instructional
Table 2 .
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Strategy and Cognitive Level of Development
Effect of Instructional Strategy Novel Score - Hypothesis 2 .
A . Mean and Standard Deviation for novel score:
NOVEL B . ANOVA Results: Source
Treatment I Mean SD
Treatment 2 Mean SD
2.22
2 .12
SS
1 .28
1 .32
df
MS
F 0 .33 0 .33 0 .33
Main Effect TREATMENT Explained Residual
0 .57 0.57 0 .57 360 .04
212
0.57 0.57 0 .57 1 .70
Total
360.61
213
.69 1
Prob . > F 0 .571 0.571 0 .571
Note: * = significant at p < 0 .05 .
problems even with less detailed information . Treatment one students had a mean cognitive score of 20 .29, whereas treatment two students had a mean cognitive score of 19 .68 (the difference in the scores was not statistically significant) . A 2 x 3 factorial design with two main-effect terms (treatment level and cognitive level of development), one dependent term (routine score) and one interaction term (treatment by cognitive development) was used to test Hypothesis 3 . Subjects were randomly assigned to one treatment level and were classified in one level of cognitive development according to the total number of correct responses on the cognitive test. The three categories of cognitive Table 3.
Effect of Treatment and Cognitive Level of Development Routine Score - Hypothesis 3 .
Source
SS
df
MS
F
2 way interaction TREATMENT x CLD Explained Residual
8 .84 6 .56 2 .57 1 .44 1 .44 20.38 387 .96
2 2 2 5 208
2.95 6.56 1 .29 0.72 0 .72 4.08 L87
1 .58 3 .52 0 .69 0 .39 0 .39 0 .19
Total
408.34
213
1 .92
Main Effect TREATMENT CLD
Note: CLD = Cognitive Level of Development.
Prob . > F 0 .196 0 .062 0 .503 0 .681 0 .681 0 .057
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SHARON K. FORD AND TONYA K . FLESHER
development were concrete (0-14 correct responses), transitional (15-17 correct responses) and formal (18-32 correct responses) . Concrete thinkers require specific strategies and techniques that provide clear examples and concrete experiences to structure their thinking and to achieve understanding. Transitional thinkers use a systematic approach to a problem with some use of abstractions and inferences but the performance is quite inconsistent . Formal thinkers can draw inferences, hypothesize, predict, and generalize from their experiences to formulate general rules or principles . They can reconstruct their knowledge when new situations are encountered (Arlin, 1987) . Results show no statistically significant interaction between treatment level and cognitive level of development (p = 0 .681) . The results were then analyzed for main effect differences . The main effect of treatment revealed a statistically significant difference at the formal level, but there were no significant differences at the transitional and concrete levels . At the formal level, students in treatment level two performed significantly better than students in treatment level one . Results are provided in Table 4 . The main effect of cognitive level of development (Table 5) revealed no significant differences among the three levels in the number of correct responses to routine questions . This result agrees with conclusions reached by Amemic and Beechy (1984), Tuckman and Orefice (1973) and Shute (1979) who found that students perform equally well on routine questions regardless of their cognitive or conceptual level . Students classified in the formal level did not score significantly better than students classified in the transitional and concrete categories . Since there was a significant difference at the formal level for the main effect of treatment, Hypothesis 3 was not supported . A 2 x 3 factorial design with two main-effect terms (treatment level and cognitive level of development), one dependent term (novel score) and one interaction term (treatment by cognitive development) was used to test Hypothesis 4 . Subjects were randomly assigned to one treatment level and were classified in one level of cognitive development according to the total number of correct responses on the cognitive test . Results show no statistically significant interaction between treatment level and cognitive level of development (p = 0 .449) . The results were then analyzed for main effect differences . The main effect of treatment level did not have a significant impact (p = 0 .966) on the number of novel questions answered correctly at each level of cognitive development (Table 7) . The main effect of cognitive level of development shows a significant difference (p = 0 .000) in the number of novel questions answered correctly among the levels of cognitive ability (Table 8) . Thus, Hypothesis 4 was not supported .
77
The Effect of Instructional Strategy and Cognitive Level of Development Table 4.
Main Effect - Treatment Routine Score .
A . Mean and Standard Deviation for novel score : Treatment I Mean SD Concrete Transitional Formal
3 .11 (9) 3 .05 (22) 3 .12 (76)
Treatment 2 Mean SD
136 . .33 1 .45 1
3 .53 (15) 3 .39 (23) 3,77 (69)
1 .25 1 .27 1 .34
B . ANOVA Results : Source
SS
df
MS
F
0 .60 0 .60 0 .60
0 .446 0 .446 0 .446
080 . 0 .80 0 .80
0 .377 0 .377 0.377
7 .79 7 .79 7 .79
0 .006 0 .006 0 .006
1 . CONCRETE* Main Effect TREATMENT Explained Residual
.00 .00 .00 36.62
I 1 1 22
1 .00 1 .00 1 .00 1 .67
Total
37 .62
23
1 .64
2. TRANSITIONAL* Main Effect TREATMENT Explained Residual
1 .35 1 .35 1 .35 72.43
I I I 43
1 .35 1 .35 1 .35 .68 1
Total
73 .78
44
1 .68
3 . FORMAL* Main Effect TREATMENT Explained Residual
15 .27 15 .27 15 .27 280.22
1 I 1 143
15 .27 15 .27 15 .27 1 .96
Total
295.49
144
2 .05
Prob . > F
* = Concrete - use of a systematic approach to problems but unable to form a general rule or abstraction from the problems . Transitional - use of a systematic approach to problems and some use of abstractions and inferences but the performance is inconsistent . Formal - capable of abstractions and making inferences by drawing on previous experiences .
Special Tests Since there were three levels of cognitive development, a Student NewmanKuels test was conducted to determine differences between all possible pairs of means . The mean scores on novel questions for the three levels (concrete, transitional, formal) were 1 .50, 1 .74, and 2 .42, respectively . Results of the
SHARON K . FORD AND TONYA K. FLESHER
78
Table 5.
Main Effect - Cognitive Level of Development Routine Score .
Source
SS
df
MS
F 0.53 0 .53 0 .53
Main Effect TREATMENT Explained Residual
2 .04 2 .04 2 .04 406 .30
2 2 2 211
1 .02 1 .02 1 .02 1 .93
Total
408 .34
213
1 .92
Table 6.
Prob . > F 0.590 0 .590 0 .590
Effect of Treatment and Cognitive Level of Development Novel Score - Hypothesis 4 .
Source
SS
df
MS
F
Prob . > F
5 .80 0 .00 8 .50 0.80 0.80 3 .94
0.001 0.966 0 .000* 0 .449 0.449 0 .002
Main Effect TREATMENT CLD 2 way interaction TREATMENT x CLD Explained Residual
7 .54 0 .00 26 .92 2 .55 2 .55 31 .20 329 .40
3 1 2 2 2 5 208
9 .18 0 .00 13 .46 1 .27 1 .27 6.24 1 .58
Total
360 .60
213
1 .69
Note: CLD = Cognitive Level of Development ; * = significant at p < 0 .05 .
Student Newman-Kuels procedure indicated statistically significant differences in mean novel score between transitional and formal and between concrete and formal . There was no significant difference between transitional and concrete . A paired-samples t-test was used to evaluate the results for simple effect differences between routine score and novel score within each treatment level . The paired samples were routine score and novel score and results are presented in Table 9 . The results of this evaluation show that there was a statistically significant difference (t = 0 .000) in question structure for treatment level one and that there was a statistically significant difference (t = 0 .000) in question structure for treatment level two . As expected, the novel problems were more difficult to solve for both treatment groups . The overall results indicate that students in both treatment levels had a higher mean number of correct responses on routine questions than on novel questions . This result was expected since accounting
The Effect of Instructional Strategy and Cognitive Level of Development
Table 7.
79
Main Effect - Treatment Novel Score.
A. Mean and Standard Deviation for novel score : Treatment / Mean SD Concrete Transitional Formal B . ANOVA Results : Source
1 .67 (9) 1 .55 (22) 2.49 (76)
SS
Treatment 2 Mean SD
1 .32 0.91 1 .29
1 40 (15) . 1 .96 (23) 2 .33 (69)
1.12 1 .30 1 .32
df
MS
F
0.28 0 .28 0 .28
0 .603 0 .603 0 .603
1 .50 1 .50 1 .50
0 .227 0 .227 0 .227
0 .50 0 .50 0 .50
0 .481 0 .481 0 .481
1 . CONCRETE* Main Effect TREATMENT Explained Residual
0.40 0 .40 0.40 31.60
1 1 1 22
0.40 0.40 0.40 1 .44
Total
32.00
23
1 .39
2 . TRANSITIONAL* Main Effect TREATMENT Explained Residual
1 .90 1 .90 1 .90 54.41
I I I 43
1 .90 1 .90 1 .90 1 .27
Total
56 .31
44
1 .28
3 . FORMAL* Main Effect TREATMENT Explained Residual
0.85 0 .85 0 .85 244.32
I I I 143
0.85 0 .85 0.85 1 .71
Total
245 .17
144
1 .70
Prob . > F
= Concrete - use of a systematic approach to problems but unable to form a general rule or abstraction from the problems . Transitional - use of a systematic approach to problems and some use of abstractions and inferences but the performance is inconsistent . Formal - capable of abstractions and making inferences by drawing on previous experiences .
students are exposed to routine problem solving in most courses, but are given few opportunities to exercise analytical skills needed for novel problem solving . (Eleven subjects scored a perfect six points on the routine questions and three subjects scored zero points on the routine questions . One person scored a perfect six points on the novel questions and 21 subjects scored zero points on the novel questions .)
SHARON K . FORD AND TONYA K . FLESHER
80 Table 8.
Main Effect - Cognitive Level of Development Novel Score . SS
Source
df
MS
F 9 .08 9 .08 9 .08
Main Effect TREATMENT Explained Residual
28 .57 28 .57 28 .57 332 .03
2 2 2 211
14 .29 14.29 14.29 1 .57
Total
360 .60
213
1 .69
Table 9.
t Corr .
Value
107
0 .21
3 .10 -5 .37 2.22
A . TREATMENT 1 : Routine Novel Paired difference : B . TREATMENT 2 : Routine Novel Paired difference :
0 .000 0 .000 0 .000
Paired Samples T-test .
Number of pairs
107
Prob . > F
0.24
3 .65 -9.74 2.12
2 tail significant
Mean
1 .41 0 .00* 1 .28 -0 .88
-1 .20
SD
1 .31 0 .00* 1 .32 -1 .53
1 .63
Note: * = significance at p < 0 .05 .
CONCLUSION This study has several limitations that affect its generalizability . First, volunteer students may not be a representative sample of the students enrolled in the selected courses . This effect was mitigated somewhat because all students in the designated classes were tested for more than three-fourths of the total number of subjects . Secondly, the experiment includes only one tax issue (depreciation) with pre-existing knowledge. The results may not be generalizable to other tax issues or to tax issues with no pre-existing knowledge . Also, faculty members may use different approaches to teach depreciation that may also limit the generalizability of this topic . Thirdly, the testing process consisted of multiple-choice responses, so it is difficult to determine if the response selected
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of Instructional
Strategy and Cognitive Level of Development
81
was based on knowledge or if the choice was strictly a good guess . Students who guessed correctly may have scored very well even though they may not have learned, or understood, the material presented . A different question structure may have led to different results . Multiple-choice answers may have generated bias since the choices are more closely linked to routine situations that call for a correct answer . Answers that required a written solution to justify the response would have been more applicable in the novel situations . Thus, all conclusions are stated within these limitations . The results of this study show that information gained through evaluation of court cases helped students solve routine problems, but the additional information provided little assistance in solving novel problems . Although students at the formal level correctly solved more problems than students in the concrete and transitional levels, the difference was not significant . This lends support to the theory that knowledge and application does not require a high level of cognitive ability for successful resolution of a structured situation . Students in the formal level of cognitive development performed significantly better than students at the concrete and transitional levels in solving novel problems . This result was not unusual since students at a higher level of cognitive development should have more highly-developed logic and critical thinking skills . The novel problems were more difficult to solve than routine problems at all levels of cognitive development . This result emphasizes the fact that students need to have opportunities to develop their higher-order thinking processes so they are prepared to deal with unstructured situations in practice . Educators must be supportive of a learning environment in which thoughtprovoking exercises and problems are introduced on a regular basis . One of the difficulties facing educators is how to include situations that require higher-order thinking skills that are appropriate for the cognitive levels of all students . In most tax classes, there will be a few students who function at the low level of cognitive development and they will likely have difficulty in analyzing complex situations . The most logical course of action is to start with situations that involve only one issue . As students develop skill and confidence in their ability to reason and consider various possibilities, the problems can become more complex later in the semester . If students become active learners and creative thinkers, then they are more likely to remember the concepts and implications applicable to the laws and how they can synthesize and evaluate information . Textbook authors provide numerous situations that are designed to stimulate and enhance conceptual abilities and educators should use some or all of these techniques in their classroom . Future study in the use of different instructional strategies might include a topic other than depreciation . Another possibility is that there could be some
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or all open-ended questions where students must justify their responses . Finally, a similar study could be done using a different cognitive test or students from different universities .
REFERENCES Accounting Education Change Commission (1990) . Objectives of Education for Accountants : Position Statement Number One . Issues in Accounting Education, 5(2), 307-312 . American Accounting Association Committee on the Future Structure, Content, and Scope of Accounting Education (The Bedford Committee) (1986), Future Accounting Education : Preparing for the Expanding Profession . Issues in Accounting Education, 1, 168-195 . Amenic, J . H., & Beechy, T . H . (1984) . Accounting Students Performance and Cognitive Complexity : Some Empirical Evidence . The Accounting Review, LIX(2), 300-313 . Amernic, J. H ., Arrays, N ., & Pollock, J . (1979) . Is There a Generally Accepted Standard Accountant. CA Magazine (October), 34-42 . Andersen, A ., & Co ., Young, A ., Coopers & Lybrand, Deloitte Haskins and Sells, Ernst & Whinny, Peat Marwick, Main & Co ., Price Waterhouse, and Touche Ross (The Big Eight) . (1989) . Perspectives on Education : Capabilities for Success in the Accounting Profession . Anderson, U., Marchant, G ., & Robinson, J . (1989). Instructional Strategies and the Development of Tax Expertise . The Journal of the American Taxation Association (Spring), 7-23. Arrays, N ., Men, E . I ., & Bar-Ilan, A. (1978) . An Empirical Examination of the Stereotype Accountant Based on Holland's Theory . Journal of Occupational Psychology, 5](2), 139-145 . Arlin, P . K. (1984) . Arlin Test of Formal Reasoning . New York: Slosson Education Publications, Inc . Arlin, P . K . (1987) . Teaching for Thinking . New York : Slosson Educational Publications, Inc. Bloom, B . S . (Ed .) (1956) . Taxonomy of Educational Objectives Handbook 1 Cognitive Domain . New York : David McKay Company, Inc . Booker, Q ., Brenner, V . C ., & Blum, J . D . (1998). Brave New World for the CPA Exam. Journal of Accountancy (January), 61-64 . Fry, N . E., & Fry, E. H. (1988). How Journal Entries Aid the Teaching of Taxation. Journal of Accounting Education, 6, 149-157 . Geary, W . T., & Rooney, C . J . (1993) . Designing Accounting Education to Achieve Balanced Intellectual Development . Issues in Accounting Education, 8(l), 60-70. Hatfield, T ., & Hatfield, S. R . (1992) . As if Your Life Depended on it : Promoting Cognitive Development to Promote Wellness . Journal of Counseling and Development, 7](2), 164-167 . Hermanson, D . (1994) . The Effect of Self-Generated Elaboration on Students' Recall of Tax and . Issues in Accounting Education (Fall), 301-318 . Accounting Material : Further Evidence Hite, P . A., & Parry, R . W., Jr. (1993) . An Investigation of How Incorrect Examples Can Enhance Tax Rule Comprehension . Journal of Accounting Education, 11, 227 241 . Holland, J . L. (1973) . Making Vocational Choices : A Theory of Careers . Upper Saddle River : Prentice Hall . Hunter, J . E ., & Hunter, R. F. (1984) . Validity and the Utility of Alternative Predictors of Job Performance . Psychological Bulletin, 96, 72-98 . Inhelder, B ., & Piaget, J . (1958) . The Growth of Logical Thinking from Childhood to Adolescence . New York : Basic Books, Inc.
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Kitten, M . . 1 (1976) . Adaptors and Innovators: A Description and Measure . Journal of Applied Psychology, 62, 622-629 . Limberg, S . T., Schadewald, M. S ., & Spilker, B . C . (1995). Organizing Tax Instruction : Evidence Regarding How Students Organize Tax Knowledge . Journal ofAccounting Education, 13(1) . 45-58 . Marchant, G., Robinson, 1 ., Anderson, U ., & Schadewald, M . S . (1989) . A Cognitive Model of Tax Problem Solving . Advances in Taxation, 2, 1-20 . May, G . S ., Winds], F . W., & Sylvestre, J . (1995). The Need for Change in Accounting Education : An Educator Survey . Journal of Accounting Education, 13(1), 21-43 . Perry, W . G ., Jr . (1970) . Forms of Intellectual and Ethical Development in the College Years . Fort Worth : Holt, Rinehart and Winston . Reilly, R. R ., & Lewis, E . L . (1983) . Educational Psychology: Applications for Classroom Learning and Instruction . New York : Macmillan Publishing, Revsine, L . (1970) . Data Expansion and Conceptual Structure . The Accounting Review, XLV(4) . 704-711 . Sander 1 . F ., & Reding, K. F . (1993) . An Empirical Investigation of Entry-level Accountants' Cognitive Abilities . Accounting Educator's Journal, 5(I), 42-54 . Schadewald, M . S ., & Limberg, S . T . (1992) . Using Pictorial Models to Teach Complex Tax Rules : An Experimental Investigation . Journal of Accounting Education, 10, 133-149 . Schadewald, M . S ., & Limberg, S . T . (1990) . Instructor-Provided Versus Student-Generated Explanations of Tax Rules : Effect on Recall . Issues in Accounting Education, 5(l), 30-40 . Schnee, E . 1 . (1980) . An Alternative Final Examination - A Tax Debate, The Journal of the American Taxation Association (Summer), 29-31 . Segovia, J . J ., & Bloom, R . (1988) . A Cognitive Approach to Accounting Instruction : An Application to The Introductory Course . Accounting Educator's Journal (Spring), 118-128 . Shute, G . E . (1979) . Accounting Students and Abstract Reasoning : An Exploratory Study. Sarasota : American Accounting Association . Subotnik, D . (1987). What Accounting can learn from Legal Education . Issues in Accounting Education, 2(2), 313-324 . Tuckman, B . W . . & Orefice . D . S . (1973) . Personality Structure, Instructional Outcomes, and Instructional Preferences . Interchange, 4, 43-48 . Welk, C . M ., & Cates, T . A . (1994) . Problem-Solving Styles of Accounting Students : Are Expectations of Innovators Reasonable. Journal of Accounting Education, 12(4), 269-281 . Young, L. (1992) . Critical Thinking Skills : Definitions, Implication for Implementation . NASSP Bulletin, 76, 47-54 .
APPENDIX A Court Cases
49 AFTR 491, 231 F .2d 635, 56-1 U .S .TC 19441 . Ekberg v. U .S., 5 AFTR 2d 979, 60-1 U .S .TC 19332 . Johnson, Jr . v . U.S ., 7 AFTR 2d 793, 61-1 U .S .TC 19278 . Alexis M. Hawkins and Rosemary K. Hawkins, 713 F .2d 347, 44 TCM 715 Commissioner of Internal Revenue v. Doyle,
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Keith C. Nickisch and Teresa J. Nickisch v. Commissioner, T . C . Memo . 1984-275 . Associated Obstetricians and Gynecologists, P . C. v. Commissioner of Internal Revenue, 46 TCM 613, TC Memo . 1983-380. Westinghouse Broadcasting Company, Inc. v. Commissioner of Internal Revenue, 36 TC 912 . (1962) . J. J. Sexton, 42 TC 1094 . (1964) . Paul P. Slawek and Susan C. Slawek v. Commissioner, T. C . Memo 1987-438 .
MARGINAL TAX RATES ON FOREIGN PROFITS OF U .S . MULTINATIONALS Gregory G. Geisler and Ernest R . Larkins
ABSTRACT Many studies find that taxes influence capital location, income shifting, and capital structure decisions of multinational companies . So, reasonably estimating the marginal tax effect of international business decisions is important. However, simple marginal tax rate (MTR) proxies, such as a foreign country's top statutory rate or a rate that assumes remittance of all foreign profits as current dividends, fail to capture many tax law complexities. This article develops an algebraic "mixed remittance" model for calculating a U.S. company's MTR on its foreign subsidiary's profits . In contrast to the simpler proxies, the mixed remittance model allows foreign profits to be remitted in different forms (i .e . not just as dividends) and across varying time periods (i.e . not just the current period) . Also, the mixed remittance model considers withholding taxes, tax deferrals from postponed dividends, and foreign tax credit positions . Paired t-tests show that the resulting MTR measure often differs significantly from the two simpler MTR proxies.
Advances in Taxation, Volume 14, pages 85-116 . Copyright 0 2002 by Elsevier Science Ltd . All rights of reproduction in any form reserved . ISBN : 0-7623-0889-3 85
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GREGORY G . GEISLER AND ERNEST R. LARKINS
INTRODUCTION Many studies provide evidence that taxes influence capital location and income shifting behavior of multinational companies (e .g . Altshuler & Newlon, 1993 ; Harris, 1993 ; Klassen et al ., 1993 ; Wilson, 1993 ; Jacob, 1996 ; Mills & Newberry, 2001 ; Vines & Moore, 1996 ; Collins et al ., 1998 ; Collins & Shackelford, 1998 ; Kemsley, 1998) .' Other studies find that tax law changes affect capital structure decisions of multinationals (e .g . Collins & Shackelford, 1992 ; Smith, 1997 ; Newberry, 1998) . Thus, reasonably estimating the marginal tax effect of any international business decision is important . Since tax rates differ across countries, marginal tax rates (MTRs) on foreign direct investments vary across countries . Scholes et al . (2002, p . 139) observe that since a multinational company "is composed of distinct legal entities, its left pocket is often taxed differently from its right pocket ." One tax planning principle is to shift income so it is taxed in the "lower-taxed pocket." Thus, understanding MTRs and their calculations is essential for a taxpaying entity's evaluation of "in-place" or proposed direct investments abroad and the corresponding effects on the entity's profits . This article develops a mixed remittance model for calculating a U .S . multinational corporation's MTR from a foreign subsidiary earning and remitting foreign profits .' The model is flexible enough to consider a variety of remittance strategies (i .e. dividends, interest, and royalties) that cover both current and future years and is termed "mixed" since any combination of remittance forms can be included in the model . After-tax foreign profits are a function of foreign profits and taxes . Taxes depend on the MTR ; this article focuses on MTRs . 3 An MTR is the present value of additional tax on an incremental (i .e. marginal) amount of foreign profits divided by the incremental foreign profits . The additional tax in the MTR's numerator includes both tax paid currently and the present value of any tax paid in the future . The decision context in this article involves a firm's foreign direct investment or, more specifically, a U .S . multinational's operation of a foreign subsidiary . Thus, the denominator is the foreign subsidiary's foreign profits, while the numerator includes foreign income tax, foreign withholding taxes on remittances (i .e . repatriation of foreign profits), and U .S . income tax attributable to the foreign profits . Modeling and calculating MTRs for direct investments abroad are more complex than for domestic investments due to additional layers of tax and the limitations on credits for foreign taxes paid . Depending on the foreign jurisdiction and its laws, foreign profits are generally subject to foreign income tax, and profit remittances may be subject to withholding taxes . Withholding
Marginal Tax Rates on Foreign Profits of U .S. Multinationals
87
tax rates may vary depending on the remittance form (e .g . dividends versus interest)" Also, modeling and calculating MTRs requires knowledge of the home country's foreign tax credit rules and their impact on a given remittance decision.' Shevlin (1990) and Graham (1996a, b) estimate a firm's MTR on an additional $1 of worldwide income but do not address this article's decision context . For example, Shevlin (1990, p . 59) states that his MTR "assumes all income, both domestic and foreign, is subject to" tax at the U .S . statutory rate . This assumption is valid only when all foreign profits are subject to foreign income tax at rates not exceeding the U .S . statutory rate, all profits remaining after foreign income tax are repatriated in the current year, and the taxpayer has no foreign tax credit position . In contrast, we estimate the MTR on a foreign subsidiary's profit that is remitted in a variety of forms, over one or more years, and to a U .S . parent with an existing foreign tax credit position . The MTR measure we develop in this article, using the mixed remittance MTR model, incorporates tax planning procedures . It differs significantly from two measures academicians and practitioners sometimes use to proxy for MTRs : (1) the foreign country's top statutory tax rate (e.g . Gordon & Jun, 1993 ; Smith, 1997 ; Zahlander, 1992) ; and (2) a tax rate based on the assumption that all foreign profits are currently remitted as dividends (e .g . Eskinazi, 1994 ; Larkins, 2000) . Our mixed remittance MTR model permits more accurate estimates of MTRs than either of these other two measures since it allows for both remittances in different forms and deferral of dividends . Stated more broadly, our mixed remittance model captures much more of the "richness" contained in U .S . and foreign taxation rules . MTRs are important to several groups including tax planners, academic researchers, policy analysts, and policy makers . Tax planning involves making investment and financing decisions to maximize the present value of risk-adjusted, after-tax returns . A key input for determining the after-tax return from a given decision is the MTR, which tax planners apply to expected before-tax returns . The process of modeling MTRs highlights, and often leads to a clearer intuitive understanding of, the relevant tax factors and their interactions . Government tax policy analysts and academic researchers must understand the economic incentives the tax laws create to explain and predict behavioral reactions to tax legislation . For example, a simple comparison of U .S . and foreign statutory income tax rates might not provide sufficient insight into where multinationals are expected to shift income in reaction to new tax legislation . One reason for the insufficiency is that withholding tax rates are also important determinants since ultimately profits must be remitted to the home
88
GREGORY G . GEISLER AND ERNEST R. LARKINS
country . If the foreign tax law is structured such that most multinationals attempt to remit profits in deductible forms and few constraints exist to such a strategy under the host country tax law, any analysis that ignores withholding taxes might lead to both prediction and measurement errors . Specifically, a withholding tax rate applies to such profits in lieu of the host country's income tax rate and the two rates often differ significantly . Reasonably accurate predictions of behavioral reactions to tax law changes (i .e. shifts in multinational investment and remittance patterns) lead to better estimates of the tax revenue effects . Anticipating the pattern of behavioral reactions before legislative proposals become law allows government policy makers to either reverse or modify legislation to preclude or mollify unintended firm behavior . Thus, determining MTRs on foreign profits is important for policy analysts who must project tax revenues, policy makers concerned with reactions to tax laws, and academic researchers seeking to explain behavioral responses of multinational companies .' The first section defines the MTR concept and explains some overall assumptions underlying the model . As a basis for the examples and model that follow, Section 2 presents a brief review of the foreign tax credit . Section 3 provides examples with a combination of remittance forms to calculate MTRs for direct investments abroad in both high- and low-tax foreign countries . Section 4 develops the MTR model . In Section 5, we calculate a U .S . multinational's MTRs for foreign subsidiaries in a variety of countries . We demonstrate that the estimates from the mixed remittance MTR model often differ from both statutory tax rates and tax rates based on remittance of all after-tax profits as dividends each year . Section 6 provides concluding observations.
1. MTR DEFINITION, USE, AND ASSUMPTIONS A company's MTR on foreign profits generally is equal to the present value of its current and future income tax liability resulting from a foreign business decision divided by the incremental income from the same decision? The MTR's numerator includes incremental federal and foreign tax liabilities, where the latter includes both foreign income and withholding taxes .' The foreign income tax rates include all national and local taxes based on income .9 The MTR's denominator is the incremental U .S . taxable income from foreign business operations . MTRs are useful for making many types of decisions relating to direct investments abroad . 10 Common decisions include :
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• whether to shift income between two countries (e.g . through changing transfer pricing policies) ; • whether a U .S . multinational should establish a foreign subsidiary to conduct business abroad and, if so, in which foreign country to establish it ; • how to remit foreign profits back to the home country (e .g . as interest, royalties, current dividends, future dividends, or some combination) ; and • where to obtain debt financing .
The MTR model developed assumes the following : both the United States and the foreign country similarly measure the taxable income resulting from a foreign direct investment, after-tax profits equal earnings and profits (E&P) (i .e . no book/tax differences), all tax rates are stable over time, and multinationals are subject to the maximum statutory rate in the relevant countries .'' The home country is assumed to be the United States . 12 Finally, the models focus on fundamental tax strategies for earning and remitting foreign profits from foreign subsidiaries . 13
2. OVERVIEW OF FOREIGN TAX CREDIT RULES Since the foreign tax credit (FTC) mitigates the effect of double taxation, it is an integral part of our MTR models . The FTC provisions appear in I.R .C . Sections 901 through 908 . The first four sections contain the fundamental rules . 14 I .R .C. Section 901 allows a FTC for foreign income taxes paid or accrued directly to a foreign country . Such taxes are known as creditable taxes or levies . I .R .C . Section 902 grants a FTC to U .S . corporations receiving dividends from their foreign subsidiaries based on income taxes the latter pay ." I .R.C . Section 903 permits a FTC for any tax substituting for a foreign income tax such as withholding taxes on profits remitted as dividends, interest, and royalties . I .R .C . Section 904 limits the FTC allowed under I .R .C . Sections 901 through 903 to the U .S . tax imposed on foreign source income . Deemed Paid Credit
While I .R .C . Sections 901 and 903 permit a FTC for taxes directly paid or withheld, I .R .C . Section 902 allows a FTC for creditable taxes deemed paid . To qualify for a deemed paid credit (DPC), a U .S . corporation must receive a dividend from a ten percent-owned foreign subsidiary . 16 In effect, the U .S . corporation is treated as though it paid the foreign income taxes that its foreign subsidiary actually paid . However, the attribution of the foreign income taxes to the U .S . company occurs only as it receives dividends from its foreign
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GREGORY G . GEISLER AND ERNEST R. LARKINS
subsidiary . In other words, the dividends bring with them creditable taxes . The proportion of the foreign subsidiary's earnings and profits (E&P) that it remits as a dividend determines the percentage of the foreign subsidiary's foreign income taxes attributable to the U .S . parent . The U .S . corporation claims a DPC for all or some portion of the foreign subsidiary's foreign income taxes and reports the dividends as gross income . The DPC concept can be summarized as follows : Dividend Received from Foreign Subsidiary Section 902 DPC = E & P of Foreign Subsidiary (1) x Tax Foreign Subsidiary Paid I.R .C . Section 78 requires the U .S . company to "gross up" the dividend, which means increasing its gross income by the DPC . In substance, I.R .C . Sections 78 and 902 combine to treat the foreign subsidiary as though it transferred funds necessary to pay its foreign income tax to its U .S . parent company, and the latter paid such taxes directly . To illustrate, assume a U .S . corporation organizes a wholly-owned subsidiary in a foreign country . During its first year, the subsidiary earns before-tax profits of $1,000, pays foreign income tax of $200, and has $800 of E&P. At year end, the subsidiary pays a $720 dividend to its parent company (90% x $800 E&P) . The U .S . corporation is entitled to a DPC of $180 (90% x $200 foreign income tax) and must include $900 in its gross income ($720 dividend received + $180 DPC) . Note that the $900 inclusion in gross income is 90% of the before-tax profits . FTC Baskets Foreign levies that qualify for the FTC are called "creditable" taxes . The creditable taxes for a given U .S . company consist of directly paid taxes under I .R .C . Section 901, "in lieu of' taxes under I .R .C . Section 903, and deemed paid taxes under I .R.C. Section 902 . I .R.C . Section 904 separates creditable taxes into "baskets" based on the type of income taxed ." For example, one basket includes only passive income . However, the only basket we consider in our analysis is the "residual income" basket, also known as the "general" basket . This basket includes general business profits, management fees, business royalty income, some export profits, and passive income received from a subsidiary's
Marginal Tax Rates on Foreign Profits of U .S. Multinationals
91
underlying business profits . We only analyze the residual income basket because our focus is entirely on foreign business profit - approximately 75% of most U .S . multinationals' foreign income according to the U .S . Department of the Treasury (1993, 20) ." I .R .C . Section 904(d)(3) changes the way creditable taxes are segregated into baskets when a U .S . company receives certain passive income from a controlled foreign corporation (CFC) . A CFC is a foreign corporation of which U .S . shareholders own more than 50% of either stock value or voting power . When a CFC pays dividends, interest, rents, or royalties to its U .S . parent company, the foreign withholding tax is not automatically placed in the passive income basket . Instead, a "look-through" rule applies so that creditable taxes are apportioned among baskets based on the CFC's underlying income . For example, if the CFC's income for the year consists entirely of business profits, any withholding tax on dividends the CFC remits to its U .S . parent company is placed in the residual income basket, not the passive basket . If instead the CFC's underlying income is 80% from business operations and 20% from passive investments, only 80% of any withholding tax on dividends from the CFC to its U .S . parent is placed in the residual basket. The other 20% portion goes into the passive basket . Similarly, 80% of the dividend income is included in the numerator of the residual basket's limitation formula that will be discussed below . Only 20% of the dividend income is included in the numerator of the passive basket's limitation formula. FTC Limitations
In addition to defining baskets, I .R .C. Section 904 establishes a formula approach that identifies the maximum FTC allowed in each basket . The limitation formula is equal to a ratio multiplied by the U .S . tax on the company's worldwide income . Foreign source taxable income appears in the ratio's numerator, while its denominator includes worldwide taxable income . A simplified version of the limitation formula, often a reasonable approximation, is equal to foreign source income multiplied by the highest U .S . tax rate ."' The equations below summarize this concept :
Section 904 Limit on FTC = Foreign Source Taxable Income Worldwide Taxable income (2) x U .S . Tax Before FTC
92
GREGORY G. GEISLER AND ERNEST R . LARKINS Foreign Source Taxable Income Worldwide Taxable Income
(3)
x (Worldwide Taxable Income x U .S Tax Rates)
= Foreign Source Taxable Income x Top U .S . Tax Rate
(4)
To illustrate the FTC limit, assume a U .S . multinational has foreign business income of $120 and U .S . business income of $80 . Assume the company pays a foreign income tax of $48 on its foreign profits (i .e . the average foreign tax rate is $48/$120 or 40%) . Assuming a 35% U .S . tax rate, the U .S . tax on worldwide income is $70 (35% x ($120 +$80)). The ratio of foreign source to worldwide income is 60% ($120/($120 + $80)) . So, the limitation formula for the residual income basket yields a maximum allowed credit of $42 (60% x $70 or $120 x 35%) . Of the $48 creditable tax, only $42 is allowed as a FTC in the current year. Thus, the company has an excess credit of $6 ($48 - $42) . In effect, I .R .C . Section 904 limits the amount of creditable tax in each basket allowed as a FTC to the U .S . tax imposed on foreign source income for the same basket . Stated another way, the FTC derived from a given basket is the lesser of the basket's creditable tax or the U .S . tax on the basket's foreign source income . Thus, all creditable taxes are not allowed as a FTC on the U .S . tax return when the average foreign tax rate exceeds the average U .S . tax rate . The U .S . company that cannot credit all its foreign income taxes has an "excess credit ." This means, effectively, that two different jurisdictions are imposing tax in the current year on part of the same income stream . U .S . multinationals with excess credits in one or more baskets generally engage in tax planning to relieve this "double taxation problem ." I .R .C . Section 904 allows taxpayers to carry excess credits back two years and forward five years . Excess credits not absorbed during this carryover period are lost . 20 Companies claiming a FTC for all their creditable tax are in an "excess limit" position (i .e. they have no double taxation problem) . Excess limits occur when the effective foreign tax rate is lower than the effective U .S . tax rate. U .S . multinationals conducting business primarily in high-tax (low-tax) foreign countries often have excess credits (limits) in their residual income baskets .
Marginal Tax Rates on Foreign Profits of U .S. Multinationals
93
3. MARGINAL TAX RATE EXAMPLES MTRs on foreign profits are a function of foreign income tax rates, foreign withholding tax rates, U .S . income tax rates, and the U .S . multinational's FTC position . In addition, MTRs depend on how and when foreign profits are remitted from the foreign subsidiary to the U .S . multinational . All of these factors must be considered to accurately estimate MTRs . For several reasons, multinationals usually cannot return all profits to the home country in the one form that minimizes the MTR . First, the host country's tax or commercial law may contain specific restrictions on the amount that can be deducted or legally remitted in particular forms . For example, tax laws in many countries contain thin capitalization rules that limit debt and, thus, interest payments . Also, central banks in some countries restrict the amount that can be remitted as interest and royalties . Second, debt, royalty, and management or technical service agreements are written before the subsidiary's foreign profits available to remit are known for the year . Thus, the opportunity to remit profits in these forms is based on prior year financing, investment, and human resource choices . Modifying such agreements from one year to the next in response to anticipated changes in foreign profits involves many potential costs . Thus, it is unrealistic to expect that all profits each year can be returned to the home country in the form incurring the lowest tax burden . Using a combination of remittance forms that, together, lower the MTR below a benchmark is a practical strategy ." The examples below use a combination of remittance forms .
Foreign Country with Low Tax Rate Suppose a foreign subsidiary expects $100 of foreign profits before any contractual agreements with its U .S . parent and wishes to remit 20% as a royalty, 30% as a current dividend, and the remainder of current E&P as a dividend in five years . Assume the following :
• foreign and U .S . income tax rates of 20% and 35%, respectively ; • foreign withholding rates on royalties and dividends of 15% and 10%, respectively ;
• U .S . parent company expects $2 and $1 excess credit in years zero and five, respectively, before considering the foreign subsidiary's $100 profit ; and
• discount rate for future taxes of 10% .
94
GREGORY G . GEISLER AND ERNEST R . LARKINS
Deducting the royalty reduces the subsidiary's taxable income to $80 ($100 $20), making the foreign income tax $16 ($80 x 20%) . Thus, the E&P are $64 ($80 - $16) . The current year dividend is $30, so it results in $34 of retained earnings ($64 - $30) . The withholding tax on the $20 royalty is $3 ($20 x 15%), and the withholding tax on the $30 dividend also is $3 ($30 x 10%) . The U .S . parent company reports the pre-withholding $30 dividend and $20 royalty as gross income . The I .R .C . Section 78 gross up is $7 .50 (percent of E&P paid as a current dividend ($30/ $64) x $16 foreign income tax) . Thus, the parent company's U .S . taxable income is $57 .50 ($30 + $20 + $7 .50) . The U .S . tax before credits is $20 .13 ($57 .50 x 35%) . The FTC is $15 .50 ($7 .50 DPC, which is always the same as the I .R .C . Section 78 gross up, + $3 dividend withholding + $3 royalty withholding + $2 excess credits) . Thus, the U .S . tax liability is $4 .63 ($20 .13 tax - $15 .50 FTC) . Panel A in Fig . 1 summarizes these calculations (i .e . what has occurred in year zero) . Panel B captures the implications in year five when the remaining $34 E&P are remitted as a dividend to the U .S . multinational. The subsidiary pays a $3 .40 dividend withholding tax ($34 x 10%) . The U .S . parent reports $42 .50 as gross income - the $34 pre-withholding dividend and the I .R .C . Section 78 gross up of $8 .50 (percent of E&P paid as a dividend in year five ($34/$64) x $16 foreign income tax paid in year zero) ." Thus, the U .S . tax liability before credits in year five is $14 .88 ($42.50 x 35%) . The FTC is $12 .90 ($3 .40 dividend withholding tax + $8 .50 DPC + $1 excess credit), and the U .S . tax liability in year five is $1 .98 ($14 .88 - $12 .90) . The remittance pattern in this example causes the MTR to be 29 .97%, as shown at the bottom of Fig . 1 . The numerator consists of the four taxes accrued or withheld in the first year plus the present value of the two taxes in year five . As is generally the case when conducting business in low-tax countries, the deductible royalty payment does not reduce the MTR 24 In contrast, paying a deductible royalty in a high-tax country, as in the following example, reduces the MTR significantly . Foreign Country with High Tax Rate Assume the same facts except that the foreign income tax rate is 40% instead of 20% and the excess credits are now excess limits . 25 The subsidiary's foreign income tax is now doubled or $32 ($80 x 40%) . Of the remaining $48 ($80 $32), $30 is again distributed as a dividend to the U.S . multinational . Thus, $18 is retained until year five ($48 - $30) . The U .S . parent company has gross income of $70 ($30 dividend + $20 royalty + $20 I.R .C . Section 78 gross up ($30/$48 x $32 foreign income tax)) .
Marginal Tax Rates on Foreign Profits of U.S. Multinationals
95
Panel A: Low-Tax Country In Year 0
U.S. Corporation Dividend Withholding Royalty Withholding Net Receipt
$30 -3 20
100%l
$44
Controlled
Dividend Gross Up Royalty Taxable Income
$30.00 7.50 jMOO $57 .50
Foreign Profit Royalty Taxable Incom e Foreign Tax EUP
$100 _ _ma $ 80
I
Foreign Corporation
14 $ 64
Taxable Income $57.50 U .S. Tax Rate X AS Pre-FTC Tax $20.13 FTC (Year 0) -13 .50 Excess Credit _;Em U .S . Tax $4 .63
E&P $ 64 Dividend _;IB Retained Earnings $ 34
Panel B : Same Country In Year 5
U .S. Corporation r Dividend Withholding Net Receipt
$34 .00 -3 .40
)Do%,
Dividend $34 .00 Taxable Income Gross UP 8 .50 U .S. Tax Rate Taxable Income $42 .50 Pre-FTC Tax FTC (Year 5) Excess Credit U .S . Tax
$42 .50 x.35 $14 .88 -11 .90 -1 .00 $ 1 .98
$30.60 Controlled Foreign Corporation
M•dg m
$16 + $3 + $3 + $4 .63 + (S3 40 +S1 .981/161nci
=2991%
$100
Assumptions.
• The foreign income tax rate in the low-tax country is 20% . The foreign withholding tax rate on dividends (royalties) Is 10% (15%) . The U.S . Inane tax rate Is 35%. • The CFC pays a $30 ($34) dividend In year zero (five) . • The U.S . corporation has a $2 ($1) excess credit in year zero (five) . • The discount rate Is 10% on tax payments in year 5 (i.e., 1 .61051 - (1+ .1) 5 ) .
Fig . 1 .
MTR on Mixed Remittances in Low-Tax Country .
The parent's U .S . tax before credits is $24 .50 ($70 x 35%) . The FTC is $26 ($20 DPC + $3 dividend withholding + $3 royalty withholding) . Since the FTC is $1 .50 more than the U .S . tax before credits ($26 - $24 .50), the excess is carried back against the $2 excess limit from prior years . Thus, the U .S . parent receives a $1 .50 tax refund. Panel A in Fig . 2 displays these calculations (i .e . what has occurred in year zero) .
96
GREGORY G . GEISLER AND ERNEST R . LARKINS Panel A : High-Tax Country In Year 0
U.S. Corporation Dividend Wlthholdag Royalty Wlhhdding Net Recalpt
$30 -3 20 _j, $44
Dividend Gross Up Royalty Taxable Income
$30.00 20.00 20.00 $70.00
1
Taxable Income U.S. Tax Rate Pre-FTC Tax FTC (Year 0) U.S. Refund
$70.00 x .35 $24 .50
$ 7 .50
100% i
Controlled Foreign Corporation
Foreign Profit Royalty Taxable Income Foreign Tax ESP
$100
:ZSI $ 80 , $ 48
ESP $ 48 Di nd Retained Earnings $ 18
~u
Panel 8 : Same Country in Year 0
U .S . Corporation $18 .00 Dividend Withholding -7 .80 Net Receipt $16 .20
Dividend $18.00 Taxable Income Gross Up 12_00 U .S. Tax Rate Taxable Income $30 .00 Pre-FTC Tax FTC (Year 5) U .S . Refund
$30.00 x .35 $10.50 -11 .50 $1 .00
too%[
Controlled Foreign Corporation
MTR- 197 + 33 + $9-$1 .50 + ($1 .R0-511/1 .61051 $100
=370&A
Assumption&
• The foreign Income tax rate In the low-tax country Is 40% . The foreign withholding tax rate on dividends (royalties) Is 10% (15%) . The U .S. Income tax rate Is 35%. • The CFC pays a $30 ($18) dividend in year zero (f") . • The U .S. corporation has a $2 ($1) excess limit in year zero (five) . • The discount rate to 10% on tax payments In year 5 (I .e ., 1 .61051 - (1 a .1) 5 ) .
Fig. 2 .
MTR on Mixed Remittances in High-Tax Country .
Panel B shows the results in year five . The subsidiary distributes the remaining $18 as a dividend, resulting in a $1 .80 withholding tax ($18 x 10%) . The parent company reports $30 of gross income ($18 dividend + $12 I .R.C . Section 78 gross up ($18/$48 x $32 foreign income tax paid in year zero)) 26 The U .S . tax before credits is $10 .50 ($30 x 35%) . Of the $12 foreign income tax paid in year zero for which a FTC has not yet been claimed, only $11 .50
97
Marginal Tax Rates on Foreign Profits of U .S. Multinationals
is allowed in year five ($10 .50 U .S . tax before credits + $1 excess limit) . Thus, the U .S . tax refund in year five is $1 . The MTR is 37 .00% as the calculation at the bottom of Fig . 2 shows . In contrast to the low-tax country example in Fig . l, the royalty payment does reduce the MTR in the high-tax country . Without the $20 royalty, the MTR would be 42 .24% - an increase of more than five percentage points 2 7 The lower 37% MTR occurs from averaging high-taxed income (i .e . foreign profits remitted as nondeductible dividends) and low-taxed income (i .e . foreign profits remitted as deductible royalties) . Thus, remitting foreign profits in deductible forms (i .e. not as dividends) generally reduces the MTR when conducting business abroad in high-tax countries .
4. MODEL DEVELOPMENT The examples in Figs 1 and 2 provide some guidance in formulating a model to determine MTRs. In both examples, the numerator includes all income taxes paid or withheld . 2% More specifically, the numerator includes all foreign income, foreign withholding, and U .S . income tax (after the foreign tax credit) paid in the current year on current foreign profits . In addition, the numerator includes the present value of all foreign withholding tax and U .S . income tax (after the foreign tax credit) paid in future years on the current foreign profits . The denominator contains foreign profits . Following the MTR examples in the previous section, the model can be expressed as follows :
FOIT + DIV + INT + ROY nO
USIT o - FTC,) + °
DIV + USIT - FTC y y (1+d)v
PRFT () where : tm = marginal tax rate on foreign profits earned in the current year, FOIT = foreign income tax paid, DIV = withholding tax on dividends remitted to parent, INT = withholding tax on interest remitted to parent, ROY = withholding tax on royalties remitted to parent, USIT = U .S . tax liability (refund) before the FTC, FTC = foreign tax credit (including carryovers), PRFT = pre-remittance, pre-tax foreign profits, 0 = current year (i .e . year zero),
(5)
98
GREGORY 0 . GEISLER AND ERNEST R . LARKINS y d
= future year (i .e . when current year retained earnings are remitted as dividends), and = discount rate .
In the following equations, the various components in the model above are defined more precisely to derive a more generalizable model . As a result, the model derived later (i.e . Eq . (15)) will have more easily identified inputs since it will rely on tax rates rather than computed tax amounts . Equation (6) defines the current foreign income tax liability (FOIT .) appearing in Eq . (5) as the foreign income tax rate applicable to foreign profits (after deducting interest and royalty remittances) multiplied by foreign profits : FOIT. = (1 - pi., - P,oy) (tf ) PRFT.
(6)
where : pj ~ t =
percentage of PRFT O currently remitted to U .S . parent company as interest, p ,t,y = percentage of PRFTO currently remitted to U .S . parent company as royalties, and = foreign income tax rate on PRFT.. Equation (7) defines the current withholding taxes on dividends (DIV .), interest (INT.), and royalties (ROY .) appearing in Eq. (5) . The equation yields the percentage of foreign profits remitted as dividends, interest, and royalties multiplied by the respective withholding tax rates, which, after summing together, are multiplied by foreign profits : DIV . + INT. + ROY. =
( Pdit,
td,,
+
P,m t, M + Proy t,o) PRFT.
(7)
where : percentage of PRFT O currently remitted to U .S . parent company as dividends, = foreign withholding tax rate on interest, tut troy = foreign withholding tax rate on royalties, and tdiv = foreign withholding tax rate on dividends . 29 Pdm =
The current year's deemed paid credit (DPC.), though not appearing as a separate component in equation (5), is defined next since it is an important
Marginal Tax Rates on Foreign Profits of U.S. Multinationals
99
factor in Eqs (9), (10), and (12) that follow . The deemed paid credit in Eq . (8) is equal to the percentage of after-tax foreign profits remitted as a dividend multiplied by the foreign income tax rate paid on the before-tax foreign profits multiplied by foreign profits :
DPC0 -
(1 ( 1 - Pint -
ProY)(1 - t, )
Pint -
Pr) ) (tI.) PRFT0 (8)
PrIV tf
I - ti
PRFT~
Equation (9) yields the current year's U .S . tax before FTC (USIT 0) as the product of the U .S . income tax rate, the percentage of foreign profits included in gross income from foreign operations, and foreign profits . The gross income includes profits the U .S . parent company receives as dividends, interest, and royalties as well as the I .R .C. Section 78 gross-up, which is the same as the deemed paid credit : US ITO
=
(P, + P int
+
p, + DPC0) (tn, ) PRFP 0
(9)
where t = U .S . income tax rate. The current year's foreign tax credit (FPC 0) is the lesser of: (a) the I .R .C . Section 904 limitation formula (i .e . portion of Eq . (10) below preceding the comma multiplied by foreign profits) ; or (b) creditable foreign taxes (i .e . portion of equation (10) below following comma multiplied by foreign profits) . Regarding (a), the I .R .C . Section 904 limit is generally equal to the U .S . income tax rate multiplied by foreign source income (i,e . all foreign remittances and the I .R .C . Section 78 gross-up) as illustrated earlier in the FTC Limitations subsection . Generally, the I .R .C . Section 904 limit is less than creditable foreign taxes when the U .S . company is conducting business abroad in high-tax countries . In such cases, if the U .S . company has an unused excess limit from the prior two years, the foreign tax credit is increased since the current excess credit from high-tax countries can be carried back against the prior year unused excess limit . Regarding (b) above, creditable foreign taxes (i .e . the second part of Eq. (10) below) are equal to the applicable foreign tax rates multiplied by foreign source income (i .e. all foreign remittances and the I .R .C . Section 78 gross-up) . Generally, creditable foreign taxes are less than the I .R .C . Section 904 limit when the U .S . company is conducting business abroad in low-tax
100
GREGORY G . GEISLER AND ERNEST R. LARKINS
countries . In such cases, the unused excess credit from the prior five years increases the foreign tax credit in the current year. Equation (10) summarizes these provisions : 3o
FTCoO
min{
U SITO PRFT0
+ x'~O
J
+ xlimo' b .01
+ DPCO + INTO + ROYO PRFT0
PRFTO
where xijmQ = ratio of unused excess limitation from two years preceding the current year to the current year's foreign profits, and x,reo = ratio of unused excess credits from five years preceding the current year to the current year's foreign profits . Equation (11) provides the dividend withholding tax applicable to dividends paid in a future year (DIV Y ) . Foreign profits remaining after the interest and royalty deductions are multiplied by one minus the foreign income tax rate to determine the foreign E&P available for dividends . Current dividends are subtracted to determine the portion of foreign profits retained for future dividend payments, all of which are remitted as dividends in year y (i .e. the foreign subsidiary retains no E&P after year y) . The future dividends multiplied by the dividend withholding rate multiplied by foreign profits yields the withholding tax on dividends distributed in year y : DIVY = [(1 - Rm - P my )(1 - tf) - PawI (tdjv) PRFTO
(11)
Equation (12) determines the deemed paid credit in the future year (DPC Y) when the U .S . company receives the future dividend . Any foreign income tax not resulting in a DPC in the current year is treated as a DPC in the later year when the remaining foreign profits are distributed as dividends . Thus, DPC Y equals the foreign income tax on foreign profits in the current year less the DPC in the current year. DPC Y appears in Eqs (13) and (14) : DPCY = FOITO - DPC O
(12)
Marginal Tax Rates on Foreign Profits of U .S . Multinationals
101
Equation (13) defines the U .S . tax liability in the future year before considering the foreign tax credit. The U .S . tax is the product of the U .S . tax rate, dividends received in the future year, and foreign profits . The future dividends equal the current year foreign profits after reduction for foreign income tax and dividends paid in the current year but increased for the I .R .C . Section 78 gross-up in the future year (i .e. DPC,,) : DPC USIT= (1 - P, M -P,~Y)(1-t,)-Pa,,+PRFT ](t,,,)PRF"l'„ a
(13)
Equation (14) provides the future year foreign tax credit . Other than the different year involved, it is similar to the calculation for FTC, (i .e . Eq . (10)) . However, Eq. (14) does not contain variables for withholding taxes on interest and royalties since any such payments in year y do not affect the MTR for the current year (i .e. tn „) : 31 USIT° DIVr + DPC Y + x FTC =min { + xr, m } PRFT O PRFT, ' v PRFT, r where xi . .. . Y = ratio of unused excess limitation from two years preceding year y to the current year's foreign profits and = ratio of unused excess credits from five years preceding year y to the current year's foreign profits ." Now, the separate equations will be combined into the "mixed remittance model." Substituting Eqs (6) through (14) into Eq . (5) and combining like terms results in Eq . (15) . In effect, the concepts in Eq . (5) have been converted into variables that are more easily identifiable . Thus, the model in Eq . (15), though a bit more cumbersome than Eq . (5), is more useful for analysis since it is based on tax rates and percentages of foreign profits rather than dollar amounts ." This mixed remittance model computes the MTR (t m ) on foreign profits for a variety of remittance patterns ." Only country-specific tax rates, the discount rate, the U .S . parent's FTC position, and how and when the foreign subsidiary remits such profits to its U .S . parent are needed as model inputs :"
102
GREGORY G . GEISLER AND ERNEST R. LARKINS
tm = (I
-
Pint -
Pray) tf
+ max {Pdiv tdiv + Pint tint + Proy
(Pdiv \1-If
+ max
+ Pmt +
f
Pray
t
-
Pd, t f 1 If -
tray - x
lim0'
reo
[(1 - Pint - Proy) (I - td - Pdiv) td, (1+d)y
Pdiv tf (1 - Pdi v - 1 t - Pant - Pray) tus - (1 - Pim -
Pray ) t
Pdiv tf f + 1 - C.
- x
cmy
(1+d)y The model's first term (i .e. everything preceding the first max expression) is the foreign income tax contribution to the MTR, the second term (i .e . the first max expression) is the greater of the current year's withholding tax or the current U .S . tax contribution, and the last term (i .e . the second max expression) is the total contribution to the MTR from dividends paid in subsequent years . The second and last terms, each equal to the greater of two parts (i .e . maximum of foreign withholding taxes or incremental U .S . tax), depend on whether the foreign subsidiary is subject to low or high foreign taxation . In low-tax countries, the second part within each term (i .e . incremental U.S . tax, which appears after the commas) is the greater amount and, thus, increases the MTR . In high-tax countries, the MTR increase comes from the first part within each term (i .e . foreign withholding taxes, which precede the commas) . Equation (15) simplifies when certain assumptions hold . For example, assume that all after-tax foreign profits are remitted as dividends in a later year and no foreign profits are remitted in deductible forms (i .e . pint , pray, and Pdiv are all zero) . As a result, Eq . (15) simplifies to Eq . (16), which we will call the "future dividend model" : max I tdiv (1 - If ) - xlim tns y, t n, = tf + (1+d)y
(16)
Marginal Tax Rates on Foreign Profits
of U.S.
Multinationals
1 03
Continuing with the assumptions underlying equation (16) but adding the further assumption that all after-tax foreign profits are remitted as dividends in the current year, Eq . (16) simplifies to Eq . (17), which we will call the "current dividend model" : t = max { tt+ tdiv (1 - t t) - x r.mu , tu , - x o , t, 1 36
(17)
5. PROXIES FOR MARGINAL TAX RATE As mentioned earlier, the mixed remittance model in Eq . (15) may yield an MTR that differs substantially from two rates that are sometimes used to proxy for the MTR - a country's top statutory tax rate or a tax rate based on the current dividend model in Eq . (17) . Statutory rates may understate MTRs since they ignore the impact of dividend and other withholding taxes . On the other hand, using a current dividend model generally overstates the MTR since it ignores tax savings that may be available through deferring dividends or remitting earnings as interest or royalties . Tax planners and tax policy analysts relying on either proxy as reasonable approximations of the MTR could reach inappropriate conclusions . Also, academic researchers using either proxy as an explanatory or control variable might develop better specified models using MTRs based on the mixed remittance model. The mixed remittance model arguably yields a richer MTR measure than either top statutory tax rates or the current dividend model . Thus, the MTR from the mixed remittance model may provide a more appropriate rate for either tax planning by practitioners or explaining corporate behavior by academics and tax policy analysts . To illustrate the differences in the MTR proxies, we selected ten countries with the highest U .S . foreign direct investment (FDI) from each of three major geographical regions (U .S . Dept. of Commerce, 1999) . Table 1 presents the top statutory tax rates for these 30 countries as well as the withholding tax rates on dividends, interest, and royalties on remittances to a U .S . parent company . 37 To incorporate the tax planning behavior of multinationals, we use the mixed remittance model in Eq . (15) and assume that 30% of foreign profits are remitted as either interest or royalties, whichever remittance form has the lower withholding rate ." We also assume after-tax profits not remitted in deductible forms are distributed as dividends in year five, using a 10% discount rate ." Interest and royalty remittances generally reduce tax liabilities in countries with high
GREGORY G . GEISLER AND ERNEST R. LARKINS
104
Table 1 .
Foreign Income and Withholding Tax Rates in Regional Countries with Highest U .S . Direct Investment . Top Statutory Tax Rate
Dividend Withholding Rate
Interest Withholding Rate
Royalty Withholding Rate
Asia and Pacific Australia China Hong Kong Indonesia Japan Korea Malaysia New Zealand Singapore Thailand Regional Mean
36 .00% 33 .00% 16 .00% 30 .00% 42 .05% 30 .80% 28 .00% 33 .00% 26 .00% 30 .00% 30.49%
15 .00% 0 .00% 0 .00% 10 .00% 10 .00% 11 .00% 0 .00% 0 .00% 0 .00% 10 .00% 5 .60%
10.00% 10.00% 0.00% 10.00% 10.00% 13 .20% 15 .00% 10 .00% 15 .00% 15 .00% 10 .82%
10 .00% 10.00% 1 .60% 10 .00% 10 .00% 16 .50% 10 .00% 10.00% 15 .00% 15 .00% 10.81%
Europe Belgium France Germany Ireland Italy Luxembourg Netherlands Spain Switzerland United Kingdom Regional Mean
40 .17% 40 .00% 43 .51% 32 .00% 37 .00% 37 .45% 35 .00% 35 .00% 25 .10% 31 .00% 35.62%
5 .00% 5 .00% 5 .00% 0 .00% 5 .00% 5 .00% 5 .00% 10 .00% 5 .00% 0 .00% 4.50%
15 .00% 0.00% 0.00% 0.00% 12.50% 0.00% 0.00% 10.00% 5 .00% 0.00% 4.25%
0 .00% 5 .00% 0 .00% 0.00% 10 .00% 0 .00% 0 .00% 10 .00% 0 .00% 0 .00% 2.50%
Latin America Argentina Brazil Chile Colombia Costa Rica Ecuador Mexico Panama Peru Venezuela Regional Mean
35 .00% 34 .00% 15 .00% 35 .00% 30.00% 25 .00% 35 .00% 30 .00% 30.00% 34 .00% 30 .30%
0 .00% 0 .00% 23 .53% 7 .00% 15 .00% 0 .00% 5 .00% 10 .00% 0.00% 0 .00% 6.05%
35.00% 15 .00% 35 .00% 0.00% 15 .00% 33 .00% 15 .00% 6.00% 30 .00% 10.00% 19.40%
28 .00% 15 .00% 30 .00% 39 .55% 25 .00% 33 .00% 10 .00% 30 .00% 30 .00% 10 .00% 25.06%
Combined Regions Mean
32.14%
5.38%
11 .49%
12.79%
Primary Sources: Deloitte Troche Tohmatsu (1999), Pricewaterhouse Coopers (1999) .
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1 05
statutory tax rates since such remittances are deductible and, thus, escape foreign income tax . However, as discussed earlier in the "Foreign Country with Low Tax Rate" subsection, interest and royalty payments may actually increase tax liabilities in some low-tax countries . Since we assume the U .S . multinational adopts a remittance strategy to minimize the MTR, the MTR from the mixed remittance model is compared with the MTRs from both the current and future dividend models, and the least of these three rates is our "tax planning MTR ." Table 2 illustrates the general approach to calculating the various MTR measures for two countries - Malaysia and Spain .40 A visual inspection of the 30 foreign countries in Table I reveals that statutory income tax rates and the withholding rates on dividends, interest, and royalties vary widely not only across countries but also across regions of the world . Table 2 illustrates how the mixed remittance model can result in a very different estimate of the MTR than either of two simpler MTR measures - the top foreign statutory income tax rate and a MTR based on the current dividend model . Admittedly, if Table 2 had examined countries other than Spain and Malaysia, the differences between our tax planning MTR and the two benchmark MTRs might have been very small . So, testing whether our tax planning MTR differs significantly from the two benchmarks (either often or rarely) is important . If differences are rarely significant, one might make an argument that despite the increased richness of the tax planning MTR measure, it is not very useful since the simpler MTR proxies provide estimates that are "close enough" to the "richer" tax planning MTR measure . To provide evidence on this question, Table 3 compares the tax planning MTR with statutory tax rates (Panel A) and the current dividend MTR (Panel B) . Using a paired t-test for each of the 30 countries in Table 1, we test for significant differences between these rates within each region (i .e . the three regions containing ten countries each) and worldwide (i .e . all 30 countries) . In each panel, we allow the FTC position of the U .S . parent company to vary from an excess credit equal to 10% of current year's foreign profits to an excess limit of the same magnitude . The excess credit (limit) results from operating in high- (low-) tax countries in the prior five (two) years . In Panel A, the tax planning MTR exceeds the statutory rate in each region and in the combined regions when no FTC history is assumed . The mean differences range from 1 .43% in Europe to 4 .18% in the Asia/Pacific region 4 1 The paired t-test indicates that the two rates are significantly different in the Asia/Pacific region (p < 0 .01), Latin America (p < 0 .025), and the combined regions (p < 0 .01) . When the U .S . parent has an excess limit of 10% from prior years, the tax planning MTR exceeds the statutory rate in the Asia/Pacific region and Latin America region, but not in Europe . The paired t-test is not significant
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Table
2.
Illustration of Differences between MTR Measures . Sources of Information
Variables in MTR Models' U .S. tax rate (toy) Internal Revenue Code Foreign income tax rate (t f) Table 1 Withholding rate for : Dividends (ta ,„) Table I Interest ( .m) Table I Royalties ftTable 1 Percent of profits remitted as: Varies^ Current dividends (p i ) Interest (pias) Varies' Royalties (p,%,) Varies° User's choice Discount rate (d) Years deferred (y) User's choice Marginal Tax Rate Models Top statutory rate Mixed remittance model° Future dividend model' Current dividend model• Tax planning MTR Lesser :
Same as t r above Equation (15) Equation (16) Equation (17) Equations (15), (16), (17)
Differences in MTR Measures Tax planning MTR less Top statutory tax rate (as benchmark) Tax planning MTR less Current dividend MTR (as benchmark)
Malaysia
Spain
35 .00% 28 .00%
35 .00% 35.00%
0 .00% 15 .00% 10 .00%
10.00% 10.00% 10.00%
10 .00% 5
10.00% 5
28 .00% 33 .14% 32 .35% 35 .00% 32.35%
35 .00% 37.83% 39.04% 41 .50% 37 .83%
+4 .35% -2.65%
+2.83% -3 .67%
We assume no prior, current, or future FTC positions for the company . Thus, x iim,,, x ,,md , x,,my , and x, all equal zero . The timing and percentage of profits remitted depends on the MTR model . Consistent with the assumptions in the PROXIES FOR MARGINAL TAX RATE section, the mixed remittance MTR assumes that 30% of the foreign profits are remitted as either interest or royalties - whichever is subject to a lower withholding tax rate . After-tax profits not remitted during the current year as interest or royalties are assumed to be remitted at the end of y years as a dividend (i .e . future dividend) . d The model assumes that p .m, proy , and pdi „ are zero since all after-tax profits are remitted as dividends at the end of year y . `The model assumes that p.,,, and p, are zero and that p , ,, a is 100% since all after-tax profits are remitted as current year dividends . a
at the 0 .025 level in any region . Assuming that the U .S . parent has excess credits causes the tax planning MTR to drop below the statutory rate in each region . Given a 10% excess credit, the paired t-tests are significant in the Asia/Pacific region (p < 0.01), Europe (p < 0 .01), and in the combined regions (p < 0 .01) .
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Table 3 .
107
Paired t-Tests' : Comparison of Tax Planning MTR' with Two Benchmarks . Three Regions of Ten Countries Each , Asia/ Latin Pacific Europe America
Panel A : Tax Planning MTR Less Top Statutory Tax Rate (as Benchmark)' Assuming Excess FTC of 10% ** ** (Mean Difference)' (-4 .19%) (-8 .44%) (-2.08%) Assuming Excess FTC of 5% ** (Mean Difference) (-1 .44%) (-3 .95%) (-0.20%) Assuming No FTC History ** (Mean Difference) (4 .18%) (1 .43%) (3 .68%) Assuming Excess Limit of 5% * (Mean Difference) (3 .13%) (-0 .43%) (2 .95%) Assuming Excess Limit of 10% (Mean Difference) (2 .71%) (-1 .13%) (2 .92%) Panel B : Tax Planning MTR Less Current Dividend MTR (as Benchmark)' ** ** ** Assuming Excess FTC of 10% (Mean Difference)s (-8 .79%) (-1130%) (-0 .61%) ** ** ** Assuming Excess FTC of 5% (Mean Difference) (-7 .14%) (-6 .92%) (-5 .23%) ** ** ** Assuming No FTC History (Mean Difference) (-3 .43%) (-2 .74%) (-2.55%) ** ** * Assuming Excess Limit of 5% (Mean Difference) (-2 .73%) (-1 .28%) (-1 .80%) ** * Assuming Excess Limit of 10% (Mean Difference) (-2.15%) (-0.64%) (-1 .78%)
All Countries in Combined Regions
(-4.90%) (-1 .86%) (3 .10%) * (1 .88%) (1 .50%)
** (-8.90%) ** (-6 .43%) ** (-2 .91%) ** (-1 .94%) ** (-152%)
** p-value significant at the (1.01 level . * p-value significant at the 0.025 level . 'All p-values are based on paired t-tests . Ten pairs exist in each of the three regions, and the combined regions include 30 pairs . The p-values are not based on a r-test of the mean difference between the region's average tax planning MTR and the region's average benchmark rate . s Using the mixed remittance model, 30% of foreign profits are remitted as either interest or royalties, whichever incurs the lower withholding tax rate . Residual profits are remitted as dividends after five years . The resulting MTR is compared to the MTRs from both the current and future dividend models. The tax planning MTR is the lower of the three results . `See Table 1 for the ten specific countries in each of the three regions . All p-values in Panel A are two-sided . Mean difference in Panel A is the region's average tax planning MTR less the region's average foreign statutory income tax rate . Mean difference is presented only for descriptive purposes . ' All p-values in Panel B are one-sided since, by definition, the tax planning MTR never exceeds the current dividend MTR . s Mean difference in Panel B is the region's average tax planning MTR less the region's average current dividend MTR . Mean difference is presented only for descriptive purposes .
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Panel B presents the results when the tax planning MTR is compared with the current dividend MTR . By definition, the tax planning MTR cannot exceed the current dividend MTR . The mean differences in Panel B are significant (p < 0 .01) in almost all regions regardless of the parent company's FTC position in prior years . The mean differences increase (decrease) as the parent's excess credit (limit) position increases . Thus, the current dividend MTR and the tax planning MTR for any country are usually the closest (farthest) when the parent company has an excess limit (credit) position of 10% . Overall, Table 3 confirms the notion that the mixed remittance MTR is often significantly different from the two other MTR proxies, supporting its use over simpler proxies ."
6. CONCLUSION Using the top statutory foreign income tax rates as a proxy for the MTR or computing an MTR based on the assumption that all after-tax foreign profits are remitted currently as dividends can cause significant measurement error vis-a-vis estimating MTRs using our mixed remittance model . The mixed remittance model provides a richer MTR estimate since it incorporates more of the factors that influence a U .S . multinational's MTR . Unlike statutory tax rates, the mixed remittance model takes into account that, sooner or later, profits are remitted to the home country, and the remittance has tax consequences . Unlike current dividend MTRs, the mixed remittance model allows foreign profits to be remitted to the home country through deductible remittances in the current year and dividends in future years . Thus, the mixed remittance model provides more realistic estimates of the MTR on foreign profits . This article develops an MTR measure for multinational companies that incorporates an economic approach in its mathematical modeling . Unlike other MTR proxies, our MTR measure varies with the tax rate incentives from operating in a particular foreign country (e.g . incentive to remit profits via interest payments if the interest withholding tax rate is low or zero) . This provides heterogeneity in the MTR measure that is absent from other MTR proxies, such as the top statutory tax rate and the MTR derived from the current dividend model . Since it allows reasonable tax planning assumptions, the mixed remittance model permits more accurate measures of MTRs applicable to foreign profits in many decision contexts . Where to locate foreign subsidiaries, whether to shift income between countries, where to obtain debt financing, and how and when to remit foreign profits are some examples of decision contexts in which the MTR is an important factor. The mixed remittance MTR model yields useful estimates for tax planners, academic researchers, and policy analysts and makers ." Though large multinationals
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109
may retain in-house tax professionals or use sophisticated international tax planning software to estimate MTRs, smaller companies, particularly those going global or with relatively small investments abroad, often do not have access to these resources . For these smaller companies, the mixed remittance model can provide reasonable estimates and, thus, useful inputs into the decisions mentioned above . The lack of company-specific data is one reason prior academic studies of foreign decisions have omitted MTR measures as independent variables or have proxied for such measures with statutory tax rates (e .g. see Gordon & Jun, 1993) . However, our MTR model relies primarily on country-specific data that are readily available . For U .S . companies going global, only country-specific data and the discount rate are needed to estimate MTRs since such companies have no FTC history . For companies with existing multinational operations, researchers need one more piece of information - a proxy for FTC position (e.g . see Smith, 1997 ; Kemsley, 1998) 44 Our MTR model also provides estimates for testing countrylevel hypotheses as, for example, in Kemsley (1998) . Like academic researchers, policy analysts and makers can use MTR estimates to predict income-shifting behavior or to help project revenue effects from tax rate changes .
NOTES I . As these studies indicate, taxes are often significant factors affecting international business decisions. However, Porcano (1993), Rolfe and White (1992), and Single (1999) document that taxes generally are not dominant factors . 2 . Except where otherwise indicated, "foreign profits" are pre-remittance, pre-tax foreign profits . 3 . Foreign profits for the same investment can vary across countries and, thus, can impact the decision of where to invest . To illustrate, assume that a given investment is expected to yield a $100 profit in country A where the MTR is 33% and a $120 profit in country B where the MTR is 40% . Applying the MTR to anticipated foreign profits provides the expected investment return after taxes for a given investor. Returning to the example, the after-tax profits from countries A and B are $67 and $72, respectively . Ceteris paribus, the investor should invest in country B even though the MTR is higher for investments in that location . In this article, we ignore company managers' estimates of before-tax profits for each country under consideration (i .e . $100 in country A and $120 in country B) so that we can focus on computing MTRs . 4 . Scholes et al . (2002, p . 279) state, "different forms of repatriation . . . may be subject to different levels of withholding tax, which makes the repatriation alternatives even less perfect substitutes for one another ." 5 . The foreign tax credit rules can add complexity to the MTR model since operation in some countries can affect the MTR in other countries and vice versa . 6 . Professors also can use the MTR analysis as a teaching tool for students . International tax textbooks typically do not synthesize statutory and regulatory rules to
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emphasize how a decision affects a company economically . Following a textbook's lead, professors teaching international taxation often only teach the topic from a legal perspective, so students have little choice but to learn the material in the same way . For example, classroom instruction of the complex foreign tax credit provisions typically involves only a legal perspective without elaboration on how the results apply in decision-making contexts . Though the legal perspective is vital, an understanding of how results from applying the legal rules become inputs into businesses' decision-making contexts also is important. Such applications equip students to move beyond tax compliance skills and become "tax planning problem solvers ." Specifically, the analytical abilities to compute MTRs and understand the effect of various factors on MTRs are important decisionmaking skills since MTRs significantly affect the after-tax profits of foreign investment projects . The AICPA (1999) asserts that "individuals entering the accounting profession should display effective problem solving and decision-making skills, good insight and judgment, as well as innovative and creative thinking ." Tax professionals who are proficient in identifying the MTRs of alternative investments and determining the impact of changes to the relevant factors affecting MTRs develop such traits and are better prepared to serve their clients or employers and, thus, excel in their careers . 7 . MTRs differ fundamentally from statutory tax rates (STRs) and effective tax rates (ETRs) . STRs are based on the tax rate schedule specified in a country's tax laws . An ETR is an average rate of tax that measures a company's overall tax burden . Generally, the ETR is defined as total tax divided by total net income for a given company (Scholes et al., 2002, p . 161) . Since this article focuses on a U .S . multinational's incremental decisions about a foreign subsidiary's profits and their remittance to a U .S . multinational, MTR is the appropriate concept for focusing on the marginal income and taxes related to these decisions . Both STRs and ETRs can differ significantly from MTRs . Use of any measure other than MTR may not provide a reasonable estimate of the present value of expected tax resulting from a given decision. 8 . We did not incorporate U .S . state and local taxes in the MTR model . Healy and Boucher (2000) indicate that hardly any state allows a foreign tax credit (FTC) to offset the state tax liability . Instead, some permit a state tax deduction for the federal FTC, others permit a state tax deduction only if the taxpayer deducts its foreign taxes rather than claiming a FTC on its federal return, and still others permit no tax benefit at all . Thus, we decided against incorporating state and local taxes in our U .S . income tax measure because of the inconsistency among states in the treatment of the federal FTC . If desired, the impact of state and local taxes can be reasonably estimated and either separately modeled or incorporated into the calculations on an ad hoc basis . 9 . The foreign income tax includes the following : national foreign income tax ; any national surtax - which countries generally base on either foreign income or the foreign income tax ; and any state, provincial, or other local foreign income tax - adjusted for whether it is deductible at the national level . We incorporate the above taxes into the foreign income tax measures since U .S . law treats them as creditable taxes for FTC purposes . On a separate issue, the foreign income tax rate in some countries varies depending on the taxpayer's industry or business activity . For example, Canadian income tax rates vary across provinces and also are generally lower for companies involved in manufacturing or processing activities . 10 . MTRs are not the only important factors in foreign investment decisions . For example, when choosing a foreign location for manufacturing activities, other significant factors might include labor rates, labor supply, work force education levels,
Marginal Tax Rates on Foreign Profits of U.S . Multinationals
IlI
transportation costs, market proximity, legal protections for intellectual property rights, expropriation and political risks, financial services, and infrastructure reliability . Thus, the MTR impact of foreign location decisions is one of many potentially important factors . 11 . The presence of operating losses in some years can increase the complexity of determining a firm's MTR. Our article focuses on the current year profits of a U .S . corporation's foreign subsidiary and, thus, makes no assumptions about the pattern of profits and losses over time . An appropriate MTR, in the presence of loss years, should consider the past and future pattern of a company's profit and losses . For a discussion of these and other relevant issues, see Shevlin (1990), Graham (1996a, b), and Plesko (1999) . Also, we do not focus on alternative minimum tax (AMT) issues for two reasons . First, AMT represents principally a timing issue . Though the spread between the AMT rate and the top U .S . statutory rate seems large, the present value differences over time are much smaller . Second, the AMT affects relatively few companies today vis-a-vis the number of corporations affected a decade ago . Since 1990, and with the easing of the AMT rules in 1997, not more than one or 2% of corporations pay the AMT each year . The U.S . Treasury (2001) reports that the minimum tax credit on all 1998 corporate income tax returns totaled $3 .4 billion while the total income tax before credits totaled $231 .4 billion . These minimum tax credits, which offset the regular income tax, could have been generated any time over the last decade . 12 . Many capital-exporting countries (e .g . Japan and the United Kingdom) have tax systems containing FTC provisions similar to those under U .S . law . Thus, much of this article's analyses are generalizable to multinationals based in such countries . 13 . Rather than organizing a foreign subsidiary, a U .S . corporation might establish a foreign partnership, branch, or similar structure . These alternatives involve a different MTR model than the one we develop in this article since such structures do not permit tax deferrals. Of course, one reason such structures are unpopular is their potential legal liability exposure . As another alternative, U .S . multinationals can use the check-the-box regulations to establish hybrid entities (i .e . partnerships under U .S . law and corporations under foreign law) . Hybrid entities might be used to either flow through foreign losses or avoid the foreign tax credit restrictions when the U .S . parent company receives dividends from noncontrolled section 902 corporations (see I .R .C. Section 904(d)(1)(E)) . A U .S . multinational's MTR for a hybrid entity would not involve tax deferrals since hybrid entities flow through foreign profits and foreign income taxes . 14 . The last four sections do not directly relate to our models . Briefly, I .R .C . Section 905 permits cash-basis taxpayers to claim the FTC on an accrual basis, I .R .C. Section 906 explains the conditions under which foreign persons can claim the FTC, I .R .C . Section 907 clarifies the FTC allowed for oil and gas extraction taxes, and I .R .C. Section 908 reduces the FTC for taxpayers participating or cooperating in an international boycott . Thus, in developing our MTR model, we reasonably assume that the U .S . parent corporation is an accrual basis taxpayer that does not engage in the oil and gas extraction business and does not participate in an international boycott. 15 . Similar in application, I .R.C . Section 960 permits a FTC for taxes foreign subsidiaries constructively, rather than actually, pay . 16 . The U .S . corporation also is entitled to a DPC for foreign income taxes that a second-tier foreign subsidiary pays if: (1) the second-tier entity pays a dividend to the first-tier entity that, in turn, pays a dividend to the U .S . parent, (2) the U .S . corporation owns at least 10% in its first-tier subsidiary, (3) the first-tier subsidiary owns at least 10% in the second-tier subsidiary, and (4) the U .S . corporation indirectly owns at least
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GREGORY G . GEISLER AND ERNEST R . LARKINS
5% of its second-tier subsidiary. The 5% indirect threshold is tested by multiplying the U .S . corporation's direct ownership percentage in the first-tier subsidiary by the first-tier subsidiary's direct ownership percentage in the second-tier subsidiary . A similar ownership test applies for determining whether the U .S . corporation is entitled to a DPC from third-tier through sixth-tier foreign subsidiaries . Consider a U.S . corporation that owns 40% of a foreign subsidiary's voting stock . This first-tier entity, in turn, owns 20% of a second-tier foreign company's voting stock . Thus, the direct ownership is at least 10% at each level and the indirect ownership is at least 5% (0 .4 x 0.2=8%o) . Depending on the portion of E&P remitted as dividends, the U .S . parent is entitled to a DPC for some of the foreign income tax that the second-tier entity pays . A change of the facts illustrates a situation when a DPC is not allowed . Suppose the first-tier subsidiary owns only 10% in the second-tier entity rather than 20% . In this case, the indirect ownership is less than 5% (0 .4 x 0.1 = 4%) . Thus, the U .S . company is not allowed a FTC for foreign income tax that the second-tier entity pays . 17 . As discussed in the next section, U .S . law segregates creditable taxes into baskets to make it more difficult for taxpayers to average high-taxed foreign income against low-taxed foreign income and, thus, increase their FTC . The country where income is earned does not affect the basket placement of creditable taxes or foreign income . For example, German income tax on business profits and Japanese income tax on business profits are placed in the residual basket . 18 . The model we develop in this article applies to foreign business profits, which constitute the bulk of foreign income for most foreign subsidiaries . The majority of other foreign income consists of passive amounts . In many cases, these passive amounts constitute Subpart F income that the U .S . multinational currently recognizes as a constructive dividend . Thus, unlike the model we develop, a MTR model for passive income would not include a term allowing U.S . income tax to be deferred. 19 . Under the U .S . statutory tax rate schedule, the average tax rate on taxable income above $335,000 is always between 34 and 35% . Thus, using 35% (i .e . the top U .S . Lax rate) instead of U .S . tax before the FTC in computing the I .R .C. Section 904 limitation almost always results in a reasonable approximation . 20 . If the corporation expects to use the current year's excess credit during the carryover period (e .g. it has foreign operations in a low-tax country that it expects to turn profitable next year), the incentive to engage in tax planning to relieve the double taxation is lessened . However, many taxpayers with excess credits can expect, without tax planning, to have excess credits in future years also . In these cases, the excess credits will expire after the five-year carryforward period. Thus, excess credit situations often create strong incentives to engage in tax planning to relieve the double taxation problem . 21 . For example, an MTR based on returning all after-tax profits to the home country as dividends during the year earned (i .e . a current dividend strategy) might be a reasonable benchmark . 22 . Excess credits from prior years reduce the current year MTR from operating in a low-tax foreign country since the current year excess limit can absorb at least a portion of the prior year excess credits . In contrast, excess limits from prior years generally would not reduce the MTR from operating in a low-tax country . So, we assumed excess credits since they impact the MTR in this example . 23 . Note that the DPC in years zero and five ($7 .50 + $8 .50) sum to the total foreign income tax paid in year zero ($16). Also, summing the taxable income in years zero and five ($57 .50 + $42 .50) yields the total foreign profits earned in year zero ($100) .
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24 . In effect, the $4 foreign income tax savings in year zero from paying a deductible royalty ($20 x 20%) is more than offset by the $3 royalty withholding tax in year zero ($20 x 15%) plus the change in U .S . income tax in years zero and five attributable to the royalty . So, the royalty payment in this example actually causes the MTR to increase from 28 .83 to 29 .97% . To derive the 28 .83%, the numerator would be : $20 + $3 + $ .625 + [($5 + $3 .375)/1 .61051] . 25 . Excess limits reduce the MTR from operating in a high-tax foreign country by allowing the U .S . multinational to claim a FTC for some current year foreign income tax that otherwise would have to be carried over . In contrast, excess credits from prior years generally would not reduce the MTR from operating in a high-tax country . So, we assumed excess limits since they impact the MTR in this example . 26 . As in Fig. 1, the DPC in years zero and five ($20 + $12) sum to the total foreign income tax paid in year zero ($32) . Also, as in Fig . 1, summing the taxable income in years zero and five ($70 + $30) yields the total foreign profits earned in year zero ($100) . 27 . To derive the 42 .24%, the numerator would be: $40+$3-$2+[($3-$1)/ .61051] . 1 28 . Appropriately, our model does not incorporate taxes based on something other than income. Thus, property taxes, value-added taxes, and other taxes based on asset values or consumption are not model inputs . Of course, such taxes should be considered in the calculation of the expected before-tax foreign profits to which the MTR is applied . 29 . Applicable withholding rates may differ from those existing in the tax laws of the foreign host country or a treaty between the host and home countries since large multinationals often reduce withholding taxes through remittance treaty shopping (e .g . see Collins & Shackelford, 1998) . Thus, as appropriate, the model inputs should be the lower rates from routing remittances through a different country (or countries) with more favorable treaty provisions . 30 . In estimating domestic MTRs, Shevlin (1990) treated current net operating losses (NOLs) as tax benefits affecting the current MTR based on estimates of when the loss was expected to be absorbed in the future . The MTR model in this article considers a different tax benefit - a firm's foreign tax credit position . We must consider the effect that excess credits or limits from current year operations have on the current year's MTR . The absorption period is much shorter than the absorption period of an NOL. Also, an excess credit is absorbed through future excess limits that often depend on international tax planning such as generating foreign income taxed at relatively low rates . So, for tractability, we assume any excess credit (limit) from current year operations has no impact on the MTR if the company has prior unused excess credits (limits) . In effect, we assume the current and prior excess credits (limits) are carried over and expire unused . In contrast, if the company has unused excess credits (limits) from prior years and an excess limit (credit) in the current year, the MTR is affected . Such a situation occurs in both illustrations in the "Marginal Tax Rate Examples" section . 31 . Interest and royalties might be paid in year y, but, if so, they do not affect the MTR in year 0; instead, they are treated as paid from year y foreign profits and affect the MTR calculation for year y . 32 . Difficulty in projecting a firm's FTC position in some future year might suggest that x and x, 1 ,,,, should be input as zero .
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33 . Note that foreign profits (i .e . PRFTQ) drops out of Eq . (15) since it appears in the denominator of Eq . (5) and appears in the equations we substituted into the numerator of Eq . (5) . 34 . If desired, Eq . (15) can be expanded to include other remittance forms such as the payment of technical fees to the parent company . 35 . Though Eq. (15) captures much of the complexities involved in determining MTRs on foreign profits, the authors grant that it does not deal with all intricacies (e .g . for tractability, the model does not consider the I.R .C . Section 864(e) interest apportionment rules) . 36 . Tax practitioners sometimes use the current dividend model, but omit the FTC variables (i .e . x1 n.0 and x ,,o), to approximate the MTR applicable to a foreign direct investment. 37 . Statutory tax rates and withholding rates are obtained from PricewaterhouseCoopers (1999) and Deloitte Touche Tohmatsu (1999) . Any differences between these reference sources are reconciled through other resources . On request, the authors will share their Excel spreadsheet of statutory and withholding tax rates . 38 . Collins and Shackelford (1998) found evidence that the remittance forms multinationals select are negatively related to the respective withholding tax rates, which suggests the type of tax planning incorporated into the mixed remittance model . 39 . Of course, multinationals can remit foreign profits as dividends after more or less years than five . In fact, it is common to defer dividends until earnings can be distributed without incurring additional U .S . tax . Our model accommodates any assumption about when and what percentage of foreign profits are remitted as dividends . Our assumption that dividends are paid after five years is simply to illustrate the potential differences between MTR measures . 40 . To illustrate the calculation of our MTR measure and its differences from two benchmark MTR proxies, we selected one low-tax and one high-tax country . Malaysia's income tax rate (28%) falls well below the U .S . income tax rate (35%) . Spain's 35% income tax rate, when combined with its 10% withholding tax rates, causes it to be a high-tax country . These countries illustrate how the tax planning MTR can differ from both benchmark MTRs - the top statutory rate and current dividend MTR . 41 . Since even single percentage point shifts in tax rates can mean sizeable changes in tax liabilities, these differences also are significant from an economic perspective . 42 . On request, the authors will share their Excel spreadsheet that includes the MTR models . 43 . Professors also can use our MTR models to assist students in synthesizing many complex tax law provisions affecting international business activities . One pedagogical strategy we recommend is to progress from easy illustrations (using diagrams similar to Figs I and 2 with many simplifying assumptions) to more complex situations (using the same diagrams but gradually relaxing time period, remittance, and FTC assumptions) . Following each increasingly complex illustration, the professor might demonstrate how a MTR model provides a quicker and easier way to determine MTRs than using the diagrams . Specifically, the professor might estimate the MTR initially assuming that the foreign subsidiary remits all profits as current dividends and the U .S . parent company has no prior FTC position . The current dividend model in Eq . (17) could be used to confirm the diagram results . Second, the professor might relax the current dividend assumption, follow the diagram approach to calculate the MTR assuming foreign profits are not immediately remitted, and use the future dividend model in Eq . (16) to confirm
Marginal Tax Rates on Foreign Profits of U.S. Multinationals
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the MTR result . Third, the professor can illustrate the MTR change from implementing other remittance strategies (i .e . interest and royalties) and verify the analysis using the mixed remittance model in Eq . (15) . Fourth, the professor can return to the initial diagram, but relax the assumption that the U .S . parent company has no prior FTC position, and use Eq . (15) to verify the resulting MTR . 44 . For researchers with access to actual tax return data (e .g . see Plesko, 1997 and Mills & Newberry, 2001), details on companies' FTC positions can be derived directly from the data rather than using proxies.
ACKNOWLEDGMENTS Ernest Larkins acknowledges financial
support
for this project from the J . Mack
Robinson College of Business's Research Program at Georgia State University . Gregory Geisler performed much of this work while on the Georgia State University faculty and appreciates research release time received . Gregory Geisler completed this work while a visiting assistant professor at Indiana University . The authors gratefully acknowledge helpful comments from Michael Calegari, two anonymous reviewers, and the editor, Tom Porcano .
REFERENCES Altshuler, R ., & Newton, T. S . (1993) . The effects of U .S . tax policy on the income repatriation patterns of U .S . multinational corporations . In : A . Giovannini, R . G . Hubbard & J . Slemrod (Eds), Studies in International Taxation (pp . 77-115). National Bureau of Economic Research . Chicago : University of Chicago Press . American Institute of Certified Public Accountants (1999) . The AICPA Core Competency Framework for Entry into the Accounting Profession . New York: AICPA . Collins, J ., Kemstey, D ., & Lang, M . (1998). Cross-jurisdictional income shifting and earnings valuation . Journal of Accounting Research, 36(Autumn), 209-229 . Collins, 1 ., & Shackelford, D . A . (1992) . Foreign tax credit limitations and preferred stock issuances . Journal of Accounting Research, 30(Supplement), 103-124 . Collins, J ., & Shackelford, D . A . (1998) . Global organizations and taxes : An analysis of the dividend, interest, royalty, and management tee payments between U .S . multinationals' foreign affiliates . Journal of Accounting and Economics, 24(December), 151-173 . Deloitte Touche Tohmatsu (1999) . Corporate and Withholding Tax Rates . New York : Deloitte Touche Tohmatsu . Eskinazi, R . (1994) . South Africa proceeds cautiously to win foreign investors . Journal of International Taxation, 5(September), 404-409 . Gordon, R. H ., & Jun, J . (1993) . Taxes and the form of ownership of foreign corporate equity . In : A. Giovannini, R . G. Hubbard & J . Slemrod (Eds), Studies in International Taxation (pp . 13-46), National Bureau of Economic Research . Chicago, IL : University of Chicago Press . Graham, J. R . (1996a) . Debt and the marginal tax rate. Journal of Financial Economics, 41(May), 41-73 .
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Graham, J . R . (1996b) . Proxies for the corporate marginal tax rate . Journal of Financial Economics, 42(October), 187-221 . Hams, D . G. (1993) . The impact of U .S . tax law revision on multinational corporations' capital location and income-shifting decisions . Journal of Accounting Research, 31(Supplement), 111-140 . Healy, J . C., & Boucher, K. J . (2000) . Multistate Corporate Tax Guide . Gaithersburg . MD : Aspen Publishers . Jacob, J . (1996) . Taxes and transfer pricing : Income shifting and the volume of intrafirm transfers . Journal of Accounting Research, 34(Autumn), 301-312 . Kemsley, D. (1998) . The effect of taxes on production location . Journal of Accounting Research, 36(Autumn), 321-341 . Klassen, K ., Lang, M ., & Wolfson, M. (1993). Geographic income shifting by multinational corporations in response to tax rate changes . Journal of Accounting Research, 31(Supplement), 141-173 . Larkins, E . R. (2000) . Business taxation in Latin America : Similarities, trends, and strategies . Journal of International Taxation, 11 (November), 22-37 . Mills, L . F ., & Newberry, K. J . (2001) . Do worldwide tax incentives affect the income reporting and debt policy of foreign-controlled U .S . corporations? Working paper, University of Arizona . Newberry, K. J . (1998) . Foreign tax credit limitations and capital structure decisions . Journal of Accounting Research, 36(Spring), 157-166 . Plesko, G . A. (1999) . An evaluation of alternative measures of corporate tax rates . Working paper, Massachusetts Institute of Technology . Porcano, T . M. (1993) . Factors affecting the foreign direct investment decision of firms from and into major industrialized countries . Multinational Business Review, 1(Fall), 26-36 . Pricewaterhouse Coopers (1999) . Corporate Taxes 1999-2000 : Worldwide Summaries . New York: John Wiley & Sons . Rolfe, R. J ., & White, R. A . (1992) . Investors' assessment of the importance of tax incentives in locating foreign export-oriented investment: An exploratory study. Journal of the American Taxation Association, 14(Spring), 39-57 . 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, II(Spring), 51-67 . Single, L . E . (1999) . Tax holidays and firms' subsidiary location decisions . Journal of the American Taxation Association, 21(Fall), 17-34 . Smith, J . K . (1997). The effect of the Tax Reform Act of 1986 on the capital structure of foreign subsidiaries . Journal of the American Taxation Association, /9(Fall), 1-18 . U .S. Department of Commerce . Bureau of Economic Analysis (1999) . International accounts data : U.S. direct investment abroad. Retrieved (n .d .) from beadata .bea .doc.gov/bea/di/dia-ctry .ht m . U .S . Department of the Treasury (2001) . Statistics of Income. Returns of Active Corporations . Vines, C . C ., & Moore, M . L . (1996) . U .S . tax policy and the location of R&D . Journal of the American Taxation Association, 18(Fall), 74-88 . Wilson, G . P . (1993). The role of taxes in location and sourcing decisions . In : A. Giovannini, R . G . Hubbard & J. Slemrod (Eds), Studies in International Taxation (pp. 195-234), National Bureau of Economic Research . Chicago, IL: University of Chicago Press . Zahlander, H . (1992) . Sweden reduces taxes while nearly doubling its tax base . Journal of International Taxation, 3(July/August), 115-116 .
DO FIRMS HAVE A TAX INCENTIVE FOR STOCK BUYBACKS? AN EMPIRICAL EXAMINATION Daryl M . Guffey, Dan L . Schisler and Douglas K . Schneider
ABSTRACT This study examines whether there is a tax incentive for firms to engage in stock buybacks . Using methods previously established by Manzon (1994) and Scholes and Wolfson (1989), the results show that firms with high marginal tax rates are more likely to announce stock buybacks than firms with low marginal tax rates . Additionally, firms that announce stock buybacks have lower debt-equity ratios than firms that do not announce buybacks . Tax considerations do not appear to be a factor in the acquisition technique used, open market or tender offer. However, the tax motive and limited investment alternatives appear to he the major explanatory variables in the stock buyback decision.
INTRODUCTION During the 1990s, a large number of publicly-traded companies acquired their own stock . In 1998, for instance, 1,879 companies announced $208 billion of share buybacks . In addition, 1,289 firms announced share buybacks worth $181 billion in 1997 (Standard & Poor's, 1999) . Treasury stock can be purchased Advances in Taxation, Volume 14, pages 117-136 . Copyright O 2002 by Elsevier Science Ltd . All rights of reproduction in any form reserved. ISBN : 0-7623-0889-3 117
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either on the open market or through tender offer repurchases from shareholders . Various hypotheses exist to explain why firms repurchase their shares, including : (1) to meet employee stock compensation contracts ; (2) to increase earnings per share by reducing outstanding shares and/or to increase return on equity ; (3) to convey management's positive private information about the firm's future prospects to market participants ; (4) to reduce a firm's agency costs by returning excess funds back to the shareholders ; (5) to guard against take-over attempts, and ; (6) to increase stock prices . Firms use two dominant techniques to repurchase their shares : open market share repurchases and tender offer share repurchases . In both instances, stock buyback reduces the amount of the firm's assets and stockholders' equity by the amount of cash expended to execute the stock buyback . Regardless of the method used to account for stock buybacks (cost method or par value method), total stockholders' equity is reduced by the cost to repurchase the shares of stock . Thus, the decision to repurchase stock is also a capital structure decision because it increases the proportion of a firm's debt, thereby increasing a firm's leverage. Various factors contribute to a firm's capital structure decision . The motives for stock buybacks cited earlier are all noted non-tax reasons for a firm to reacquire its stock . Scholes and Wolfson (1989) suggest that capital structure decisions are based on both tax and non-tax factors . Other prior studies have examined capital structure decisions in light of a firm choosing to issue either additional debt or equity securities (Mackie-Mason, 1990 ; Dhaliwal et al., 1992 ; Manzon, 1994 ; Carter & Manzon, 1995) . These studies conclude that tax considerations do affect the proportion of debt the firm carries such that firms with higher tax costs tend to have a greater proportion of debt than do firms with lower tax costs . Mackie-Mason (1990) found that firms with high marginal tax rates are more likely to issue debt than firms with low marginal tax rates . However, when firms cannot make efficient use of tax shields, they prefer to issue equity securities instead of debt . Dhaliwal et al . (1992) concluded that firms with higher investment-related tax shields use less debt in their capital structure because of the tendency under U .S . tax laws for investment-related tax shields to lead to the loss of the deductibility of debt-related tax shields . Manzon's (1994) results suggest that firms with low marginal tax rates that retire debt tend to reduce their firms' leverage to a greater degree than do firms with high marginal tax rates . Carter and Manzon (1995) found that firms with low marginal tax rates were more likely to issue equity than debt as compared to firms with high marginal tax rates . These studies provide evidence that tax consequences are a consideration in capital structure decisions .
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If a company has extra cash for investment, the buyback of stock makes tax sense. First, the buyback is preferable to debt retirement because the debt produces a tax interest deduction where dividends do not . This suggestion supports the findings of Manzon (1994) and Carter and Manzon (1995) . Second, the buyback of stock may be an attractive investment opportunity for firms with high MTRs . If a firm is able to purchase treasury stock at a low market price and then resale the stock at a higher price, a company benefits from a tax-free investment in its own stock on which it has considerable knowledge and control . The buyback itself may actually increase the stock price in and of itself .' Finally, another possible tax motivation for a stock buyback may be the increased use of stock in employee compensation packages . If a company purchases treasury stock at a low price, then subsequently reissues the stock as compensation to employees, a deduction is allowed for the fair market value of the stock issued. The company receives a cash-free tax deduction for any appreciation of the stock since the repurchase . We investigate the treasury stock buyback decision to determine if the MTR is a factor in the decision . The tax influence is investigated in conjunction with other factors . One such variable is the investment opportunities of a company . If a company's investment opportunities are limited, it may be more inclined to acquire its own stock, especially since any `gain' from subsequent re-issuance at a higher price will not be taxed. Thus, a measure of a company's investment opportunities (approximation of Tobin's q as developed by Chung and Pruitt (1994)) will be added to the analysis . Firms use two common methods for purchasing treasury stock - open market purchases and tender offers . Typically, tender offers involve a firm making a public announcement, such as an advertisment in The Wall Street Journal, of an offer to repurchase shares at a stipulated price during a stated time period . For holders of the firm's stock to participate in the stock buyback, they must "tender" or submit their shares for repurchase . When a firm uses a tender offer, the offer is usually for a larger number of shares and requires advance notice and preparation . It is hypothesized later in this study that firms using tender offers are more likely than firms using open market repurchases to have non-tax reasons for acquiring their own stock . Hence, firms using open market purchases are more likely to have one of the tax motivations discussed above for acquiring their stock . The remainder of the paper will be organized as follows . First, stock reacquisition techniques are briefly discussed . Second, the proxies used for the marginal tax rate (MTR) and Tobin's q are presented . Then, the hypotheses, research method, results, and conclusions are presented, respectively .
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STOCK REACQUISTION TECHNIQUES A stock buyback, or treasury stock, is a transaction requiring a cash outflow by the acquiring firm . In some instances, the dollar amounts are in the billions of dollars . Typically, firms purchase treasury stock through either the open market technique or through the tender offer technique . The differences between these two techniques are not limited to just the mechanics of the transaction . Open market repurchases are by far the more frequently used technique. According to Securities Data Company, Inc ., in 1996, a time period covered in this study, 723 firms announced open market buybacks while only 50 firms announced tender offer buybacks . 2 Although tender offers were less frequent during this time period, the average size of tender offers tended to be larger than the average open market repurchase . The sample of firms in this study includes both open market and tender-offer firms . The firms in our sample are coded according to their respective buyback technique . The tests conducted in this study, discussed later, compare open market and tender offer firms with each other and with a control group of firms that did not make stock buyback announcements . These comparisons provide additional insights into the motives for stock buybacks .
MARGINAL TAX RATES - A PROXY FOR TAX COSTS In this study, marginal tax rate (MTR) is used as a tax cost proxy . This measure was developed by Manzon (1994) . MTR reflects the present value of explicit taxes on additional income while taking into account net operating loss carryovers (NOL) . MTR is calculated as follows :
MTR =
($1) (1+r)"
(1)
NOL, n = EFA,_
(2)
where : r n
= a non-firm specific discount rate ; = number of periods the firms will have NOLs available to offset taxable income ; NOL,_ i = net operating loss available at period t-1 to offset taxable income (Compustat Data Item 52) ;
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EFAI,_ = market value of equity multiplied by discount rate r at period t- I (Compustat data item 25 multiplied by item 199) . The tax rate is removed from the formula because the formula assumes that all of the firms in the sample are subject to the maximum statutory tax rate .' The above formula is based on equation (4) from Manzon (1994) . MTR does not represent the actual or estimated firm marginal tax rate, but, rather is a relative measure of the marginal tax rate for a firm that allows comparison between firms . The MTR formula requires the choice of a discount rate . A discount rate of 10% is used in the equation, which is the same rate used by Manzon (1994) . Manzon noted that the discount rate should be equal to the rate applied to future income used by investors to price equity . However, this rate is not observable. Rates of 5% and 20% also were used, and they did not significantly change the final test results used in this study . MTR has certain limitations, as noted by Manzon (1994) . Kinney and Swanson (1993) reported that errors exist in the Compustat NOL data . Specifically, Compustat often reports NOLs available to offset book income instead of taxable income, which can reduce the accuracy of the MTR measure . Another concern with MTR is the assumption that firms without NOLs have a tax rate equal to the maximum rate . MTR fails to take into account the possibility of a firm generating losses in the future that could be carried back and offset against current income . Despite these limitations, Manzon (1994) provides evidence that the MTR measure is a reasonable estimate of the tax cost of a firm . Accordingly, MTR is used as an independent variable in this study . More specifically, it is used to examine any difference in the marginal tax rates of firms that repurchase their stock from those that do not . In addition, MTR is used to measure any difference in the marginal tax rates between buyback firms that use the open market repurchase technique versus those that use the tender offer technique . The results of these tests provide a basis for making an inference with respect to the possible tax motive for firms to repurchase their shares .
TOBIN'S Q - A PROXY FOR INVESTMENT ALTERNATIVES Tobin's q is the ratio of the market value of a firm's assets to the replacement cost of those assets . A value greater than one indicates that the going-concern value of a firm exceeds the current cost of the assets necessary to generate the cash flow
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opportunities, a market value greater than replacement value indicates that the firm has positive net-present-value projects . A q less than one indicate that the firm's current projects, and perhaps also its future growth opportunities, have negative net-present-values . In general, firms with higher Tobin's q values have better investment opportunities than those with lower q values . We use the Chung and Pruitt (1994) approximation of q (C-P Q) as a proxy for investment opportunities . C-P Q does not require an estimate of the market values of debt and preferred stock, and approximates the replacement value of assets as its book value. Thus, C-P Q alleviates the need to gather bond and preferred yield data, and increases sample sizes dramatically (Lee & Tompkins, 1999, p . 23) . The Chung and Pruitt (1994) measure is : C- P Q = [MV (CS) + BV (PS) +BV (LTD) (3) + BV (CL)-BV (CA)]/BV (TA) where : MV (CS) = the market value of common stock ; BV (TA) = the book values of total assets ; BV (LTD) = the book values of long-term debt ; BV (CL) = the book values of current liabilities ; BV (CA) = the book values of current assets ; BV (PS) = is the liquidating value of the firm's outstanding preferred stock, if available, or the book value of preferred stock if the liquidating value is not available . The last two terms in the numerator reflect the value of a firm's short-term liabilities net of its short-term assets .
HYPOTHESES The research issues discussed above are developed into testable hypotheses . The first hypothesis addresses the possible tax motive for stock buybacks . An ex ante expectation is that firms that announce stock buybacks have higher marginal tax rates (MTRs) than do firms that do not announce stock buybacks . As mentioned earlier, several potential tax motives exist for the purchase of treasury stock . Although which tax motive influences the repurchase decision is not directly tested, one purpose of this article is to establish evidence that repurchase firms do indeed have higher tax costs . Thus, the investment opportunity in one's own
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stock and the increased use of stock and stock options as compensation, as well as the notion of high tax cost firms being less likely to reduce debt, are all potential tax motives for repurchases . Internal Revenue Code QRC) Section 1032 states that a company is never taxed on the issuance of its own stock . Thus, a firm can acquire its own stock and subsequently resell the stock at a higher share price and not be taxed on the "gain ." A firm may be in a favorable position to acquire its own stock and then subsequently re-issue it at a higher price because the management of the firm may have access to information and strategic plans poor to the market . The use of treasury stock as compensation to employees presents another possible tax motive. A company is allowed a deduction for the fair market value of the treasury stock even if the stock has appreciated in value over the company's cost (Revenue Ruling 62-217, 1962-2 CB 59) . According to IRC Section 1032, the company is not taxed on the appreciation of the stock while held as treasury stock . Thus, a company can receive a tax deduction with no current outlay of cash (no outlay for the appreciation of the stock) . While none of these tax-related reasons for stock buybacks are directly tested in this research, they underscore the appeal of buybacks to firms with high marginal tax rates . Hypothesis one (in the alternative form) is : HI : Firms with higher MTRs will be more likely to announce stock buybacks than will firms with lower MTRs . As mentioned earlier, firms can repurchase their stock either on the open market or through tender offers to shareholders . Firms using tender offers to acquire their stock tend to purchase larger quantities than do firms purchasing their stock in the open market as demonstrated in Table 2, column 9. (Table 2 will be discussed in greater detail later.) This tendency suggests that firms using tender offers are more likely to have non-tax motives than are firms engaging in open market repurchases (such as increasing earning per share or fending off a corporate take-over or poor alternative investment opportunities) . Because of the ease of purchase, a firm's use of the open market to buy back shares is more likely because of the tax savings . If firms use treasury stock as an investment, the use of the open market is more likely because of the ability to quickly invest idle cash as a short-term investment . The use of the open market would allow a firm to take tax-free advantage of short-term shifts in their stock price. Thus, hypothesis two is : H2 : The MTRs of firms buying their own stock on the open market will be higher than the MTRs for firms issuing tender offers .
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Hypotheses one and two deal primarily with tax motives . However, the treasury stock buyback decision also encompasses many possible non-tax considerations, such as investment alternatives and existing debt structure . Consequently, hypotheses three and four focus on these two testable non-tax characteristics . It is hypothesized above that firms acquiring their stock by tender offer are likely to have specific reasons (other than a tax motivation) to repurchase their shares related to the strategic objectives of the firm . In other words, given the relative ease of repurchasing shares using the open market technique, a firm would likely have a specific reason to make a tender offer that is more unusual than a desire to have a tax-free investment . Accordingly, the third hypothesis is : H3 : Outside investment alternatives for firms buying back stock by open market repurchases will be better than the outside investment alternatives for firms issuing tender offers . Earlier it was discussed that stock buybacks result in a firm's capital structure having an increased proportion of debt to equity. Firms that already are highly leveraged would be less likely to repurchase their shares because further increases in their debt-equity ratio may carry unacceptable costs to the firm, such as violation of debt covenants or decreases in credit ratings . In contrast, firms with lower debt-equity levels would appear better positioned to absorb the impact of a stock buyback . Accordingly, the fourth hypothesis tested in this study is that firms repurchasing their own stock will have lower debt-equity ratios than those firms not repurchasing their stock . H4 : Firms repurchasing their own stock will have lower debt levels than non-repurchasing firms . Each of these hypotheses is tested using the data, models, and statistical tests discussed below.
RESEARCH METHOD This section discusses the collection of data and the development of the model . Subsequent sections discuss the results, limitations and conclusions . Data
A sample of firms announcing share buybacks was acquired from Securities Data Co . The data collected is for U .S . firms from January 1994 through December 1996 . Further screening was conducted, shown in Panel C of Table 1, to eliminate duplications (i .e . firms with multiple announcements from 1994
Do Firms Have a Tax Incentive for Stock Buybacks?
125
through 1996) and to eliminate all firms not listed in the industrial file of the Compustat database . Only those observations identified by Securities Data Co . as tender offers or open market repurchases were used . Deleted from the sample were announcements that indicated privately negotiated placements or firms that used more than one stock repurchase technique in combination with another repurchase technique. This allows a comparison not only of firms that engage in stock repurchase activities with those that did not, but also a comparison between those that used tender offers as opposed to those that used open market repurchases . Next, all observations indicating banking or financial service firms (SIC codes 6000 - 6999) were deleted from the sample . The final sample contains 482 firms that announced open market repurchases and 32 firms that announced tender offers . Table 1, Panel A, presents the distribution of the sample by year and mode of repurchase . Open market repurchases account for 94% of all repurchases . Table l, Panel B, shows the distribution of the sample by the number of shares to he repurchased in the announcement . Table 2, Panel C, provides detail on the number of firms deleted from the original sample and the reason for the deletion . A control sample of non-repurchasing firms with the same four-digit SIC industry groupings was selected from Compustat . The use of the four-digit Table 1 .
Share Repurchase by Year and Number of Shares .
Panel A: Distibution of Share Repurchases by Year and Mode Year
Open Market Repurchases
Tender Offer Repurchases
1994 1995 1996
192 139 151
10 8 14
202 147 165
Totals
482
32
514
Total
Panel B : Frequency Distribution of Share Repurchases by Size of Repurchase. Number of Shares
Open Market Repurchases
Tender Offer Repurchases
Total
0-249,999 250,000 - 499,999 500,000 - 999,999 1 .000,000 - 2,499,999 2,500,000 - 4,999,999 5,000,000 or more
66 74 92 126 47 77
1 3 2 8 7 11
67 77 94 134 54 88
Totals
482
32
514
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DARYL M . GUFFEY ET AL.
Table].
Continued .
Panel C : Sample of Buyback Firms .
All share announcements from Securities Data Company Eliminations : Firms making more than one announcement per year Firms with no ticker symbols in Compustat* Total firms downloaded from Compustat Eliminations : Firms in the banking industry (SIC codes 6000-6999) Firms which did not have sufficient data for variables in the model Firms using private negotiation or combination of techniques** Net number of firms used in statistical tests
1994
1995
1996
Total
1,147
1,223
600
3,970
(109)
(391)
(730)
(1,230)
(265)
(249)
(304)
(818)
773
583
566
1922
(288)
(193)
(152)
(633)
(157)
(122)
(129)
(408)
(126)
(121)
(120)
(367)
202
147
165
514
* The process of uploading ticker symbols into Compustat generates a file of all ticker symbols accepted by Compustat and a separate file for those rejected . Compustat does not contain all incorporated firms and does not contain privately-held firms, thus some firms from Securities Data Company do not appear on Compustat. In addition, the process of uploading ticker symbols into Compustat automatically eliminates duplicate ticker symbols . The uploaded file creates a Compustat "set" with no ticker symbol appearing more than once. Therefore, when the data are downloaded for that set the ticker symbols appear only once. ** A categorical variable was used to identify the buyback technique . If a firm used a private negotiation technique or a combination of techniques such that a single technique was not used, then such firms were eliminated .
SIC industry groupings minimizes any industry or sample selection biases . This control sample also was screened to eliminate any firms that had announced repurchases during 1994 through 1996 . All firms with SIC codes of 6000 to 6999 were deleted . The control sample contains 7,697 observations .
Models The purpose of this study is to determine whether a firm's choice to repurchase shares depends on a firm's marginal tax rate, in addition to other variables . To address the hypotheses of this study, several logistic regression models were
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developed to analyze stock repurchases from 1994 through 1996 . The general form of the model is presented as follows : Dep . V ar. _ (3,+ (3 i MTR + (3 2 TOBINSQ + (3, DEBTEQ + R, LOGTA + R, PER + s
(4)
where : Dependent Variable = 0 or 1, specific for each model ; MTR = marginal tax rate ; TOBINSQ = approximation of Tobin's q as a proxy for investment opportunity as established by Chung and Pruitt (1994) ; DEBTEQ = total debt divided by total equity ; LOGTA = natural logarithm of total assets ; PER = approximate percentage of stock repurchased . At least two models were calculated . The first compares the repurchase firms with a control sample of like firms, and the second compares open-market repurchasers with tender offer repurchasers . The main variables of interest are MTR and TOBINSQ . TOBINSQ is a widely-accepted measure of a firm's investment alternatives . The other variables in the model have been shown in other studies to affect the stock repurchase decision and are included for control purposes . Smith et al . (2001) classify repurchase motives into four categories . One motive is that stock buybacks provide companies with a means of adjusting their capital structure. A second major motivation is to eliminate a company's free cash flow, the excess cash that cannot be profitably reinvested in the business and that is likely to be wasted if left on the balance sheet . A third motive is that stock buybacks provide a more flexible and tax-advantaged substitute for dividend payments . The fourth common motive for stock buybacks is to "signal" - and, in many cases, to profit from - a perceived undervaluation of the firm . The first two categories are included in our models by including the debt to equity ratio and Tobin's q . The third motive focuses on the tax advantages to stockholders of receiving excess cash in the form of repurchases in lieu of dividends, an issue that does not pertain to this study . The fourth motive involves traditional event study methodology . That is, the market response to announcements and is not relevant to this study . To further control for extraneous factors we include a proxy measure for both firm size (LOGTA) and industry (4-digit SIC codes) .
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Assuming that each individual hypothesis is important, univariate t-tests should be conducted in addition to testing the independent variables within a logistic regression model . A potential difficulty encountered in the use of ratios is the potential presence of outliers . To control for outliers, each ratio was estimated and then upper and lower limits were established for each ratio . All observations that were more than two standard deviations from the mean of the total sample were set to two standard deviations from the mean .
RESULTS This section reviews the univariate results, discusses the results of the logistic regression models, and draws inferences based on those results . Univariate Results The results of this study are presented in Table 2 and in Panels A through E in Table 3 . Table 2 reports mean and univariate statistics for the MTR and the other independent variables . Columns 2, 3 and 4 in Table 2 shows that the MTR of buyback firms is larger than the MTR of non-buyback firms . The difference is statistically significant at the 0 .01 level (one-tailed test) . This finding supports Hl, which hypothesized that buyback firms have a higher MTR than do non-buyback firms. The results in Table 2 support this conclusion . Columns 5, 7, and 9 compares MTRs for open market repurchase firms and tender offer firms . H2 hypothesized that MTRs should be higher for open market firms than for tender offer firms . However, Column 9 in Table 2 shows a t-statistic of 0 .7534 that is not significant . This result does not support H2 . Thus, the univariate tests do not support the argument that open market repurchase firms have higher MTRs than tender offer firms . Therefore, it does not appear that the choice of acquisition technique is motivated by tax considerations . H3 hypothesizes that the alternative investment opportunities, Tobin's q, for open market firms would be higher than those available to firms making tender offers . In Table 2, columns 5, 7 and 9 support H3 . Tobin's q is 1 .4178 for open market firms and is 0.8085 for tender offer firms, with a t-statistic of 6 .3146 significant at the 0 .01 level for a one-tailed test. The larger the absolute value of Tobin's q, the better the alternative investment opportunities available to firms. Thus, it can be concluded that alternative investment opportunities are a consideration in the choice of buyback technique . That is, firms engaging in tender offers have a weaker set of alternative investments . Therefore, repurchase of stock through tender offers are motivated by a lack of alternative investment opportunities .
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H4 is addressed in Table 2 by columns 2, 3 and 4 along the debt-equity row . H4 hypothesized that firms announcing buybacks have a lower debt-equity ratio than do firms not announcing buybacks . This hypothesis was based on the premise that the repurchase of stock increases a firm's debt-equity ratio, which would be more difficult for a firm with an already high debt-equity ratio . Buyback firms had a debt-equity ratio of 1 .1153 while non-buyback firms had a debt-equity ratio of 1 .6724, significant at the 0 .01 level . This result supports H4 and suggests that debt-equity ratios are likely to be lower for buyback firms than for non-buyback firms . The inference drawn from this result is that a firm's capital structure is a factor in the buyback decision .
Logistic Regression Models' Results Logistic regression models were developed to determine whether the variables used in this study could differentiate between firms announcing buybacks and those that did not . Table 3 contains the model specifications and Table 4 contains the results of five logistic tests, each discussed below, and related "Pseudo R's" (or likelihood ratio index) . Panels A and D of Table 4 are the most relevant to H1 through H4 because they involve comparisons between the categories of firms tested in H1 through H4 . The other Panel is presented for completeness and to provide insights into the research issues addressed in this study . Panel A shows the logistic regression results for all firms announcing a stock buyback and those firms that did not announce a buyback . The results of this regression model include a chi-square statistic of 212 .412 that is significant at the 0 .01 level . TOBINSQ is significant at the 0.02 level and MTR, DEBTEQ and LOGTA are all significant at the 0 .0001 level . The signs of the coefficients for MTR and LOGTA are both positive and the signs for TOBINSQ and DEBTEQ are both negative . These signs are in the expected direction . These results suggest that the independent variables, with particular interest in MTR (Hl) and DEBTEQ (H4), are significant variables concerning stock buyback announcements . The results in panel A support the hypotheses that larger firms with higher MTRs, less attractive alternative investment opportunities, and less debt are more inclined to participate in stock buybacks . Panel B presents the results of open market repurchase firms compared to non-buyback firms . The logistic regression test has a chi-square of 201 .464 (p < 0 .01) . TOBINSQ has a p-value of 0 .0638 while MTR, DEBTEQ and LOGTA are significant at 0 .001 . TOBINSQ is marginally significant and not as strong a variable in this model as in the model in panel A .
Do Firms Have a Tax Incentive for Stock Buybacks? Table 3 .
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Logistic Regression Models .
General Models Dependent variable= (30+(3I MTR+(32TOBINSQ+ (33DEBTEQ+(34LOGTA+(35PERCENT +e where : Dependent variable = specified for each model in PANELS A through E below ; MTR = relative measure of the marginal tax rate of each firm ; TOBINSQ = approximation of Tobin's Q for each firm computed using the Chung and Pruitt (1994) method ; DEBTEQ = total debt divided by total equity ; = natural logarithm of total assets ; LOGTA PERCENT = approximate percentage of stock repurchased : = intercept term; (30 = regression coefficients ; and (31-35 e = error term . Tests by Segmentation of Sample Firms and Control Group Firms PANELS A through E of Table 4 :
Table 4 PANEL
Dependent Variable Coding
PANEL A :
PANEL. B : PANEL C : PANEL D : PANEL E :
0: I: 0: I: 0: I: 0:
Segment of the Sample or Control Group Firms Entire sample of firms announcing stock buybacks regardless of stock buyback method . All control group firms no announcing stock buybacks . Only sample firms announcing open market buybacks . All control group firms not announcing stock buybacks . Only sample firms announcing tender offer buybacks . All control group firms not announcing stock buybacks . Only sample firms announcing tender offer buybacks .* Only sample firms announcing open market buybacks .* Only sample firms announcing tender offer buybacks .* Only sample firms announcing open market buybacks .*
*PANEL D does not include an independent variable PERCENT, for the approximate percentage of shares outstanding to be repurchased, while PANEL E does include PERCENT .
Panel C compares tender offer repurchase firms with firms that do not buyback their shares. TOBINSQ and LOGTA are both significant at the 0 .0078 and 0 .0036 levels, respectively . MTR and DEBTEQ are not significant . An important finding in panel D is that MTR is not significant in distinguishing which buyback firms will make tender offers versus open market repurchases . While the chi-square for the model is 16 .479 (p < 0 .01), MTR is
DARYL M . GUFFEY ET AL .
132 Table 4.
Logistic Regression Results .
PANEL A: Share Repurchase : Dependent variable = I if firm engaged in share repurchase ; 0 if not involved in share repurchase activity . There are 514 firms coded I and 7,697 firms coded 0 . Model Chi-Square 212 .412 with 4 degrees of freedom (p < 0 .01) .
Beta Coefficient p-value
Intercept
MTR
TOBINSQ
DEBTEQ
LOGTA
-5 .4965 0.0001
2 .2521 0.0001
-0.0788 0 .0209
-0 .2049 0.0001
0.2105 0 .0001
Pseudo R 2 Statistic (or likelihood ratio index) = 0 .055
PANEL B : Open Market Share Repurchase: Dependent variable = I if firm engaged in open market share repurchase ; 0 if not involved in share repurchase activity . There are 482 firms coded I and 7,697 firms coded 0 . Model Chi-Square Statistic 201 .464 with 4 degrees of freedom (p < 0 .01) .
Beta Coefficient p-value
Intercept
MTR
TOBINSQ
DEBTEQ
LOGTA
-5 .6710 0 .0001
2 .3726 0 .0001
-0 .0627 0 .0638
-0.2253 0 .0001
0 .2094 0 .0001
Pseudo R2 Statistic (or likelihood ratio index) = 0 .055
PANEL C : Tender Offer Share Repurchase : Dependent variable = I if man engaged in tender offer share repurchase ; 0 if not involved in share repurchase activity . There are 32 firms coded I and 7,697 firms coded 0 . Model Chi-Square 25 .745 with 4 degrees of freedom (p < 0 .01) .
Beta Coefficient p-value
Intercept
MTR
TOBINSQ
DEBTEQ
LOGTA
-6 .8157 0 .0001
1 .1560 0 .3419
-0 .8515 0 .0078
-0 .0663 0 .5536
0 .2435 0.0036
Pseudo Rx Statistic (or likelihood ratio index) = 0 .062
PANEL D : Tender Offer Share Repurchase versus Open Market Share Repurchase : Dependent variable = I if firm engaged in a tender offer share repurchase ; 0 if engaged in open market share repurchase . There are 32 firms coded 1 and 482 firms coded 0 . Model Chi-Square Statistic 16 .479 with 4 degrees of freedom (p < 0 .01) .
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Do Finns Have a Tax Incentive for Stock Buybacks . Table 4. Intercept Beta Coefficient p-value
-1 .7086 0 .2040
Continued .
MTR
TOBINSQ
DEBTEQ
LOGTA
-0 .5571 .6703 0
-1 .1285 0 .0033
-0 .9660 0 .4501
0.0961 0 .3705
Pseudo Rs Statistic (or likelihood ratio index) =0 .069 PANEL E : Tender Offer Share Repurchase versus Open Market Share Repurchase : Dependent variable = 1 if firm engaged in a tender offer share repurchase ; 0 if engaged in open market share repurchase . There are 32 firms coded 1 and 482 firms coded 0 . Model Chi-Square Statistic 38 .834 with 4 degrees of freedom (p < 0 .01) Intercept Beta Coefficient p-value
-3 .3709 0 .0268
MTR -0 .1087 0 .9388
TOBINSQ -0 .9541 0.0178
DEBTEQ
LOGTA
0 .1497 0.2361
0 .1341 0 .2410
PERCENT 8 .5921 0 .0001
Pseudo Ra Statistic (or likelihood ratio index)=0 .162
not significant (p-value of 0 .6703) . However, TOBINSQ is significant at the 0 .0033 level . DEBTEQ and LOGTA are not significant . Therefore, alternative investment opportunities appear to motivate the technique selected in buybacks . Panel E is an extension of the model tested in panel D . The variable PERCENT is added to the model, which represents the percentage of the outstanding shares announced for repurchase . Panel E shows that tender offer firms tend to repurchase a larger percentage of their shares than do open market firms . The relatively small sample of tender offer firms (32) may cause a lack of significance among some of the variables in panels C, D, and E . The imbalance between the size of the tender offer sample (32) versus open market repurchase firms (482) or the non-buyback firms (7,697) is an added consideration in evaluating the results . Demaris (1992, p . 41) provides a "Yule of thumb" that average cell size (sample size divided by number of cells) should be at least five . Sensitivity analysis tested the results in panels C, D, and E applying this rule. The "rule of thumb" required limiting each model to three independent variables . The sensitivity analysis produced four versions of the models in panels C and D and ten versions of the model in panel E . Each version for panels C and D produced results that were qualitatively the same as those shown in Table 3 . That is, the sign of each independent variable remained the same . Furthermore, the variables that were statistically significant in panels C and D remained statistically significant in each version . The variables that were not
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statistically significant remained statistically insignificant in each version . The ten versions provided essentially the same results except in one version the debt to equity ratio was statistically significant . Therefore, the results presented in Table 3 appear robust based on sensitivity analysis, and the small sample size does not appear to determine the findings . The above results provide evidence to support the following conclusions, consistent with the hypotheses tested in this study . MTR and DEBTEQ are significant when comparing all buyback firms to non-buyback firms . MTRs are higher for stock buyback firms than for non-buyback firms (Hl) and DEBTEQ, debt-equity ratios, are higher for non-buyback firms than for buyback firms (H4) . MTRs are slightly higher for open market firms than for tender offer firms (112) . However, MTR is not significant as to which firms engage in open market versus tender offer acquisition techniques . The lack of significance of MTR in this instance does not support H2 . In contrast, TOBINSQ (H3) is a significant variable (Table 3, panel D) and was found to be lower for tender offer firms than for open market firms . This result suggests that tender offer firms have less attractive alternative investment opportunities than do open market technique firms . The results provide support for HI, H3, and H4 but not for H2 . The primary purpose of this study was to determine whether tax considerations are an important factor in the stock buyback decision. The inference drawn from this paper is that marginal tax rates are a consideration in the decisions of firms to repurchase their shares, but not in terms of which acquisition technique is used .
LIMITATIONS The results of this study provide evidence to support the ex ante expectations tested in this study . One of the conclusions of this study is that firms that repurchase their shares are likely to have higher MTRs than do firms that do not repurchase their shares . That is, a repurchase of a firm's stock changes a firm's capital structure by increasing the proportion of debt to equity . The increase in the proportion of debt would mean that, after a stock buyback, distributions related to a firm's capital structure consist of a greater portion of tax-deductible debt . A plausible argument could be made that highly profitable firms have higher MTRs . Moreover, profitable firms are more likely to buy back their stock because they have sufficient cash flow to buy back their shares . Thus, firms that buy back their shares have to be more profitable to repurchase their shares and would by their very nature have higher MTRs . However, this argument
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would not vitiate a possible tax motive for stock buybacks because profitable firms with higher marginal tax rates would be highly motivated to shift their capital structure toward tax deductible debt . Therefore, the tax motive for share buybacks still would appear valid .
CONCLUSIONS This study provides evidence to support a tax motive for stock buybacks . However, tax considerations do not appear to influence the buyback techniques that firms choose . Finns that repurchase shares tend to have lower debt-equity ratios than do firms not repurchasing their shares . The tax motive, in conjunction with limited investment alternatives, tends to be a major explanatory variable in the stock reacquisition decision . Companies are using stock acquisitions as a tax-free investment device when limited alternative investments exist. Several extensions are available for this research . First, now that there is evidence of a tax motive for buybacks, the first extension involves the relationship between the buyback decision, stock compensation, and the stock price . One would expect firms to execute buybacks when the stock price is low and then reissue the stock as compensation when the stock price is high . Thus, the firm receives a higher non-cash tax deduction to the extent of the appreciation . A second related extension would be to examine the timing of the buyback/reissue decision . If firms are indeed trading tax-free in their own stock, tax motivated buybacks/investment would be executed in low stock price times and reissued at high stock price times . If the buyback is large enough, the company may even be able to manipulate the stock price .
NOTES 1 . This proposition is not directly tested in this study . It must first be ascertained whether firms buying treasury stock have higher MTRs . If that hypothesis is supported, future research is required concerning firms' profit taking on their own stock . 2 . The actual number of firms in each instance included in this study is less than the numbers cited above because firms that did not report required data on Compustat were deleted from the sample . 3 . If the tax rate (34%) were included in the equation (multiplied by 1 in the numerator of Eq . (1), firms with no NOLs would have a MTR of 0 .34 With the tax rate removed, firms with no NOLs have a MTR of 1 . The tax rate is eliminated to be consistent with Manzon (1994) .
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REFERENCES Carter, M . E., & Manzon, G . B ., Jr . (1995) . Evidence on the Role of Taxes on Financing Choice : Consideration of Mandatorily Redeemable Preferred Stock. The Journal of Financial Research, 18(Spring), 103-114 . Chung, K . H ., & Pruitt, S . W. (1994). A Simple Approximation of Tobin's q . Financial Management (Autumn), 70-74 . Demaris, A . (1992) . Logit modeling : Practical applications . Newbury Park, CA : Sage Publications . Dhaliwal, D ., Trezevant, R., & Wang, S . (1992). Taxes, Investment-related Tax Shields and Capital Structure . The Journal of the American Taxation Association, 14(Spring), 1-21 . Kinney, M . R ., & Swanson, E . P . (1993). The Accuracy of Tax Data in COMPUSTAT . The Journal of the American Taxation Association, 15(Spring), 121-135 . Lee, D. E ., & Tompkins, J. G . (1999) . A Modified Version of the Lewellen and Badrinath Measure of Tobin's q. Financial Management, (Spring), 20-31 . Manzon, G . B ., Jr . (1994). The Role of Taxes in Early Debt Retirement . The Journal of the American Taxation Association, 16(Spring), 87-100 . MacKie-Mason, J. K . (1990) . Do Taxes Affect Corporate Financing Decisions? Journal of Finance, 45, 1471-1493 . Scholes, M . S ., & Wolfson, M . A . (1989) . Decentralized Investment Bankings : The Case of the Discount Dividend-reinvestment and Stock Purchase Plans. Journal of Finance, (September), 7-35 . Smith, C ., Sirri, E ., Opler, T ., Ikenberry, D., Thevenet, R., Soter, D ., & Chew, D . (2001) . Stem Stewart Roundtable on Capital Structure and Stock Repurchase . Journal of Applied Corporate Finance, (Spring), 8-41 . Standard & Poor's. (1999). New Programs Keep Coming : Equities We Like with New Buyback Plans . Outlook, (January 13), 4-6 .
THE FAILURE OF THE IRS TO PROVIDE TOP QUALITY SERVICE' Philip J . Harmelink and William M . VanDenburgh ABSTRACT An examination of interagency evaluations of the IRS taxpayer assistance programs is used to infer the level of IRS taxpayer service . Congress mandated that IRS provide "top quality service" to taxpayers as part of the 1998 Tax Act. Based on these assessments, it appears that the IRS is not providing adequate service . The reports analyzed document a system that needs corrective actions . Until upper level IRS management publicly acknowledges the situation, inadequate service will continue. Congress must also recognize the extent of the problems and that its 1998 mandate is not near full implementation . Unless corrective actions occur, it appears that this mandate remains as only a politically expedient reaction to the 1997 Congressional hearings on IRS abuses .
INTRODUCTION The Internal Revenue Service's (IRS) stated mission is to "provide America's taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all" (IRS, 2000) . Currently, there appears to be a systematic failure to provide basic
Advances in Taxation, Volume 14, pages 137-158 . Copyright O 2002 by Elsevier Science Ltd . All rights of reproduction in any form reserved. ISBN : 0.7623-0889-3 137
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taxpayer service . An examination of the Treasury Inspector General for Tax Administration (TIGTA) Reports, the General Accounting Office (GAO) Reports, and an internal IRS study on the IRS's taxpayer assistance programs shows an inadequate system for the 2000 and 2001 filing seasons . The IRS attempts to assist taxpayers through three primary means : walk-in assistance, telephone, and the Internet. An examination of these various assistance programs indicates numerous deficiencies . The reports revealed not only incorrect answers to taxpayers' questions but also instances of offensive treatment of taxpayers . A 2001 TIGTA report (May 1, 2001) on the adequacy of answers given to taxpayers at IRS centers observed that the treatment of taxpayers was totally unacceptable . Relative to answering tax questions (the main focus of the report), the report states that the IRS did not provide correct or sufficient answers 73% of the time . The IRS's management response (p . 1) to this specific report did not question the validity of this report; in fact, it stated : Your report highlights a problem we have also identified, and one we are committed to addressing . . . . (IRS) Employees anonymously visited 544 TACs, half before and half during filing season. The results showed that 92% of the assistors addressed reviewers courteously ; 50% of tax law questions were answered correctly ; and 79% of the reviewers received service .
This TIGTA report (p . 3), however, had observed : In an IRS draft report on the Walk-In Quality Review Visitation program for the 2000 Filing Season, the IRS determined that only 19% of tax law questions were answered correctly by assistors according to tax law and use of the IRS's Probe and Response Guide .
It appears that the IRS revised its internal accuracy figure from 19 to 50% rate . Nonetheless, even the IRS's final numbers show that nearly 10% of its reviewers were treated discourteously, over 20% did not receive service, and 50% of the tax questions were answered incorrectly . Severe problems were reported in other TIGTA and GAO reports on taxpayer telephone service. The IRS reported a correct telephone response rate of only 78% for the 2001 tax-filing season . Based on TIGTA and GAO reports, this number, however, appears to be upwardly biased . A 2001 TIGTA report (June 29) states that it received "appropriate responses" to 53% of the questions in an examination of telephone service . In the area of simply answering phone calls, a 2001 GAO report (January) states, "IRS data showed that the answer rate for the 2000 filing season was 62%, which is lower than the 72% IRS achieved in the 1998 filing season ." The Internet component of taxpayer assistance was noted to have security problems/issues as well . A synthesis of all these reports shows that the IRS appears to have difficulty in providing taxpayer service and that its mission statement is misleading, and perhaps unrealistic . This conclusion is valid regardless of whether the IRS,
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TIGTA, or GAO reported numbers are accepted as correct . Indicative of this problem, numbers vary widely even for the same report . As the Chairman on the Subcommittee on Treasury and General Government stated in September 2001, there will be "hell to pay" if taxpayer service does not improve . Further, the problem is so severe that he emphatically stated that "if we don't put service back into the IRS," tax compliance of the American people would erode (Mohr, 2001) .
TYPES OF TAXPAYER ASSISTANCE Taxpayers in need of assistance can contact the IRS either through a visit to a Taxpayer Assistance Center (TAC), by telephone, and/or via the Internet . Nine million taxpayers sought IRS assistance at over 400 nationwide TACs in 2000 (TIGTA, May 1, 2001) . The IRS is expected to handle 100 million telephone calls in fiscal year 2001 (TIGTA, August 22, 2001) . Actual IRS representatives will handle 32 million calls and automated systems will handle the remaining 68 million calls (for such purposes as refund status and pre-recorded tax information) . Taxpayers also interact with the IRS through the Internet . In this area, Congress has mandated that 80% of returns be electronically filed by 2007 . In comparison, the IRS audited an insignificant number of taxpayers as reflected in Table 1 . The IRS Restructuring and Reform Act of 1998 mandated that the IRS mission be restated to stress the importance of service to taxpayers . The 1998 Act called upon the IRS to improve taxpayer service . In an attempt to accomplish this, the IRS has three stated goals (TIGTA, August 9, 2001) : 1 . Service to each taxpayer. 2 . Service to all taxpayers . 3 . Productivity through a quality work environment . The above goals are not very meaningful if there are numerous IRS failures to meet them . Taxpayers are faced with a system that has chronic problems Table 1 . Year
Percent
1996 1997 1998 1999 2000
1 .67 1 .28 0.99 0 .90 0 .50
Source : Guttman (2000) .
IRS Audits of Individuals . Number (in millions) L .9 1 .5 1 .2 1 .1 0 .6 (est .)
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in dealing with them. While a GAO report (January 2001) observes some improvements in the 2001 program risk analysis of the IRS, it does state that taxpayers are "often frustrated" once they are able to get to the IRS and "implementation of modernization strategy may take 10 years or more ." An analysis of current taxpayer service studies shows, however, that the IRS has many fundamental problems that are not being addressed .
TAXPAYER WALK-IN ASSISTANCE As noted, severe problems in giving incorrect answers were identified by the TIGTA (May 1, 2001) in an assessment of the IRS's walk-in service for the 2001 tax-filing season . However, more disturbing are the following instances (paraphrased) that were observed during this audit by the anonymous TIGTA reviewers . One IRS official placed another taxpayer's return in front of the TIGTA reviewer getting assistance from another IRS official . The IRS official proceeded to show the other IRS official a mistake that had been made . Incredibly, the social security number on the return was read out loud . After waiting 20 minutes for help, a disabled taxpayer in a wheelchair left because he was in pain . A taxpayer with difficulty in understanding English was asked in a condescending manner to read tax lines . In addition, the IRS representative stated in regard to a tax form the taxpayer had filled out "Let's see what kind of grade you get on this . . . ah, only a C ." A taxpayer was attempting to file his 2000 return and the prior four years' returns . IRS office policy generally was to help a taxpayer on one return per visit. When the taxpayer attempted to make appointments for the other returns he was informed he would have to come back on a daily basis to make one appointment for each day only. A taxpayer was attempting for the second time to get forms and publications . He noted that the first time the receptionist was rude and he even complained to a supervisor to no avail . He concluded that he "was talking to the ceiling ." Taxpayers standing in line commented that they waited in line until noon the previous day when they were told they would have to return another day . One commented in a humorous manner, "The IRS will make you go `postal' because we have had to wait so long ." One TIGTA reviewer after waiting in line nearly two hours was informed by a departing taxpayer that the IRS representatives were in the back talking among themselves and not helping anyone.
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• Taxpayers were told at one facility, "Congress has not allocated enough money for us to help everyone, so we have limited our help to people who make $41,000 or less ." • Reviewers noticed confusion in form distribution to taxpayers . Taxpayers were routed from the fourth floor to the first floor and then back to the fourth floor (to stand in line once again) . The IRS employee working at the first floor area had left from 12 :00 to 1 :40 p .m .
The report (page 4) contains the following additional examples (exact quotes) : 1.
2.
3.
4.
One reviewer, while stating her question, was interrupted and told to return on another day since no one was available to answer questions for that particular topic . The reviewer was not even referred to a publication . Another reviewer, upon arriving at a different TAC at 11 :00 a.m ., was told that no assistance was available to answer her questions for that day . The reviewer was then told she would have to come back the next day . At another TAC, a reviewer (who waited 1 .5 hours) was told to read a stack of publications and "do her homework" to figure the answer out . The IRS employee, in less than 5 minutes, told the reviewer that it would take 8 hours to answer all of her questions and he did not have the time . At yet another TAC, a reviewer was told that she would have to come back the next day to ask her questions because they were not issuing any more numbers after lunch . The assistor handed her some publications related to her scenario and told her that she would also need the Form 1040 publication, but they were out of them .
Although the TIGTA report notes that in the majority of their contacts the reviewers were served within 15 minutes and were treated courteously, instances such as the above would rarely or never occur in a system that provided "top quality service ." In addition, management would take immediate corrective action . IRS management's audit response to this issue was unsatisfactory . The IRS was required to respond by at least April 23, 2001, but it missed this deadline by seven days . The response stated that it was in the process of implementing a corrective plan based on its own 2000 review . It called for the creation of a higher-level position of a Tax Resolution Representative (TRR) for the centers and other improvements . It stated that the focus was on improving services, obtaining better employees, and expediting service . While these are long-range corrective steps (if implemented), a more immediate reaction should have occurred . At a minimum, top Treasury officials should have publicly
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addressed the observed problems, expressed their intolerance for it, and immediately placed high-level personnel at customer contact centers to initiate a solution. Other major problems were noted. For instance, in 32% of the TACs (15 out of 47 visited), many of the IRS employees did not wear identification tags nor did they identify themselves ; however, all IRS employees who deal directly with the public are required to identify themselves . One IRS employee upon request for identification gave a reviewer a false name and identification number after giving the reviewer a "dirty look ." At another center, a fellow taxpayer was assisting other taxpayers (taxpayers were unaware that the assisting taxpayer was not an IRS employee) . The main focus of the audit was to determine the quality of answers given to taxpayers . Incorrect or insufficient answers were given out 73% of the time . Pre-selected questions were asked in the areas of tax credits (earned income and education), head of household, sale of residence, Individual Retirement Accounts, and child investment income (see Appendix I). Auditors visited 47 sites in 11 states in different geographical areas between January and February of 2001 . The audit involved 90 separate visits to IRS centers (see Appendix II) . In the GAO report (December, 2000), the IRS lacked the information needed to assess the performance of its walk-in sites, such as reliable data on customer satisfaction . For example, it appears that there was a 5% decline in the use of walk-in site service from the 1999 to the 2000 tax filing season . The GAO noted that an attempt was made in 2000 to determine customer satisfaction with the walk-in sites, but the IRS had not established an adequate management process to ensure that the survey was conducted appropriately . The GAO also stated that there were strong indications of the need for more intensive training . Clearly, the IRS was not unaware of this problem before the audit . Its own 2000 review resulted in a similar appraisal . The IRS's internal assessment shows an organization with some severe and basic management issues . Conditions at the TACs in January/February 2001 were unacceptable, and many of the underlying problems still are present (as shown in a subsequent section of this article) . The above reports by the GAO, TIGTA, and even the IRS, show extensive system-wide problems . The TIGTA's conclusion (May 1, 2001, p . 6) is conservative in stating : The IRS has not yet overcome its inability to provide quality customer service to taxpayers requesting assistance at IRS offices . Taxpayers continue to be denied service or receive inappropriate answers to their tax law questions .
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TELEPHONE ASSISTANCE In January and February 2001, the TIGTA made 368 calls to the IRS seeking answers to predetermined tax questions (TIGTA, June 29, 2001) . It was unable to reach the IRS 37% of the time (137 times) . The times the TIGTA did get through it received an incorrect or incomplete answer 47% of the time, but it did note that most IRS employees were "courteous and professional ." Generally, the TIGTA was able to obtain assistance in 15 minutes, but times varied . The average time to reach an assistor was 15 minutes (minimum time was less than 1 minute and the maximum time 1 hour 35 minutes) . The average time talking to an assistor was 8 minutes (minimum time was less than 1 minute and the maximum time was 1 hour 4 minutes) . The TIGTA selected its questions by looking at ten tax topics that were listed by the IRS as Frequently Asked Questions (FAQs) (see Appendix III) . These were selected out of an original list of "398 questions ." It stated that the "TIGTA believed that using the IRS's own FAQs was not only fair, but actually gave the IRS an advantage ." Table 2 from this TIGTA report (June 29, 2001) shows the subject areas of the questions and the response rates . While the TIGTA audit was performed in accordance with Government Auditing Standards, the results "were not statistically valid for projection," even though the practical significance is overwhelming . However, a comparison of its results to the supposedly statistically valid IRS method was similar for the sample time frame . In addition, one can see in Table 2 that the highest "appropriate responses" (dependents, Social Security income) occurred for what should be relatively easy areas . The IRS Commissioner's response speaks Table 2. Type of Question
Number of Times Spoke to an Assistor
Child Care Credit Dependents Estimated Tax Nonemployee Itemized Deductions Pensions and Annuities Social Security Income Earned Income Credit TOTAL
Percentages of Appropriate Responses . Number of Appropriate Responses
Percent of Appropriate Responses
25 25 25 24 24 12 23 24
10 22 17 8 8 5 19 13
40 88 68 33 33 42 83 54
182
102
56
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volumes for its inability to address this fundamental problem . The response states : After careful review of TIGTA's audit report on the IRS's response to tax law questions over its toll-free lines, I conclude that it does not accurately portray the quality of service the IRS furnished . . . The audit's methodology is seriously flawed, and, therefore, the findings are often misleading (IRS Commissioner's response, p . 1) . The IRS then points out that it has a 22% incorrect rate when it uses its allegedly "statistically valid system," as opposed to the 47% reported by the TIGTA . Either figure should indicate a drastic need for change at the IRS . The IRS took exception to the use of hypothetical questions and stated that it cannot design a system to answer every taxpayer's questions . It did indicate, however, that telephone taxpayer assistance is "critical ." Perhaps IRS employees should identify the tax questions they cannot answer . When this occurs, an organization that provides "top quality service" should direct the call to someone who could at least analyze the question fully as well as track its final disposition . Interestingly, the IRS is unable to estimate the cost of its telephone service . The TIGTA (August 22, 2001) audited the telephone service to determine its cost . It estimated the fiscal year 2001 cost at over $627 million . The report also states that "the IRS's financial system can readily identify toll-free costs totaling over $31 million . . . . The $31 million captures only the costs directly attributable to the toll-free system ." The GAO report (2000) also noted severe problems . On the matter of helping taxpayers, the IRS did not fare well . The IRS's performance in providing telephone service in 2000 (62%) was below the level of service achieved in 1998 (72%), although it was better than that of 1999 (only 51 %) . This level of service is calculated by dividing the number of calls answered by the total calls attempted . In addition, relative to the accuracy of the answers, which the IRS measured by monitoring a sample of taxpayer calls, the IRS itself calculated an accuracy rate of only 71 .9% for the 2000-filing season, which was below the IRS's goal of 80% . In another GAO report (April 6, 2001), the following problems were noted : • Telephone assistance results were mixed and fell short of world-class service • Interrelated factors influenced IRS's telephone performance (demand, staffing level, productivity, assistors' skills, assistors' guidance) • Interrelationships make identifying key factors difficult • The IRS's analysis of its performance was incomplete • The IRS's performance management system restricts the use of productivity data.
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IRS Commissioner Charles O . Rossotti noted in his reply (April 6, 2001) that he agreed with the GAO's assessment of the performance during the 2000 filing season . He noted that achieving "world class service" will take many years, and that the IRS now has a "sophisticated modeling tool" to help in this regard . Once again, taxpayer assistance is shown to be inadequate by the TIGTA, GAO, and the IRS . The TIGTA (June 29, 2001, p . 6) concluded the following in its assessment of the telephone system : Our experience in asking the IRS tax law questions on its toll-free system often was unsatisfactory . We frequently did not receive an appropriate response and occasionally encountered significant delays in reaching an assistor .
THE INTERNET The GAO's report (February 16, 2001) examined the IRS's electronic filing (e-file) program . This report was not only "temporarily restricted" but also its final version was limited in details . Similarly, distribution of a TIGTA report (June, 2001) was restricted outright (apparently due to security concerns) . It was titled "Controls over the Internet gateway should be improved to better deter and detect external attacks ." When trying to access the TIGTA report over the Internet in September 2001, the following appeared : The Treasury Inspector General for Tax Administration (TIGTA) has designated this report as Limited Official Use . . . it may only be made available to those officials who have a need to know the information contained within this report in the performance of their official duties . This report must be safeguarded and protected from unauthorized disclosure . . .
The GAO report indicates that during the 2000 tax filing system there were inadequate controls for e-file . In fact, GAO auditors were able to access taxpayer data with a "common handheld computer ." This occurred because there were ineffective restrictions on external access to computers ; operating systems that were not securely configured ; inadequate passwords ; insufficiently restricted computer access ; and the lack of encryption to protect tax return data . Even more troubling was the fact that neither the GAO nor the IRS was able to determine whether or not an external security breach had occurred . This GAO report specifically highlighted that : • The IRS is a major steward of personal taxpayer information • E-file is a major IRS tax filing initiative • E-file vulnerabilities could have allowed intruders to obtain taxpayer data during the 2000 tax filing season (view as well as modify electronically-filed data) • Intruders could have accessed other IRS systems
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• The IRS procedures for detecting intrusions were inadequate • The IRS did not ensure ongoing security of a-file systems • There were other opportunities to strengthen the reliability of e-file taxpayer • • • •
data IRS paid refunds claimed on unauthenticated electronic returns Certain data validation and editing controls could be improved Software development controls could be improved Taxpayers may not be aware of privacy considerations in filing electronic returns . (Taxpayers were informed that the data would be encrypted ; however, the data were encrypted only from the taxpayer to the third party . When the third party sent the data to the IRS, none were encrypted . Taxpayers have to file through a third party .)
These security concerns are not conducive to the aforementioned Congressional goal of 80% e-filing by 2007 . (In 2000, over 35 million individual taxpayers electronically filed their tax returns through a-file, which represented approximately 28% of all individual returns (GAO, February 16, 2001) .) While the GAO did note that the IRS had taken prompt action to address the issues it had uncovered, the IRS's efforts to achieve the Congressionallymandated 80% goal must be balanced against the need to "ensure the security, privacy, and reliability of taxpayer and other sensitive information ." IRS Commissioner Charles O . Rossotti noted in his reply that the IRS took timely corrective action and that the GAO report "accurately identified" problems .
ILLUSORY IRS IMPROVEMENTS The GAO published a study on "Tax Administration - Assessment of IRS's 2000 Tax Filing Season" in December 2000 . In the study, an assessment of the IRS's performance was made . The assessment dealt with the IRS's processing of returns and refunds and the various means through which the IRS helps taxpayers . While there were some complimentary comments in the study, there also were criticisms . Although the performance of the IRS on processing of returns and refunds fared better than the assessment of the means through which the IRS directly helps taxpayers, there were still significant problems . The GAO acknowledged that in 2000 the IRS met or exceeded its processing performance levels in 1999 for five of seven performance indicators . The IRS did exceed its goal of 26 .5% of returns to be filed electronically ; yet, they were significantly under the Congressional goal of 80% . The accuracy of individual income tax returns processed by the Code and Edit staff and "notice accuracy" were slightly less
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than the stated goals . Also, the computer systems used to process tax returns performed better in 2000 than in 1999 . In addition, the IRS made some changes in an attempt to reduce the number of taxpayer errors and enhance its processing efforts . It simplified the child tax credit worksheet, which resulted in a decrease of 37% in the number of errors in this area made by taxpayers and return preparers . In addition, the IRS revised the criteria for filing Schedule D relating to capital gains and losses . The report did, however, specifically mention the following weaknesses : • The 2000 season was only slightly better than 1999 • More can be done in assisting taxpayers and measuring performance • IRS telephone service improved in 2000, but still was below levels achieved in 1998 • Its monitoring of walk-in sites is inadequate • The IRS needs to improve its volunteer assistance programs • Some web site material was "obsolete or inconsistent" • There were inadequate performance measures to reflect the timeliness with which the IRS responded to orders of publications and forms • The effects of the IRS's efforts to improve the earned income credit (EIC) compliance were unclear • $9 .3 billion out of $30 .3 billion EIC claims were erroneously paid for tax returns filed in 1998 (IRS study) .
While a 2001 GAO report titled "Internal Revenue Service Progress Made, but Further Actions Needed to Improve Financial Management" (October 19) found some progress in the area of IRS financial statements, it still found "serious systems deficiencies and internal control weaknesses ." The GAO gave the IRS an unqualified opinion on its 2001 financial statements despite ineffective internal controls . (This report was a follow-up to the GAO report titled "Financial Audit : IRS's Fiscal Year 2000 Financial Statements" (March 1, 2001) .) Although the focus of the report was on the IRS's financial statements, issues relevant to taxpayer service were contained in the study . Security of tax data and receipts did show marked improvement, but problems still plagued this critical function . Despite an IRS policy, the GAO identified 145 employees that were working before fingerprint checks were completed (later 15% of these employees were found to have questionable backgrounds) . GAO also noted Lockbox banks were not required to meet, "minimum courier requirements applicable to IRS campuses" (the new name for IRS service centers) . Relative to the earned income credit, the study noted that the IRS for the tax years 1996 to 1998 had suspect returns with an estimated $49 billion in
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unreported income (over 39 million returns) . It had followed up on only 22% of these returns . Further, IRS had not done a serious cost benefit study of the issue . Finally, the GAO noted that the IRS's fiscal year 2000 report was the first time their combined financial statements were fairly stated in all material respects . However, it observed that "this approach does not fix its fundamental weaknesses nor produce the reliable, useful, and timely financial and performance information IRS needs for ongoing decision-making consistent with the CFO Act of 1990 ."
ROUTINE LAPSES IN ADMINISTRATION With the serious problems highlighted in this article, it is predictable that this lack of sufficient management results in routine lapses in IRS administration on tax matters . An examination of IRS mistakes occurring in 2001 clearly shows this . For example, in July 2001, the IRS mailed 500,000 statements relative to "advance payments" that overstated the amount taxpayers were due - the IRS incorrectly figured the impact of credits (Hamilton, 2001a) . The "advance payments" occurred as a result of the Economic Growth and Tax Relief Reconciliation Act 2001 (EGTRRA) . Adding to the problem, the IRS stated on August 10, 2001 that only "120,000 taxpayers" were affected (IRS, 2001b) . In another instance, on June 5, 2001, the IRS stated that "some payments and extensions or returns are missing from the IRS's Pittsburgh Post Office Box Address" (IRS, 2001a) . An IRS spokesman first claimed, "fewer than 1,500 payments were known to be missing ." In addition, it was emphasized that missing payments were "from facilities that are not staffed or managed by the IRS" (the Mellon Bank) (Herman, 2001a) . This distinction is irrelevant for taxpayers and also should be irrelevant to the IRS (which has ultimate responsibility) . In mid-August 2001, the IRS revised the missing payments to be at least 1,800 . However, practitioners in the meantime correctly predicted that the problem was more extensive than reported (Herman, 2001b) . In late August 2001, the IRS revised the figure once more to over 40,000 (Hamilton, 2001c) . In December 2001, the chairman of the Senate Finance Committee stated the number had grown to over 71,500 returns (and could grow further) . The preliminary dollar amount of lost payments is $1 .2 billion and a grand jury investigation is being conducted (Associated Press, 2001b) . Despite the magnitude of the issue, the IRS only cancelled Mellon Bank's processing contract in Pittsburgh, but not Mellon's processing contract for Los Angeles (Hamilton, 2001b). The lack of Mellon Bank's management accountability is disturbing . The IRS did inform field offices not to penalize taxpayers for missing payments and did request taxpayers to stop payment on
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uncashed checks . (Taxpayers could be reimbursed for stop payment fees by filing form 8546 - Claim for Reimbursement of Bank Charges Incurred Due to Erroneous Service Levy or Misplaced Payment Check) (IRS, 2001c) . Mellon Bank stated only that it was unable to find evidence of stolen checks or identity theft . It indicated that workers simply fell behind in processing returns, which resulted in their hiding or destroying returns . Interestingly, in 1985 the IRS had a similar problem at its Philadelphia Service Center . Refund checks were destroyed and returns were found in trash receptacles and the women's restrooms . The excuse at the time was excessive employee turnover and expensive computer problems (Associated Press, 2001 a) . The IRS management is aware of the ongoing problems in the processing of tax payments and returns . For instance, a June 21, 2001 TIGTA "limited scope review" examined why business tax payments were processed, but the accompanying tax returns were not . (The examination was the result of problems noted in an ongoing TIGTA review of another related issue) . The report found the following weaknesses : • Business returns with payments had missing information • While the payments were processed, the returns were destroyed • The information was on the payment voucher, but not the return (classified as unprocessable) • The IRS did not inform the lockbox bank to record the problem • The IRS failed to use state tax identification information that could be used to identify the business • The failure to simply record the information resulted in hardship for taxpayers, incorrect tax assessment, and additional work for the IRS itself • The net result was that after 26 weeks the taxpayer was informed that the return was missing and the IRS requested a copy .
The IRS agreed with the report and stated that it would implement a solution in January 2002 (six months later) . Further, in February 2001, the TIGTA recommended that the IRS improve the processing of tax payments in the lockbox bank in Atlanta, and in June 2001, the TIGTA (June 13, 2001) noted problems with processing of business returns at the Atlanta Processing Center . The above incidents show that the IRS is not efficiently and/or effectively handling another basic tax issue . A well-run organization would attempt to avoid problems . When processing returns, the IRS is more interested in moving the paper than doing it accurately (note the partial cancellation on Mellon processing contract) . Simple inaccuracies that could be resolved initially become much more problematic later on for the IRS . Taxpayers are greatly inconvenienced and the IRS expends considerably more resources than necessary on this issue .
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UNDERLYING CAUSE(S) OF PROBLEMS The underlying issue is in large part due directly to improper Congressional funding and increased tax law complexity . While mandating "top quality service," Congress does not properly fund the IRS for this mission . Total IRS personnel have steadily declined as seen as Table 3 . Hiring freezes and a 3-4% attrition rate have resulted in the reduction of approximately 13,000 employees over the 1995-2000 time period (Guttman, 2000) . To partially cope with the problems, the IRS annually uses 25,000 temporary workers to handle return processing . In the past, workers as young as 16 years of age have been used in this annual process . In 1999, the Cincinnati IRS processing center was understaffed by 15%, which resulted in returns being sent to other centers, thereby increasing chances for lost returns . In a separate issue, the IRS also employed 5,000 workers before their background checks were completed . Characteristic of these problems was the fact that out of the 5,000 workers, 3% had unacceptable backgrounds - including theft, assault and weapons violations (Harmelink & VanDenburgh, 2000) . IRS's upper management is not without blame . It is not close to providing adequate taxpayer service ; yet, it continues to state that it is providing improved taxpayer service . Until management publicly and fully recognizes its fundamental taxpayer service problems, the problems noted throughout this article will continue. As observed earlier, the GAO predicts that it will take ten years for full modernization . Even if correct, this does not fully recognize the immediate problems that could be solved with better front-line service to taxpayers (a basic management and funding issue) . An examination of an April 7-9, 2000 Gallup polling question on taxes provides an indication of the overall public perception of tax administration . When asked about their overall opinion of the IRS, 56% (± 5%) of taxpayers
Table 3.
IRS Full Time Employees .
Year
Employees (rounded)
1995 1996 1997 1998 1999 2000
110,711 105,341 100,500 96,961 97,739 96,995
Source : Guttman (2000) .
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indicated an unfavorable impression . This perception is not unjustified based on these interagency assessments of taxpayer service as noted in this article .
CONCLUSION Regardless of which numbers are used, it is clear that there is a systematic failure in taxpayer assistance. That is clearly indicated in all assistance and accuracy rates cited by the IRS, TIGTA, and GAO . In addition, one very important problem was the observed occurrence of discourteous taxpayer service . This was observed during the TIGTA's evaluation of IRS walk-in taxpayer service centers, as well as the IRS's own internal review . The TIGTA and GAO should immediately conduct audits to solely identify the rate of occurrence of these incidences . In addition, the lack of direct management concern on the part of the IRS needs full examination under a Congressional hearing . In closing, the likelihood of the IRS's achieving its mission during the next five to ten years is extremely low . Currently, it is not close to providing "top quality service ." Its immediate goal should be to provide at least adequate service to taxpayers . Top IRS management's recognition of the degree and extent of these fundamental problems would be a first step in addressing these chronic and ongoing issues . One need only look at the title of recent TIGTA reports on taxpayer telephone service (see Appendix IV) to see that the IRS tax assistance programs have fundamental problems .
NOTE 1 . The Hite article showed the Internal Revenue Service (IRS) as having a better than expected customer satisfaction rate in its audit division, which may not be overly surprising since taxpayers can receive more favorable outcomes than they expected . In order to present a different view of IRS customer satisfaction, the editor invited this article on taxpayer assistance . The article presents an analysis of IRS taxpayer service as documented in reports by the IRS, Treasury Inspector General of Tax Administration (TIGTA), and General Accounting Office (GAO), and complements the Hite article to provide a balanced picture of IRS performance.
REFERENCES Associated Press (2001a) . Exec says harried workers hid IRS returns . Chicago Tribune Online . (September 5). Associated Press (20016) . Tax return snafu bigger than thought . (December 8) . hitp://wire.ap.org . General Accounting Office (2000) . Tax Administration, Assessment of IRS's 2000 Tax Filing Season. (December) . Reference : GAO-01-158 . General Accounting Office (2001) . Major Management Challenges and Program Risks . (January) . Reference : GAO-01-254 .
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General Accounting Office (2001) . Information Security, IRS Electronic Filing Systems. (February 16) . Reference : GAO-01-306 . (IRS Management's Response contained within). General Accounting Office (2001) . IRS Telephone Assistance, Quality of Service Mixed in the 2000 Filing Season Filing and Below IRS's Long-Term Goal. (April 6) . Reference : GAO-01-189 . (IRS Management's Response contained within) . General Accounting Office (2001) . Financial Audit: IRS' Fiscal Year 2000 Financial Statements . (March I) . Reference : GAO-01-394. General Accounting Office (2001) . Internal Revenue Service Progress Made, but Further Actions Needed to Improve Financial Management. (October 19) . Reference GAO-02-35 . Guttman, G. (2000) . Does the IRS have the resources to do its job? Tax Notes (December 11), 1345 . Hamilton, A. (2001a) . IRS sends out 500,000 erroneous tax rebate notices . Tax Notes (July 23), 476. Hamilton, A . (2001b) . Mellon bank loses IRS lockbox contract over missing returns. Tax Notes (August 27), 1148-1149. Hamilton, A . (2001c) . Number of missing tax returns soars to 40,000 . Tax Notes (September 3), 1264-1265 . Harmelink, P ., & VanDenburgh, W . (2000) . An assessment of the IRS's modernization effort . Tax Notes (June 5), 1407-1413 . Herman, T . (2001 a) . Tax Report . Wall Street Journal Online . (June 13) . Herman, T . (2001b). Tax Report . Wall Street Journal Online . (August 15) . IRS (2000) . 1040 Instructions . IRS (2001a). Problem Alerts Report . (June 5) . http ://www.irs .gov/hotlalert-report.htm l IRS (2001b) . Problem Alerts Report . (August 10). http ://www.irs .gov/hot/alen-report .htm l IRS (2001c) . Problem Alerts Report . (August 31). http ://www.irs .gov/hot/alert-report.html Mohr, P . (2001) . Senate clears $9 .45 billion budget for IRS . Tax Notes (September 24), 1648. Treasury Inspector General for Tax Administration (2001) . Letter report: improvements at the lockbox bank in Atlanta are needed to better protect taxpayer payments and minimize processing costs . (February 26) . http ://www.usrreas.gov/tigta200lreports200140048fr .html . Reference Number: 2001-40-048 . Treasury Inspector General for Tax Administration (2001) . Letter Report: The Internal Revenue Service Continues to Give Incorrect Tax Law Information in Taxpayer Assistance Centers, (May 1) . h ttp://www.ustreas.gov/tigta2001reports200140077fr .html. Reference Number: 2001-40-077 . (IRS Management's Response contained within) . Treasury Inspector General for Tax Administration (2001) . Controls Over the Internet Gateway Should Be Improved to Better Deter and Detect External Attacks . (June) . h ttp://www. ustreas.gov/tigta200lrepons200120101fr.html . Reference Number : 2001-20-101 . Treasury Inspector General for Tax Administration (2001) . Management advisory report: concerns with the processing of small business corporation returns at the Atlanta processing center in July 1999 . Executive Summary. (June 13) . http ://www.ustreas.gov/tigta200lreports/ 200130080es .htm . Reference Number : 2001-30-080 . Treasury Inspector General for Tax Administration (2001). Management Advisory Report The Internal Revenue Service Could Reduce the Number of Business Tax Returns Destroyed Because of Missing Information, Executive Summary . (June 21) . h ttp ://www.ustreas.gov/ tigta200lreports200l30099es .html . Reference No . 2001-30-099 . (IRS Management's Response contained within) . Treasury Inspector General for Tax Administration (2001) . Letter Report: Our Experience in Asking the Internal Revenue Service Tax Law Questions on Its Toll-Free System Was Not Satisfactory. (June 29). h ttp://www.ustreas .gov/tigta200lreports200140106fr.htm l. Reference Number: 2001-40-106 . (IRS Management's Response and the TIGTA's Rebuttal contained within)
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Treasury Inspector General for Tax Administration (2001). Letter Report: Opportunities Exist to Improve the Performance Indicators Used to Convey Toll-Free Telephone Accuracy Accomplishments, (August 9) . http ://www.ustreas.gov/tigta200lreports20014Ol3Ofr.html . Reference Number : 2001-140-130. Treasury Inspector General for Tax Administration (2001) . Management Advisory Report : The Estimated Cost of the Internal Revenue Service's Toll-Free Telephone Service Exceeds $600 Million . (August 22) . http:/hvww.ustreas.gov/tigta2001repons20o14013Ofr .html . Reference Number : 2001-30-139 .
APPENDIX I TAC Scenarios and Questions Scenario No. 1 - Head of Household, Earned Income Credit, Child- and Education- Related Credits
The taxpayer is a single parent earning approximately $8,000 a year . The taxpayer has one child, born in April 2000 . The taxpayer is a full-time student in her first year of nursing school, but her third year of college . The taxpayer receives scholarships for tuition and books . Questions for Scenario No . 1 :
I am a student and I need some help with my tax return this year . I am a full-time student and I had a baby last year . I work, too, but I am really short on money now, and I wanted to know how I can get my taxes lower and get a refund . • My first question is about my scholarship . The college said to find out from you how much is taxable . How do I do that'? • I have also heard from friends that there are credits for students . How do I sign up for them? • I have also heard that there are credits that I can have because I have a child . Is this true? Scenario No. 2 - Sale of a Personal Residence (Reduced Exclusion)
The taxpayer is single and has just accepted a new job in Chicago . The taxpayer purchased his/her first home in June 2000 for between $150,000 and $220,000 . This home is currently listed with a real estate agent and the taxpayer is concerned about the tax implications of the sales transaction . Question for Scenario No. 2 :
I have some questions on selling my house . I bought it last year and now I have to sell it because I got a new job in Chicago . • My real estate agent told me that I would have to pay tax on the money she thinks I should make when I sell my house . I did not think that I would have to pay any tax
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Scenario No . 3 - Individual Retirement Account (IRA) Considerations The taxpayer is single and needs information about an IRA . The taxpayer earned more money this year and wants to know if IRA contributions are still deductible . Also, the taxpayer wants to withdraw IRA funds to purchase his/her first home . Questions for Scenario No. 3 : I have questions about my IRA . I have been putting $2,000 in my IRA every year since 1996. I did this last year, too, but things have changed since my last tax return . I am not sure what I need to do . • I got a new job and I make more money than I used to . Can I still claim the $2,000 for my IRA contribution on my tax return? • I also contribute the most I can to my office's 401(k) . They told me that it is like an IRA . Can I take a deduction for that, too? • I am planning on buying my first home this year and was going to use the money I have saved in my IRA as part of my down payment . Do I show that on my tax return? Scenario No. 4 - Child's Investment Income The taxpayers are married and have two young children . The taxpayers started investing for their children in 2000 and have questions about how to report the interest and dividend income earned by their children on these investments . Questions for Scenario No . 4 : We have some questions on how to report our children's income . • We started investing money for them this year . They are just babies - do we have to do tax returns for them or can we just report this income on our return? How will we know which way is best? And, how do we do this?
APPENDIX II Cities of Taxpayer Assistance Centers Visited Alabama California
(Birmingham, Huntsville) (Bakersfield, Fresno, Modesto, Oakland, Sacramento, San Jose, San Francisco, Santa Rosa, Stockton, Walnut Creek) Georgia (Atlanta - two sites, Augusta, Columbus, Macon, Smyrna) Massachusetts (Boston, Springfield, Stoneham, Worcester) Maine (Portland) Missouri (Kansas City, Springfield) New Hampshire (Manchester, Portsmouth)
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Oregon Texas Tennessee Washington
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(Portland) (Abilene, Austin, Dallas, Fort Worth, Houston - four sites, San Antonio, Texarkana, Tyler, Wichita Falls) (Chattanooga) (Bellevue, Everett, Olympia, Tacoma, Vancouver, Yakima)
APPENDIX III Toll-Free Telephone System Test Questions
We asked the following questions when we contacted the Internal Revenue Service's (IRS) toll-free telephone assistance program . In addition to the questions, the auditors were provided with scripted answers to questions that may have been asked by the assistors . 1 . I sold my house this year . Can I exclude the capital gain? Scenario : You bought a house in November of 1998 and sold it in July of 2000 . It was your first home . The reason you sold your home is because of a job transfer to a new city . The home was your main home and you lived in it the entire time you owned it with the exception of the time between closing and moving in . You closed on November 19, 1998, and moved in December 20, 1998 . Your filing status is Head of Household . Answer: Yes, you can exclude the gain on the sale of your home . You do not meet the use and ownership tests . However, your gain is less than the amount you qualify for under the reduced maximum exclusion . The assistor should refer you to the worksheet in Publication 523 on page 13 to determine the amount of your exclusion . 2. Can I claim child care credit for my child care costs that are more than what I paid into my dependent care benefits plan? Scenario : You file Head of Household and have a 4-year old daughter . Your earned income was $26,450 and you paid $4,500 into a dependent care benefits plan. Box 10 of your W-2 shows $4,500 paid into a dependent care benefit plan . Your daughter goes to a day care center and child care expenses were $5,100 . You have the name, address, and Employer Identification Number for the day care center . You provide the main home (an apartment) for your daughter and pay all living expenses . You are filing with a 1040A and 1040A Schedule 2 for Child and Dependent Care Expenses for Form 1040A . Answer : No, you cannot take the credit . The assistor may walk you through Part III of Schedule 2, Form 1040A or Form 2441 to determine this .
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3 . Can I claim my niece as a dependent? Scenario : Your niece lived with you for 9 months . Your niece does not work or have any income of her own . You supported your niece and her son for the last 9 months . Your niece is not married . They are both United States citizens . Answer: You can claim your niece as a dependent . 4 . I'm going to sell some stock this year . Do I need to make tax payments to cover the taxes I will owe? Scenario : You are going to sell some stock that you have had for 6 years . You are single and have always filed single. You have only wage income and the only payments you have are through the withholding on your wages . You do not itemize; you take the standard deduction . Answer: You do not have to pay estimated taxes for 2001 .
5 . My employer sent me a 1099-MISC instead of a W-2. The 1099 shows my wages as non-employee compensation. I was an employee . What do I do? Scenario : You are a wallpaper hanger. You work for a homebuilder who has hired you to hang wallpaper in new houses that he has built . You provide your own tools and equipment . The builder tells you when and where to work . He also provides the wallpaper and supplies for hanging the wallpaper . You sometimes take other paper-hanging jobs on the side when the homebuilder has no work available for you, but you do not advertise your services . The homebuilder pays you $10 .00 an hour. The homebuilder does not provide health insurance, a pension plan, vacation pay, or sick pay. Answer: You are being treated as a self-employed worker, also referred to as an independent contractor. If you believe you are an employee and not an independent contractor, you may request a ruling by filing Form SS-8 . You must file your income tax return before a determination can be issued . To file as a non-employee, you have to report your non-employee compensation on Form 1040, Schedule C, or Form 1040, Schedule C-EZ . You also need to complete Form 1040, Schedule SE, and pay self-employment tax on your net earnings from self-employment of $400 or more . 6 . I know I cannot take money from my 401(k) plan to buy a house, but can I roll some of it into an Individual Retirement Account (IRA) and then take money out to buy a house? Scenario : You have checked with your employer and your distribution from your 401(k) plan is eligible to be rolled into an IRA . You do not want to receive a distribution ; you want to roll it directly from your 401(k) into an IRA (direct
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rollover) . You want to roll over $9,000 to buy your first home. You are 35 years old . You are not married . Answer : Yes, you can roll over your 401(k) plan into an IRA and then withdraw money to use as a down payment on your first home . You will not have to pay the 10% penalty . 7 . Can I deduct the tuition that I paid for my child's school? Scenario : You and your spouse sent your blind child to a special school for the blind in 2000 . This was the first year of school for your child . This special school cost you $12,000 . Your adjusted gross income for 2000 was $67,534 . Answer : You can deduct the tuition you paid for your child to attend a special school for the blind . This deduction can be taken on the Schedule A as a Medical and Dental Expense . The amount you will be able to deduct is that amount that exceeds 7 .5% of your Adjusted Gross Income . 8 . I am planning to retire this year and I want to know if my retirement will be taxable. Scenario : You are planning to retire in June 2001 from the Department of Agriculture . You are 57 years old . Your retirement benefits are under the Civil Service Retirement System . Answer : Your retirement annuity will be partially taxable . The part that you contributed to your pension plan can be excluded from income as a recovery of your cost . The Office of Personnel Management will figure the taxable amount of your annuity using the Simplified Method . This will be shown on your Form CSA 1099-R . You may use the Simplified Method Worksheet in the instructions for Form 1040 or Form 1040A or Table 1 in Publication 721 if you would like to figure the tax-free part of your annuity yourself . 9 . Do I owe taxes on my social security? Scenario : You retired last year . You received social security benefits in the amount of $6,000 . You also received taxable retirement income of $16,000 . The only other income you had is interest income of $2,400 . You are single . Answer : You do not have to pay taxes on your social security benefits . 10. Can my son get the Earned Income Credit (EIC)? Scenario : Your son is 18 and not married . He and his girlfriend have a son and they live in a dwelling that your son owns . He made $6,434 last year . His girlfriend had no income . Answer: Your son does qualify to take the EIC . The assistor should advise you of the following :
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• Intentional disregard of rules and regulations of fraud will result in EIC being disallowed in future years .
• The requirement for and the disallowance of the EIC if social security numbers are missing or incorrect .
APPENDIX IV Recent TIGTA Reports Related to Toll-Free Telephone Operations Management Advisory Report : The Estimated Cost of the Internal Revenue Service's Toll-Free Telephone Service Exceeds $600 Million (Reference Number 2001-30-139, August 2001) Better GPRA Quantity Indicators Are Needed for Toll-Free Telephone Service (Reference Number 2001-30-131, August 2001) Letter Report: Our Experience in Asking the Internal Revenue Service Tax Law Questions on Its Toll-Free Systems Was Not Satisfactory (Reference Number 2001-40-106, June 2001) The Performance of the Customer Service Toll-Free Telephone Program Needs Improvement to Better Handle Millions of Taxpayer Calls (Reference Number 2001-40-079, May 2001) Progress in Developing the Customer Communications Project Has Been Made, But Risks to Timely Deployment in 2001 Still Exist (Reference Number 2001-20-055, March 2001) Management Advisory Report: Strategic Planning for Toll-Free Telephone Operations Has Made Significant Progress, But Further Improvements Are Needed (Reference Number 2001-30-006, October 2000) Toll-Free Customer Satisfaction Survey Results Should Be Qualified if Used for the Government Performance and Results Act . (Reference Number 2000-10-137, September 2000) Toll-Free Telephone Service Levels Declined in 1999 Despite Costly Efforts to Achieve World Class Performance (Reference Number 2000-30-062, March 2000)
THE PREPARER EFFECT ON IRS CUSTOMER SATISFACTION Peggy A. Hite
ABSTRACT This study summarizes an IRS database that includes over 500 Customer Satisfaction Surveys (CSS) from individual taxpayers who were field audited in 1998 . Descriptive statistics are provided indicating that most taxpayers were satisfied with the audit process . Most questions on the IRS survey were associated with overall audit attitude . Two variables affecting audit attitudes were additional tax assessments and use of a paid preparer . Those owing additional taxes as a result of the audit were more likely to have a negative attitude toward the audit process . Those using a paid preparer also tended to have a more negative attitude . The paper discusses reasons why those with preparer assistance were more disappointed (e .g. IRS examiner was not knowledgeable, audit took too long, and the audit outcome was worse than expected) .
INTRODUCTION When asked whether the Internal Revenue Service (IRS) should be eliminated, a recent poll found that only 19% of the respondents opposed elimination of the IRS (Massie, 1998) . In that survey, 40% of the telephone respondents believed there should be a major restructuring of the IRS ; 16% preferred complete elimination of the current tax system with a change to a national sales
Advances in Taxation, Volume 14, pages 159-183 . Copyright 0 2002 by Elsevier Science Ltd . All rights of reproduction in any form reserved . ISBN : 0-7623-0889-3 159
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tax, and 31 % wanted to replace the current system with a flat tax . Honor stories in the media imply that the IRS is an ogre with evil motives, and high profile hearings by the Senate Finance Committee raise questions about IRS practices (Associated Press, 1998) . To respond to such criticisms, the IRS initiated a Customer Satisfaction Survey (CSS) . After taxpayers were audited, they were sent a survey asking whether they were satisfied with the audit process and whether they were treated fairly and respectfully during the audit . Additional questions attempted to discover potential problem areas . If the current federal income tax system is to remain intact, accusations of IRS abuse must be resolved . The CSS contains data that attempt to address the extent of inappropriate treatment by IRS personnel during the audit process . Moreover, the data can be analyzed in a way that controls for economic self-interest . Thus, taxpayers' attitudes toward the audit process can be distinguished from the economic effects of having to pay additional taxes . Prior research has found that IRS contacts result in both deterrence and alienation effects (Kinsey, 1992) . If taxpayers have had direct personal contacts with the IRS, they tend to report lower intentions of future non-compliance . On the other hand, if taxpayers have heard stories from other taxpayers about legally incorrect tax assessments by the IRS (vicarious contacts), then taxpayers will have a general alienation toward the IRS . That is, taxpayers report lower evaluations of fairness and increased intentions of future non-compliance . Given that the annual audit rate for individual taxpayers is below 1%, most IRS contact is going to be vicarious rather than direct . The implication, therefore, is that support for the current income tax system will continue to erode if allegations of IRS abuse are assumed to be the norm . The results reported by Kinsey (1992) were based on self-reports in a Minnesota telephone survey . The analysis did not distinguish between type of IRS contact (e .g . audit, math error, unreported Form 1099 income, etc .) . The present study uses data from taxpayers who have had an IRS field audit . The questionnaire was developed by and the data were collected by the IRS . No questions regarding future intentions to comply were included . Instead, the questionnaire focused on fairness of, and satisfaction with, the audit process . If vicarious reports of bad experiences with IRS audits are associated with future non-compliance, then documentation is needed to determine the extent of and reason for negative audit experiences . The purpose of the present study is not only to measure the current level of satisfaction (or dissatisfaction) for audited taxpayers but to examine whether use of a tax preparer is associated with the taxpayers' ultimate evaluation of the audit examination . As discussed later, there are several reasons why use of a tax preparer could affect the process as well as the outcome . For example,
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if taxpayers use a paid preparer primarily to ensure an accurate return (Collins et al ., 1990), then disappointment is likely if the taxpayer is audited and found to owe more tax . Moreover, Kinsey (1992) suggests that negative vicarious reports exaggerate the alienation effect. If a taxpayer sends a representative to the audit, then all reports will be filtered through this third party ; and if those reports are negative, then the alienation effect is more likely . This study contributes to the literature in several ways . First, this is the only external documentation of the results from IRS-created CSS . Public awareness of the overall evaluation of typical field audits should be disseminated so that comparisons with media stories can be made . Second, this study helps establish whether negative reports are attributable to economic outcomes rather than actual attributes of the audit process itself . Third, the study analyzes the role of the preparer in the ultimate evaluation of the audit . If a preparer effect is identified, then taxpayers, preparers and/or IRS representatives could create mechanisms to mitigate the effect or at least encourage acknowledgment of the potential effect . The results indicate that, overall, taxpayers who recently completed a field audit were generally satisfied with the audit process . Nearly every question on the CSS was highly correlated with the overall outcome, indicating either that the IRS asked all the right questions, the questions were relatively predictable, or that an initial positive reaction led to a tendency to answer every question in the same consistent positive light. The item with the single highest correlation with overall audit attitude was expectation . If taxpayers thought the audit was better than expected, then they were satisfied with the process . If it was worse than expected, then they tended not to be satisfied with the audit. The results show that the audit was worse than expected when taxpayers were assessed additional taxes as a result of the audit . In addition, when having to pay an additional tax was controlled, taxpayers who used a paid preparer during the audit process were less likely to be satisfied with the audit . Several reasons for this preparer effect are discussed below .
BACKGROUND LITERATURE Enforcement techniques are believed to have two opposing effects on compliance . Kinsey (1992) conducted a telephone survey on individual income taxpayers from Minnesota . Specific deterrent effects were found for respondents who had prior personal contacts with the IRS . In other words, past noncompliers whose own noncompliance was detected perceived a greater certainty of detection and reported lower intentions of future noncompliance . On the other hand, a general alienation effect was found for vicarious contacts . Respondents
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who had heard stories from other taxpayers reported lower evaluations of tax fairness and increased intentions of future non-compliance . In addition to the specific deterrent effects of personal contacts involving detection, Kinsey (1992) concluded that direct experiences with legal authorities' unfairness or rudeness decreases the individual's support for the authorities and fosters noncompliance . Most people, however, do not have direct IRS contacts . Instead, they acquire information through conversations with others . Kinsey (1992) did not ask her subjects whether they were satisfied with their IRS audit because many had not been audited ; the IRS contact for many of them was only a computerized letter or math adjustment . Nonetheless, she asked those with some type of IRS personal contact whether the IRS representative was willing to listen, and 85% agreed . In contrast, when she asked those with only vicarious IRS contacts whether the IRS representative was willing to listen, only 60% agreed . Thus, the second hand information appears to be at odds with the direct experiences . Stalans and Kinsey (1994) surveyed Oregon taxpayers who had been audited by the state of Oregon . In that study, the average response to satisfaction with the audit treatment was 4 .02 on a five-point scale in which five represented "very" fair . These positive outcomes at first do not appear congruent with the Congressional war stories of IRS abuse. Of course, reports about IRS abuse are not new . In 1989, David Burnham wrote a book summarizing a myriad of stories about inappropriate IRS actions that various taxpayers have endured over time . The present study provides the direct responses of taxpayers who have recently been audited by the IRS . Based on a cartoon in the New Yorker Magazine, satisfaction with the audit examination is not expected to be positive (Herman, 1998) . The cartoon quipped, "Hi . This is Ed, over at the IRS, just checking to see how you're feeling after your audit ." The popular press, however, may not be providing an accurate summary of audit satisfaction . Based on the positive reports provided by those who had had actual IRS contacts in Kinsey (1992) and Stalans and Kinsey (1994), the audit opinion of most taxpayers is expected to be positive. In addition, Pentland and Carlile (1996) interviewed IRS agents, and the researchers report that revenue agents are concerned with impression management. They want to be perceived as fair and competent, partially so they can get prompt agreement on any proposed adjustments . Thus, it is in their best interest to promote positive communications with the taxpayer . The current research question examines the level of satisfaction with IRS audits . In its alternative form, the first hypothesis is :
HI: Most taxpayers will report positive attitudes toward the audit examination process .
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ECONOMIC INTEREST Of course, not everyone will be satisfied, so the relevant issue quickly becomes one of identifying what factors lead to less satisfaction . A clear front-runner is economic self-interest . If taxpayers are assessed additional taxes, dissatisfaction with that financial outcome could affect their perceptions of the examination process . The axioms of expected utility theory, however, have been shown to be unstable in situations involving uncertainty . Kahneman and Tversky (1979) described prospect theory as a descriptive theory explaining the importance of the frame of reference for valuing the outcome . Choices will be influenced by whether the outcome for the current asset condition is framed as a gain or a loss as opposed to the normatively preferred outcome for after-tax wealth or final asset condition . Although the theory was originally documented as an explanation for economic risk preferences, it has been validated in many decision contexts and in multi-attribute choices (Kahneman et al ., 1986 ; Shefrin & Statman, 1985 ; Levin et al ., 1987 ; Payne et al ., 1984) . Furthermore, prospect theory has been supported in several tax contexts in which attitude and tax compliance have been greater in situations involving refunds rather than tax balances due (Schepanski & Kelsey, 1990 ; White et al ., 1993 ; Dusenbury, 1994) . One important aspect of prospect theory that is relevant to the present study is that losses loom larger than gains (Kahneman & Tversky, 1982) . In other words, subjects in the IRS survey whose audit resulted in an additional tax assessment are likely to be less satisfied than are those who had no additional tax assessed . Thus, the second hypothesis is H2 : Taxpayers owing additional taxes will be more negative about the audit process than will those not owing additional taxes .
TAX PREPARER EFFECT Significant differences exist between tax returns prepared by tax practitioners and tax returns that are self-prepared by the taxpayer . Christian et al . (1994) analyzed thousands of individual income tax returns and found that those prepared by a paid preparer had significantly lower tax liabilities . Klepper and Nagin (1989) analyzed TCMP audited returns and found that paid-preparer returns had significantly higher adjustments than did the self-prepared returns . The implication is that tax preparers may be contributing to aggressive tax reporting . That assertion, however, has never been proven because the preparer differences could be the result of a clientele that has intrinsically more complex returns . Although the results are mixed as to whether tax rate and income level
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are significant factors in the decision to use a paid preparer (Long & Caudill, 1993 ; Christian et al ., 1993), Christian et al . (1993) conclude that the single most important predictor of preparer usage is self-employment. This factor encapsulates complexity, opportunity, and possible taxpayer aggressiveness . Behavioral studies have documented aggressive tendencies by tax preparers (Ayres et al ., 1989 ; Johnson, 1993), and analytical studies have asserted that tax practitioner use is associated with lower compliance (Reinganum & Wilde, 1990) . These types of studies, however, are inconsistent with studies documenting why taxpayers hire a tax preparer . Complexity of the federal income tax system, aversion to audits, desire to minimize tax liabilities, and utility of leisure time have all been cited as possible motivations (Yankelovich, Skelly & White, Inc., 1984 ; Hite & McGill, 1992 ; Collins et al ., 1990) . These studies are consistent in finding that the primary reason taxpayers use preparers is to ensure the accuracy of their returns . Furthermore, these survey reports are supported by analytical work concluding that the primary preparer function is to resolve uncertainty (Scotchmer, 1989) . In fact, Scotchmer (1989) noted that risk averse, confused taxpayers value tax preparer assistance more highly than risk-seeking and knowledgeable taxpayers . Using a preparer to reduce one's audit probabilities suggests that a taxpayer who is audited will be more dissatisfied when a paid preparer was used . Furthermore, if the audited return results in an additional tax assessment, taxpayers who hired a paid preparer to ensure an accurate return will be less satisfied than those who did not hire a preparer . In sum, dissatisfaction with the audit process may be influenced by more than just the specific audit events . In addition to the economic cost of an additional tax assessment, disappointment may be attributable to the failure of the paid preparer to provide the services that the taxpayers believed they had purchased . Pentland and Carlile (1996) interviewed over 80 IRS personnel about the audit process . According to their study, revenue agents are under significant time pressures to complete audit cases . Tax preparers are well aware of this and use delay tactics to their advantage . Although the delay may keep the audit from expanding into other issues, the prolonged time to complete the audit may displease the taxpaying client who would like for the audit to be resolved as quickly as possible . The alienation hypothesis also may contribute to the increased likelihood of disappointment among taxpayers who hire a preparer . Kinsey (1992) found that taxpayer reports were more negative when they heard about IRS contacts vicariously . Based on personal IRS contacts, only 16% of the respondents indicated that the IRS was unwilling to listen to them . In contrast, 40% of the taxpayers referring to vicarious reports indicated the IRS was unwilling to listen .
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According to Stalans and Kinsey (1994), biased reports may result from either biased recall or biased transmission . Biased recall is associated with the respondent's tendency to selectively recall information that confirms prior beliefs or rationalizes behavior . Biased transmissions result from speakers who selectively tell certain stories . After analyzing taxpayers' transmissions of state tax audits, Stalans and Kinsey (1994) concluded that taxpayers tend to discuss audit features that project a positive image of the taxpayers . This leads to a systematic bias toward positive messages . On the other hand, negative messages about unfair treatment were repeated to a greater number of people. Moreover, taxpayers with negative outcomes and negative instrumental features (e.g . perceived auditor incompetence, inefficiency, etc .) were more likely to discuss these negative features than were those with positive outcomes . They conclude that the desire to project a positive image and the desire to report inappropriate treatment are often countervailing forces, making conclusions difficult . Furthermore, they note that the confidentiality of most tax violations give noncompliers control over what will be told about their IRS contacts . The same is true with a paid preparer when the taxpayer does not accompany the preparer throughout the audit process . That is, biased recall or biased transmission may lead the preparer to project a positive image in the case of a positive outcome . Alternatively, it may lead the preparer to report negative instrumental features in the event of a negative outcome so as to focus attention on the inappropriate IRS actions rather than on the negative financial outcome that could be attributable to the preparer . Stalans and Kinsey (1994) argue that the cancellation hypothesis explains the end result because the positive images are canceling out the negative reports, By separating the two sets of reports, they are able to conclude that most reports are positive, but that negative reports are often given more weight because negative messages are told to a greater number of people . The tendency for vicarious reports to be more negative than direct experience reports and for negative reports to be told with more frequency suggest that taxpayers whose preparer handled the audit may have less positive attitudes about the audit process . Questions on the CSS survey do not directly address whether audit attitude is a result of biased recall or biased transmission . Furthermore, the questions do not explore whether a negative attitude reflects the disappointment of a paid-preparer return not being protected from audit risk or not being error free . Any one or combination of these rival explanations could lead to lower audit satisfaction for a taxpayer with a paid-preparer . Based on the logic underlying these rationales, the third hypothesis tests the following : H3 : Taxpayers with paid-preparers are less likely to be satisfied with the audit process .
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This study tests for a paid-preparer effect after controlling for economic outcome (presence or absence of an additional tax assessment) and for income and complexity level . When using archival data, it is difficult to segregate complexity from the effect of preparer usage on non compliance . The present study has an advantage in that all returns in the database were selected for audit because of some criteria associated with potential tax noncompliance . Even so, the database included both self-prepared and preparer-assisted tax returns . In addition, possible contributing factors such as income level and sole proprietorships are controlled to mitigate rival explanations . The IRS database classifies tax returns into the following AGI categories : less than $25,000, $25,000 to under $100,000, and over $100,000 . This three-level categorization is used as a covariate to control for income level . Also, the database indicates which returns had a Schedule C or Schedule F . This dichotomous variable also is used as a covariate in the model to control for complexity and opportunity that is inherent in proprietorships and is associated with preparer usage . Lastly, if the audit results in an additional tax assessment, this could be the cause for disappointment with the audit process rather than the use of a practitioner . Thus, a dichotomous independent variable was added to the model to capture the effect of having an additional tax assessment.
METHOD Field audits are conducted by revenue agents (who typically have college degrees) and are usually conducted at the taxpayer's business site . The field audit cases usually involve business entities such as large Schedule C returns . To systematically measure the quality of the examination process, the IRS developed the Examination Quality Measurement System (EQMS) . By analyzing a random sample of closed field audit cases, the reviews were intended to enable management to determine whether examiners were thorough, efficient, and accurate during the examination process . Beginning around October 1997, EQMS was expanded to include a customer satisfaction survey (CSS) . The survey was sent to taxpayers if their recent audit case was selected as part of the EQMS sample . Thus, all cases randomly selected for an EQMS review also were sent a CSS . Taxpayers were unaware that their cases had been internally reviewed . The EQMS review focused on the IRS representative's performance and did not alter the taxpayer's outcome on the closed case . The IRS uses an analytic sampling method to select cases for EQMS and, therefore, CSS . All 33 districts selected a minimum of 15 closed cases each month from the total pool of field examination files . The four regional offices (Northeast, Midstates, Southeast, and West) were responsible for ensuring that
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cases were randomly and continuously selected . To assist districts in the random selection process, National Office provided a list of randomly selected dates on which closed cases were selected . When cases were selected, the clerks selecting the case had little or no connection to the original examiner ; the duties were separated . Once the EQMS review was complete, taxpayers were sent the CSS along with a cover letter explaining that their responses would be anonymous and confidential . A second request was mailed 15 days after the first request, and a follow-up letter was sent 21 days after the second request . From approximately October 1, 1997 through March 31, 1998 nearly 111,000 field examinations were conducted and, according to the National Office, about 84,000 of those were individual returns . About 1,800 of those 84,000 individual returns/cases were selected for EQMS, and therefore for CSS . For the purposes of this research project, the IRS provided all of the EQMS data and all of the available CSS data . Nearly all of the data were collected during October 1, 1997 through March 31, 1998 . The data in Table I indicate that there were 1,806 EQMS cases . Of these 1,806 cases, 579 surveys were returned for an overall 32% response rate . A response bias is always possible . To test for possible response bias, response time was added as a covariate in the same analyses presented in this article (Tables I through 6), and the results were essentially unchanged .
Table. 1 .
Descriptive Statistics on Taxpayer Audit Database .
SURVEY RESPONDENTS (n=579)
IRS REVIEWED AUDITS (n=1806)
AGI CATEGORY Lo : <$25K Mid : $25k to < $100k Hi : $look + SOLE PROPRIETORSHIPS No : Schedule C or F: AUDIT OUTCOME Tax Increase Income Increase Deduction Decrease Taxable Income Increase Penalty Assessed TAX PREPARER Self: CPA : Other Preparers :
AGI CATEGORY Lo: < $25k Mid : $25k to <$look HE $look + SOLE PROPRIETORSHIPS No: Schedule C or F AUDIT OUTCOME Tax Increase Income Increase Deduction Decrease Taxable Income Increase Penalty Assessed TAX PREPARER Self: CPA : Other Preparers:
19% 62% 19% 17% 83% 56% 33% 47% 58% 16% 39% 45% 16
18% 62% 20% 17% 83% 59% 37% 51% 64% 24% 37% 45% 18
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Table 1 illustrates that the total EQMS database is quite similar to the survey respondents' database . Both the full data set and the CSS subset have sole proprietors comprising 83% of the samples . The low, middle, and high-income categories are similar (19 and 18%, 62 and 62%, and 19 and 20%, respectively), and the tax preparer use is about the same (61 and 63%) . Moreover, 59% of the subjects in the EQMS database had additional tax assessments, and 56% of the CSS respondents had tax increases .
RESULTS Appendix A reports the frequencies, means, and standard deviations for every question on the CSS for the individuals with field examinations ending on or before March 31, 1998 . The results on Question 1 for fair treatment indicate that 83% were treated fairly . On a four-point scale, the mean was 3 .44 (s .d . 0.96) . The mean was 3 .60 (s .d . 0.81) on Question 2, indicating that 89% reported they were treated respectfully . Question 31 asked whether the taxpayer was satisfied with the examination process, and 79% agreed (mean = 3 .19, s .d . 1 .03) . Since these three questions had a high reliability coefficient (alpha = 0 .87), the mean of the three variables was used as an overall measure of audit attitude (mean = 3 .40, s .d. 0 .84) . When the scaled variable for audit attitude was compared to the midpoint of a four-point scale (2 .5), a t-test indicated a significant difference . Audit attitude was positive, and greater than 2 .5, for 85% of the respondents . This provides support for Hypothesis 1 that, overall, most taxpayers are satisfied with the audit process . Although the average audit attitude may be positive, the concern is why some taxpayers are more dissatisfied than others . Table 2 reports the means tested in a simplistic one-way analysis for a preparer mode effect . Taxpayers with self-prepared returns were significantly (p = 0 .025) more positive about the audit process (mean 3 .52) than were taxpayers who had CPA-tax assistance (means Table 2 .
Oneway Test by Preparer Mode on Audit Attitude .* Self-Prepares
Mean Standard Deviation Cell Size * p < 0 .0252 .
3 .52 0 .73 226
Non-CPA Preparer 3 .28 0 .91 91
CPA Prepares 3 .34 0.89 250
Combined 3 .40 0 .84 567
1 69
The Preparer Effect on IRS Customer Satisfaction
3 .34) or non CPA-tax assistance (mean 3 .28) . Since the CPA and non-CPA groups were essentially equivalent, these two types of paid preparers were combined into one category for taxpayers with preparer-assisted returns . The one-way test in Table 2 does not control for moderating influences . To simultaneously test for economic self-interest, additional tax assessment and the preparer effect are tested in the same model . Besides a threshold effect for presence of an additional tax assessment, magnitude was controlled by including dollar amount of the tax adjustment as a covariate . To control for aggressive positions, presence of a penalty assessment also was included as an economic covariate . In addition, rival explanations such as complexity and opportunity were controlled by adding covariates for income level and presence of a sole proprietorship . The descriptive statistics are presented in Table 3 and the ANCOVA results are presented in Table 4 . As predicted, there are two distinct, significant main effects - one for paid preparer assistance (F = 6 .13, p = 0 .014) and one for presence of an additional tax assessment (F = 8 .03, p = 0 .005) . These findings
Table 3 .
Descriptive Statistics for Audit Attitude by Preparation Mode and Tax Assessment. Mean
s .d .
I . Self Preparer No Additional Tax Owe Additional Tax Self Preparer Averages
3 .70 3 .36 3 .52
0 .56 0 .81 0.73
107 119 226
It . Non-CPA Preparer No Additional Tax Owe Additional Tax Non-CPA Preparer Averages
3 .39 3 .22 3 .28
1 .(10
30
0 .87 0.91
61 91
3 .57 3 .16 3.34
0 .71 0 .98 0 .89
III 139 250
0 .78 0 .94 0 .89
141 200 341
0 .84
567
Ill . CPA Preparer No Additional Tax Owe Additional Tax CPA Preparer Averages
IV . Paid Preparer (Non-CPA and CPA Combined Categories) 3 .53 No Additional Tax Owe Additional Tax 3 .18 Paid Preparer Averages 3.32 Grand Average
3.40
170 Table 4.
PEGGY A. HITE Ancova for Audit Attitude by Self-Preparer Versus Paid Preparer and Tax Assessment .* DF
Within Regression Preparer (P) Tax Assessment (T) P*T
559 4 1
MS
F
P
0.65 2.21 3 .99 5 .23 0.00
3 .40 6 .13 8 .03 0.00
0.009 0.014 0.005 0 .988
R2 =0.08 Note: * The covariate controlled for taxpayers' income level, sole proprietorship, amount of tax owed, and whether a penalty was assessed. Only the latter two were significant (p < 0 .05) .
support the first two hypotheses indicating that audit attitudes are more positive when tax returns are self-prepared and when there is not an additional tax assessment. The only significant covariates (p < 0 .05) were dollar amount of the additional tax assessment and the presence of a penalty . In other words, the magnitude of the assessment, as well as the mere fact that an additional tax was assessed, increased the likelihood of a less positive attitude toward the audit. Furthermore, having a penalty assessed significantly lessened the likelihood of a positive audit attitude . Given the endogeneity problems inherent in preparer-compliance studies, an attempt was made to separate the most complex and/or non-compliant returns . If the returns represent relatively equal levels of noncompliance and/or complexity and the preparer effect remains significant, then it strengthens the likelihood that the results are not a spurious function of that endogenous effect. Consequently, an analysis of variance was separately calculated for : (I) only those taxpayers with a sole proprietorship, (2) only middle-income taxpayers (because they had the highest level of tax adjustments, 60%, compared to low-, 46%, and high-income taxpayers, 53%), and (3) only those who actually had a tax adjustment as a result of the audit. In all three cases, the preparer effect remained significant, mitigating a possible endogenous effect . In fact, the endogeneity problem is typically associated with higher noncompliance for paid preparer returns because of increased complexity . That relationship is not reflected in this database since the likelihood of a tax adjustment did not correlate with preparer usage (see Table 5) .
e
171
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t
a 0 . 0 M
a U
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Additional Analysis
This study provides support for the hypothesis that satisfaction with the audit process is lower for preparer-assisted taxpayers . Given the nature of the IRScollected data, this study documents the association but cannot provide evidence on the reason for this correlation . Table 5, however, offers some preliminary evidence by showing the correlations between preparer and other questions on the CSS . Very few questions vary significantly with preparer use . Question 7 indicates that the taxpayer's self-report of seeking a preparer's assistance correlates with the IRS data that a preparer was used . The two are not perfectly correlated because some taxpayers may have sought advice but did not ask the preparer to handle the case or to attend meetings with the IRS representative . Along those same lines, Question 8 indicates that those using a preparer were less likely to meet an IRS representative . Question 10 also is correlated with using a preparer when it is measured as a variable representing the rescheduling of a meeting to suit the preparer's preference . Naturally, that correlates with the use of a preparer . All three of these correlations are tautologically true . Question 12 indicates that those who use a preparer tended to have more additional meetings . This could be a result of complexity ; or, as Question 10 implies, it could be a result of preparers delaying the process to meet their own busy schedules . Preparer delays are consistent with the Pentland and Carlile results (1996) suggesting that paid preparers use delay tactics to avoid discussing any new issues that might be raised . Question 14 indicates that taxpayers who use a preparer are more likely to believe that the IRS representative did not seem knowledgeable . It also suggests that the Stalans and Kinsey (1994) proposition applies, because a biased transmission may have led to this negative, vicarious story . In the preparers' defense, it also could be that preparers are better judges of tax knowledge and, therefore, their description may have been more accurate than the self-preparers . If this were true, however, one would expect to have the remaining CSS questions indicate that preparer-assisted returns had more facts that were not considered (Question 23) or that the examiner made an error (Question 21) . These questions were not significantly correlated . Furthermore, the frequency of tax adjustments and the size of the tax liabilities in the EQMS database did not correlate with preparer use . If the IRS representatives were truly less knowledgeable, then one would have expected less tax adjustments or smaller dollar assessments . The only remaining variables that correlate with preparer use are Questions 15, 26 and 27 . Taxpayers using paid preparer-assistance were more likely to indicate that requests for additional information were clear . Questions 26 and
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27 involve time. Those using a preparer indicated a longer time period to complete the audit . This is consistent with Question 10 . Similarly, those using a preparer were more likely to indicate it took "too long" to complete the audit . The additional time could be a function of the preparers' busy schedules, or it could be a natural result of the time it takes when a "middle-man" is involved, because this requires time to relay the facts and questions . It could also signal a financial cost in that the increased time probably increases the economic cost of the preparer's assistance. As a follow up to the cost factor, a CPA is generally more costly than an enrolled agent or a commercial tax service . Correlations between the use of a CPA and a non-CPA were computed for all of the CSS questions . None of the items were significantly correlated (p < 0 .05) with the use of a CPA . Since the economic cost (or time in Questions 26 and 27) is not correlated with CPA, then the economic cost of a preparer's assistance does not seem to explain why preparer usage is associated with audit dissatisfaction . The reason underlying a significant preparer effect, shown in Tables 2 and 4, is unknown, but the survey items may explain some of the motivation as to why audit attitudes are more negative for taxpayers who hire tax assistance . Items that were significantly correlated with both audit attitude and use of a paid preparer were included in a stepwise regression that included only those variables that continued to significantly explain (p < 0.05) audit attitude when all targeted variables were included in the model. The variables that remained significant were questions 14, 27, and 30 (respectively, knowledgeable IRS examiner, audit completion time, and expected audit outcome) . These three variables may explain why audit attitude is more negative for preparer-assisted returns . For example, taxpayers with preparer assistance were more likely to believe that the IRS examiner did not seem knowledgeable . This attitude also was associated with a more negative attitude . Thus, the tax preparer may have exacerbated this attitude (rightly or wrongly) . Similarly, since taxpayers had a more negative attitude when the audit took "too long," preparer assistance could have increased the time needed to complete the audit (needlessly or appropriately) . Lastly, taxpayers using preparer assistance may have never expected to be audited, nor ever expected to owe additional tax . That is, their expectations were high before the audit began . In contrast, self-preparers may have expected the "worst" prior to the audit . Consequently, they were relatively more positive about the audit once it was completed . To test whether these three variables were possible proxies for the preparer effect, the same ANCOVA model used in Table 4 was computed but the three
1 75
The Preparer Effect on IRS Customer Satisfaction
variables (knowledgeable IRS agent, audit completion time, and expected audit outcome) were added as covariates . Since income level and sole proprietorship had no significant effect, they were dropped from the analysis . In sum, the revised model (presented in Table 6) tested whether preparer assistance and additional tax assessment continued to affect audit attitude when controlling for amount of additional tax assessment, presence of an assessed penalty, knowledgeable IRS examiner, audit completion time, and expected audit outcome. The results in Table 6 indicate that tax assessment remained significant (F = 5 .41, p = 0 .021), but preparer mode did not (F = 0 .29, p = 0 .593) . The significant covariates were amount of tax owed (those owing larger dollar amounts were less satisfied), less than knowledgeable IRS examiners (negative attitudes were associated with those who indicated the IRS examiner was not knowledgeable), audit completion time (those believing the audit took "too long" were less satisfied), and expected audit outcome (those indicating the audit process was worse than expected had more negative attitudes) . Although future research will need to determine exactly what leads to more negative attitudes for taxpayers who use paid preparers, the present study suggests that preparers may influence the negative attitude to the extent that they : (1) convey an opinion that the IRS examiner is less than knowledgeable ; (2) cause the audit deadline to be extended, or ; (3) communicate a priori information to the taxpayer suggesting that they do not expect any audit adjustments .
Table 6.
Revised Ancova for Audit Attitude by Self-Preparer Versus Paid Preparer and Tax Assessment .*
Within Regression Preparer (P) Tax Assessment (T) P*T
DF
MS
F
397 5 I 1 1
0 .29 30 .07 0 .08 1 .56 0 .15
103 .90 0 .29 5 .41 0 .52
P
0 .000 0 .593 0.021 0.473
R 2 =0.60 • The covariate controlled for amount of additional tax owed, whether a penalty was assessed,
knowledgeable IRS agent, audit completion time, and expected outcome . The significant (p < 0 .05) covariates were amount of tax owed, audit completion time, and expected outcome .
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PEGGY A . HTTE
CONCLUSIONS AND LIMITATIONS In summary, audited taxpayers who had preparer assistance tended to have field audits that took longer to complete, tended to believe the IRS representative did not seem knowledgeable, and were more likely to report the audit process was worse than expected . Given their decreased tendency to be satisfied with the audit process, questions still remain as to why the taxpayers with preparer assistance have less positive attitudes . Do the vicarious reports (Stalans & Kinsey, 1994) to the taxpayer increase the tendency to have negative reports recalled or transmitted? Or, is the result a function of the audit being worse than expected (suggesting that these taxpayers had higher initial expectations)? Based on some prior literature (Collins et al ., 1990 ; Hite & McGill, 1992), taxpayers hire preparers to ensure their returns are accurate . Therefore, having corrections and owing additional taxes may have been especially disappointing . In short, future research should examine which explanation is more likely . Nonetheless, this study finds that most taxpayers (85%) who recently experienced a field audit had a positive attitude about the experience . In fact, 36% thought the experience was better than they had expected ; only 15% thought it was worse than expected . The study is limited in that the questionnaire was designed and administered to satisfy the needs of the internal management at the IRS and not to answer specific research questions on the preparer issue . In addition, the overall positive responses of the subjects could reflect a response bias and a fear of voicing complaints against the IRS . The respondents, however, had taxpayer characteristics that were quite similar to the entire population of audits chosen for an internal review . Moreover, the results were consistent with the positive attitudes found by Stalans and Kinsey (1994) in a State of Oregon survey regarding state tax audits . In addition, the preparer effect held true even for taxpayers with the highest likelihood of adjustments (e .g . just middle income taxpayers or just those having audit adjustments) . The results show that taxpayers, especially those with paid preparer assistance, are more dissatisfied when the audit is prolonged . This result implies that the IRS may want to inform taxpayers up front that audits are rarely completed in a single visit and that they will be informed of the reason for any delay in completing the audit . Furthermore, Pentland and Carlile (1996) assert that the initial interview is crucial in establishing rapport with the taxpayer and for solidifying the subsequent audit process . Thus, the tax administration may want to develop a procedure that strongly encourages a taxpayer to meet with the tax agent early in the audit process . To the extent that these data reflect the average response of audited taxpayers, the good news should be told . Even so, this does not imply the audit process
The Preparer Effect on IRS Customer Satisfaction
177
is fine and should be left unscathed. It merely suggests that negative reports, which tend to get repeated more often, should be weighed cautiously against these positive reports .
REFERENCES Ayres, F., Jackson, B ., & Hite, P . (1989) . The economic benefits of regulation : Evidence from professional tax preparers . The Accounting Review, 64, 300-312 . Associated Press (1998) . The Herald Times, April 12, p. A4 . Burnham, D . (1989). The IRS: A Law Unto Itself. New York : Random House . Christian, C ., Gupta, S ., Weber, G ., & Willis, E . (1994) . The relation between the use of tax preparers and taxpayers' prepayment position . The Journal of the American Taxation Association, 16(Spring), 17-40 . Christian, C., Gupta, S ., & Lin, S . (1993) . Determinants of tax preparer usage : Evidence from panel data . National Tax Journal, 46(4), 487-504 . Collins, J ., Milliron, V ., & Toy, D. (1990) . Factors associated with household demand for tax preparers . The Journal of the American Taxation Association, 12(Spring), 9-25 . Dusenbury, R . (1994) . The effect of prepayment position on individual taxpayers' preferences for risky tax-filing options . The Journal of the American Taxation Association, 16, 1-16 . Herman, T . (1998) . Tax Report. Wall Street Journal, July 22, p . 1 . Hite, P_ & McGill, G . (1992) . An examination of taxpayer preference for aggressive tax advice . National Tax Journal, 45(4), 389-403 . Johnson, L . (1993) . An empirical investigation of the effects of advocacy on preparers' evaluations of judicial evidence . The Journal of the American Taxation Association, 15, 1-22. Kahneman, D. . Knetsch, I ., & Thaler, R . (1986) . Fairness as a constraint on profit seeking : Entitlements in the market . American Economic Review, 76, 728-741 . Kahneman, D ., & Tversky, A. (1979) . Prospect theory : An analysis of decision under risk . Econometrica, 47, 263-291 . Kinsey, K. (1992). Deterrence and alienation effects of IRS enforcement : An analysis of survey data . In : Who Pays Taxes and Why : Tax Enforcement and Tax Compliance . Ann Arbor. MI: University of Michigan Press . Klepper, S ., & Nagin, D . (1989). The role of tax preparers in tax compliance . Policy Sciences, 22, 167-194. Levin, I ., Johnson, R ., & Davis, M . (1987) . How information frame influences risky decisions . The Journal of Economic Psychology . 8. 43-54. Long, J . . & Caudill, S . (1993) . Tax rates and professional tax return preparation : Reexamination and new evidence. National Tax Journal, 46(4), 511-517 . Massie, R . (1998) . Restructuring of IRS gets support . Herald Times, April 12. Payne, J ., Laughhunn, D ., & Crum, R . (1984) . Multiattribute risk choice behavior : The editing of complex prospects . Management Science, 30, 1350-1363 . Pentland, B . . & Carlile, P. (1996) . Audit the taxpayer, not the return : Tax auditing as an expression game. Accounting, Organizations, and Society, 21(2), 269-287 . Reinganum, J ., & Wilde, L. (1990) . Equilibrium enforcement and compliance in the presence of tax practitioners . Social Science Working Paper No . 744, Pasadena : California Institute of Technology . Schepanski, A., & Kelsey, D . (1990) . Testing for framing effects in taxpayer compliance . The Journal of the American Taxation Association, 12(Fall), 60-77 .
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Scotchmer, S . (1989). The effect of tax advisors on tax compliance . In : J. Roth & J. Scholz (Eds), Taxpayer Compliance : Social Science Perspectives, (Vol . 2, pp . 182-189). University of Pennsylvania Press. Shefrin, H., & Statman, M. (1985) . The disposition to sell winners too early and ride losers too long : Theory and evidence . The Journal of Finance, 40, 777-792 . Stalans, L., & Kinsey, K . (1994) . Self presentation and legal socialization in society : Available messages about personal tax audits . Law and Society, 18, 859-899. White, R., Harrison, P., & Harrell, A . (1993). The impact of income tax withholding on taxpayer compliance : Further empirical evidence. The Journal of the American Taxation Association, 15(Fall), 63-78. Yankelovich, S ., & White, Inc . (1984) . Taxpayer Attitudes Survey : Final Report . Prepared for the Internal Revenue Service (December) .
APPENDIX A DESCRIPTIVE STATISTICS FOR QUESTIONS IN THE IRS CUSTOMER SATISFACTION SURVEY FOR FIELD AUDITS
Question
Mean
SD
Frequency
1. Regardless of whether you agree or disagree with the final outcome of your most recent examination, please rate the fairness of IRS's treatment of you . 3 .44 0 .96 1 = Unfair 9 2 = Somewhat unfair 8 3 = Somewhat fair 14 4 = Fair 69 2. Regardless of whether you agree or disagree with the final outcome of your most recent examination, please rate the degree to which the IRS treated you with respect . 3 .60 0 .81 1 = Disrespectful 5 2=Somewhat disrespectful 6 3 = Somewhat respectful 13 4 = Respectful 76 3. When you were first contacted by the IRS concerning your most recent examination, was it by letter or telephone? 1 .15 0 .36 1 = Letter 85 2=Telephone 15 4 . When you were first contacted, was it clear when your examination appointment was to be conducted? 1 .11 0 .32
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The Preparer Effect on IRS Customer Satisfaction
Question
Mean
SD
1 = Yes 2 = No
Frequency 89 II
5. When you were first contacted, was it clear where your examination appointment was to be conducted? 1.18 0.38 1 = Yes 82 18 2=No 6. Was it clear what documents and records you were supposed to have ready for your appointment? 1 .17 0 .40 1 = Yes 83 2=No 17 7. Did you receive assistance from an accountant, attorney, or other professional in the audit of your tax return? 1 .25 0 .44 1 =Yes 75 2 = No 25 8 . Did you meet in person with an IRS representative as part of your most recent examination? 0 .43 1 .25 75 1 = Yes 2=No 25 9 . Was your first meeting with the IRS conducted at the original scheduled time and date or was the meeting rescheduled? 1 .51 0 .50 I = Original time and date 49 2 = Rescheduled 51 10. Why was the meeting rescheduled? 1.68
0 .84
I = Your preference 2 = IRS's preference 3 = Your representative's preference
57 19 24
11 . Did you attend additional meetings? 1 .52 1 = Yes 2=No
.50 0 48 52
180
Question
PEGGY A . HTTE
Mean
SD
2 .34
1 .33
Frequency
12. How many additional meeting did you attend? 1 2 3 4 5-12
32 30 21 11 7
13 . In your opinion, which statement best describes the amount of time you had to prepare between meetings? 2 .02 0.39 1 =Not long enough 7 2 = Adequate 84 3 = Too long 9 14. Overall, did the examiner seem knowledgeable? 1 .12
0.32
1 =Yes 2=No
88 12
15 . Were requests for additional information clear? 1 .38
0.73
1 =Yes 2=No 3 =N/A
76 9 15
16. In your opinion, were the requests for additional information necessary to complete your most recent examination? 1 .21 0.41 1 =Yes 79 2=No 21 17. Did the IRS give you a report explaining the results of your recent examination? 1 .14 0.34 1 = Yes 86 2=No 14 18. If adjustments were made, did you understand the written explanations? 1 .54 0.83 1 =Yes 2=No 3 = N/A 19. Did you understand the computations presented in the report? 1 .52 0 .80
68 10 22
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The Preparer Effect on IRS Customer Satisfaction
Question
Mean
SD
1 =Yes 2=No 3 = N/A
Frequency 67 20
20. Did you receive any changes to the report? 1 .74
0 .44 26 74
1 =Yes 2=No 21 . Why was the report revised? 1 .93
0 .72 29 48 23
I = Examiner made an error 2 = You provided additional information 3 = Other, please specify
22. Did you have enough time to give the IRS all the information requested before getting the report? 1 .06 0.24 94 1 = Yes 6 2=No 23. Were there facts in your favor that the IRS did not consider? 1 .76 1 = Yes 2 = No
0 .43 24 76
24. Why do you believe these facts were not considered? 241 . Examiner felt the facts did not prove positions 0.22
0 .42
0 = No 1 = Yes
78 22
24 2 . Examiner did not understand your position 0.26
0 .44
0 = No 1 = Yes
74 26
24_3 . Examiner was reluctant to do additional work 0.10
0 .31
0=No I =Yes
90 10
2" . Other, please specify 0.24
0 .45
182
Question 0 = No 1 =Yes
PEGGY A . HITE
Mean
SD
Frequency 72 28
25. H you discussed your most recent examination with a supervisor, was this discussion beneficial? 2 .67 0.68 0 = Yes 12 1=No 10 2 = N/A 78 26. Which statement best describes the length of time it took to complete your most recent examination? 1.66 0.90 1 =Less than 3 months 57 2=3 to 6 months 27 3 = 7 to 12 months 9 4=More than 12 months 7 27. Which statement best describes your opinion of the time it took to complete your most recent examination? 1 .71 0.52 1=Too long 2 = Appropriate 3 = Too short
29 69 2
28. If you owed additional taxes, were you satisfied with the payment arrangements? 2 .05 0 .95 1 =Yes 42 10 2=No 3 = N/A 48 29 . How would you have preferred to pay? 30. Which statement best describes your experience with the IRS as compared to what you expected when you were first contacted for your most recent examination? 2 .21 0 .68 1 = Worse than expected 15 49 2 = About the same as expected 36 3 = Better than expected 31, Regardless of whether you agree or disagree with the final outcome of your most recent examination, please rate your satisfaction withthe examination process . 3 .19 1 .03 12 1 = Dissatisfied
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The Preparer Effect on IRS Customer Satisfaction
Question 2=Somewhat dissatisfied 3=Somewhat satisfied 4=Satisfied
Mean
SD
Frequency 9 27 52
32 . In dealing with the IRS, did you experience any problems that were due to having to conduct the examination in English? 1 .96 0.18 1 = Yes 4 2=No
96
32 . What language would you prefer? 33 . Please feel free to make any suggestions or comments about the IRS Examination Process .
THE EVOLUTION OF ESTATE TAXATION IN THE UNITED STATES Daniel P. Murphy and Ann Boyd Watts ABSTRACT Wealth transfer taxes, including the estate tax, have been an integral part of American tax policy since the eighteenth century . The current estate tax
has its roots in eighteenth century English political philosophy that provides civil law precedent over any natural rights an individual possesses in property. The purpose of the tax is to limit wealth accumulation and discourage the formation of economic dynasties . Since the adoption of the Sixteenth Amendment to the Constitution and passage of the Revenue Act of 1916, the estate tax has largely targeted high-wealth individuals . The modern estate tax began with a narrow base and relatively low rates . The tax base has expanded during the past 80 years to include both estate and lifetime transfers and tax rates have ranged from 10 to 77% . During this time, the degree of rate progressivity has remained high but has decreased since 1976 . The incidence of the tax has varied over the years due in large part to the size of the estate tax exemption or its equivalent. The estate tax's contribution to the federal budget has ranged from over five percent to its current level of about one percent . The estate tax's growth, however, has accelerated in recent years as personal wealth has increased and American society has aged .
Advances in Taxation, Volume 14, pages 185-208 . Copyright ® 2002 by Elsevier Science Ltd. All rights of reproduction in any form reserved . ISBN : 0 .7623-0889-3 185
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DANIEL P. MURPHY AND ANN BOYD WATTS
INTRODUCTION Our Constitution is in actual operation ; everything appears to promise that it will last ; but nothing in this world is certain but death and taxes . Benjamin Franklin
Is the estate tax on its deathbed? Many critics suggest burying and forgetting the existing estate tax laws . Even many of the tax's supporters agree that the current statutory provisions need simplification and resurrection in a less complex form that substantially limits the estate tax's scope and incidence . The estate tax has long been a source of contention for policymakers . However, the issue of how or whether to continue the estate tax system only recently moved from the back halls of Congress and academe to the front page of the daily newspaper. Unlike many tax proposals, liberals and conservatives both advocate estate tax reform and differ only in degree . Congress recently passed, and the President signed into law, the Economic Growth and Tax Relief Reconciliation Act of 2001 . The Act contains a number of significant changes to the estate tax laws including repeal in 2010 . However, the law also contains a "sunset" provision that makes future statutory changes necessary . Thus, the debate over estate tax reform will continue . Policy makers must understand the origin and evolution of the estate tax to assess current policy reform proposals . For example, many critics dismiss the estate tax as having negligible budgetary impact, but the tax was originally adopted for its revenue yield . While the tax does not currently produce large revenues, it has the potential to become a more substantial tax revenue source as our population ages . Critics also cite the estate tax as being an unfair tax that penalizes thrift and industry . However, increasing overall tax progressivity and ensuring that death could not be used to avoid taxes helped to motivate the adoption of the estate tax, Many decedents' estate tax base includes substantial amounts of untaxed income such as appreciated investments that would permanently escape taxation in the absence of the estate tax . Thus, the estate tax serves as a backstop for the income tax system . To determine whether the estate tax has met its policy objectives, one must examine the following :
• • • •
Estate tax policy objectives Statutory changes in the estate tax base and rates Trends in tax collections The impact of statutory changes on tax fairness .
The Evolution of Estate Taxation in the United States
187
This article begins by reviewing the origins of the estate tax . The evolution of the estate tax is examined by tracing its development through three distinct eras : the pre-modern estate tax, the modem estate tax, and the current unified transfer tax system . Statutory changes to the tax base and rates during each era are reviewed, as are changes in the tax's contribution to the federal budget . Tax fairness is analyzed by examining changes in tax progressivity and incidence over time.
THE ORIGIN OF THE ESTATE TAX Earth belongs in usufruct to the living ; the dead have neither powers nor rights over it . The portion occupied by an individual ceases to be and reverts to society . Thomas Jefferson in a letter to James Madison, 1789 A good man leaves an inheritance for his children's children . Proverbs 13 :22 The debate over the future of estate taxation in the United States intrigues observers for reasons that extend beyond current tax policy . In many respects, the estate tax reflects a philosophical expression of : (1) our society's attitude toward accumulated wealth and property rights ; and (2) the government's role to ensure a progressive tax system and an economic system that does not favor those born into wealth . Arguments in favor of the tax stem from the idea that the nation's founding principles developed from an egalitarian philosophy that rejects either economic or inherited royalty (Camegie, 1962) . Thus, proponents of the tax cite a societal need for tax policies that limit wealth accumulation and discourage economic dynasties . Conversely, arguments against the tax rest on the idea that property ownership rights, including the right to transfer property, are natural rights fundamental to our nation's founding . In the 1770s, Colonials fought against any law designed to confiscate property in the name of the public good (Brownlee, 2000) . Arguments in Favor of Estate and Wealth Taxation Whether the right to bequest property upon the death of the holder is a natural, God-given right or a civil right governed by man-made law has long served as an ideological fulcrum in the debate over the legitimacy of the estate tax . British philosopher John Locke suggested that property ownership represents a natural right as long as one adds labor (Locke, 1988) . In fact, Locke argued that the government's primary purpose includes the protection of such rights . He also
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DANIEL P. MURPHY AND ANN BOYD WATTS
argued, however, that upon death one surrenders these property rights to civil society . Under this approach, civil rather than natural law governs the right to bequest property . Eighteenth century economists Adam Smith and David Ricardo believed taxes on property transfers at death cause society to become less productive (Smith, 1937 ; Ricardo, 1819) . Despite this concern, Smith's writings in the Wealth of Nations appear to accept the tax's legitimacy . The writings of English jurist William Blackstone in his Commentaries on the Law of England (1803) greatly influenced American legal thought in the early nineteenth century . Blackstone argued that one's right to control property ceased at death otherwise the deceased retained, by will, control of the property forever. Although Blackstone recognized inheritance as a long-time custom, he also believed that upon death, property should revert back to society for the common good . Addressing property ownership, Blackstone wrote, "For naturally speaking, the instant a man ceases to be, he ceases to have any dominion" (Blackstone, 1803) . The massive wealth accumulations that occurred in the late nineteenth century provoked numerous calls for taxes on wealth and bequests . Although the Fourteenth Amendment to the Constitution, adopted in 1868, prohibits the public confiscation of private property without due process, it does not limit government's right to restrict bequests . Calls for restricting the right to bequest or inherit property came from a variety of sources . Karl Marx called for the abolition of inheritance rights in the Communist Manifesto (Marx, 1963) . Twelve years later, the Supreme Court upheld the War Revenue Act of 1898 and affirmed the civil right to control inheritances (Knowleton vs. Moore, 178, U .S . 41, 55 (1900)) . In the words of the Court, "The right to take property by devise or descent is the creature of the law, and not a natural right ." Later, in 1919, the Mississippi State Tax Commission approved an inheritance tax that effectively would confiscate all estate holdings exceeding $5 million . Arguments against Estate and Wealth Taxation At the time of this country's founding, antipathy toward economic and inherited royalty prevailed, and political sentiment favored some regulation over bequest and inheritance . Among the more prominent historical figures opposed to civil control over bequests was George Mason, author of the Virginia Declaration of Rights and signer of the Constitution . Mason recognized property acquisition and possession as a natural right and included it in the Virginia Declaration (Chester, 1982) . Many of the most influential arguments against the estate tax have been made in more recent history . In Atlas Shrugged (1957), Ayn Rand portrays a world
The Evolution of Estate Taxation in the United States
189
in which the wealthy drive society's success and suggests implicitly that any impediments to wealth creation limit society's natural order and well being . Contemporary thinkers such as George Gilder advance Rand's philosophy by arguing that individual wealth is necessary for a successful economy . Also, the Republican Party's platform since Ronald Reagan has derided the estate tax as an unfair confiscation of wealth that should be repealed . The estate tax has become an established part of the tax structure despite continuing debate over its legitimacy . It is ironic that, while many of today's politicians rail against the inherent unfairness of the estate tax, the constitutional framers, legislators, and jurists generally favored some form of wealth taxation in the name of fairness .
THE EVOLUTION OF THE ESTATE TAX The estate tax has a long and active history in the United States . Figure 1 presents a chronology of changes to the estate tax laws that traces its evolution through its three distinct eras : the pre-modem estate tax, the modern estate tax, and the current unified transfer tax system . The Pre-Modern Era
. . . the parent who leaves his son enormous wealth generally deadens the talents and energies of the son, and tempts him to lead a less useful and less worthy life than he otherwise would . Andrew Carnegie in the Gospel of Wealth, 1889
The pre-modern era encompasses the period of time beginning with our nation's founding until adoption of the Sixteenth Amendment to the Constitution . Revenue needs drove tax policy during this time, as opposed to social or economic policy, and Congress adopted and repealed these various tax regimes on an as-needed basis . The United States experimented with a number of estate and wealth taxation schemes during this era . Congress decided that taxing post-mortem transfers would serve as an efficient means of raising revenues when faced with the expense of conducting an undeclared naval war against France in 1794 . The enactment of the Stamp Act of 1797 imposed an excise fee in the form of purchased stamps that were required on wills offered for probate, inventories, and letters of administration . Table 1 shows the costs of these stamps on both duties and receipts of legacies . The stamp tax on legacies exempted required payments by widows, children, and grandchildren (Zaritsky & Ripy, 1984) . When the crises ended in 1802, Congress repealed
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DANIEL P. MURPHY AND ANN BOYD WATTS
1797-Stump Act enacted
1862 & 1864-rest Act posed to fund the Civil War 1870-Inheritance tax repealed
1898- War Revenue Act passed to fund Spanish-American War
1902 - War Revenue Repeal Act eliminated estate tones
1916 - Modem estate lax enacted Top marginal rate is 10%
1918- Charitable contribution deduction allowed
1926-Exemption increased from $50,000 to $100,000 1932-Exemption reduced to $50,000 1935-Alternate valuation date for assets is allowed 1941 - Top marginal rate increased to 77% 1948-Marital deduction introduced 1976-Unified estate and gift tax Generation skipping transfer Increased marital deduction 1981 - Unlimited marital deduction allowet
o
1984-Top Marginal Rate Reduced to 55%
1987 - Exemption equivalent is increased to $600,000 1990-Estate free. rules replaced
1997-Exemption equivalent raised to $675,000, and is scheduled to be $I million in 2006
2001 -Economic Growth and Tax Relief Reconciliation Act
Fig, 1 .
Significant Tax Law Changes, 1797-Present .
the tax (Repeal of Internal Tax Act, 1802) . Although Congress considered the tax again in 1815 to fund the war with England, the Treaty of Ghent put an end to both the war and the return of the death tax (Zaritsky & Ripy, 1984) . The estate and inheritance tax did not reappear until the Civil War . Congress enacted an inheritance tax, after considering alternative sources of tax revenue, as part of the Tax Act of 1862 and praised it as a "large source of revenue which could be most conveniently collected" (Zaritsky & Ripy, 1984) . Unlike the Stamp Act of 1797 that effectively taxed bequests, the 1862 tax applied only to inheritances of personal property . Under the Tax Act, the marginal tax rate depended on the legatee's relationship to the decedent rather than the value of the bequest or size of the estate . Like the 1797 Act, however, bequests to a
191
The Evolution of Estate Taxation in the United States Table 1 .
1797 Death Tax Amounts .
Duties* : Inventories Probate of Wills Letters of administration
10 cents 50 cents 50 cents
* levied on any dollar amount Receipts of Legacies : < $50 bequests $50 < $100 bequests $100 < $500* bequests
0 cents 25 cents 50 cents
*additional $1 for each subsequent $500 bequest Source : Federal estate, gift, and generation skipping taxes : A legislative history and description of
current law (Report No. 84-156A ; see Zaritsky & Ripy, 1984) .
surviving spouse were exempt from tax as were bequests less than $1,000 . All other bequests, however, were subject to tax at rates ranging from threequarters of one percent to five percent . Table 2 contains the 1862 and 1864 tax rates . Also, unlike current law, the Act taxed bequests to charitable groups at the highest marginal rate. Congress passed the Internal Revenue Law of 1864 to meet the rising cost of fighting the Civil War . The Law increased tax rates and expanded the tax
Table 2 .
1862 and 1864 Death Tax Rates . 1864
Relationship
1862*
Rates on Real Property
Lineal issues, ancestors Siblings Descendants of siblings Uncle, aunt, and their descendants Great uncle, aunt, and their descendants Other relatives and individuals not relate Charities
0 .75% 0.75% 1 .50% 3 .00% 4 .00% 5 .00% 5 .00%
1 .00% 2 .00% 2 .00% 4 .00% 5 .00% 6 .00% 6 .00%
Rates on Legacies
Increase in Legacies over 1862
1 .00% 1 .00% 2.00% 4.00% 5 .00% 6.(10% 6.00%
33 .33% 33 .33% 33 .33% 33 .33% 25 .00% 20 .00% 20 .00%
Note : * tax base = $ 1,000 or larger . Source: Federal estate, gift, and generation skipping taxes : legislative history and description of
current law (Zaritsky & Ripsy, 1984) .
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DANIEL P. MURPHY AND ANN BOYD WATTS
base to include bequests of real property . The Law applied the tax to any bequest or transfer of real property made during the decedent's life for less than adequate consideration . Thus, the Law established the nation's first gift tax . The need for additional revenue ceased when the Civil War ended and upon the subsequent discharge of war debts . Congress passed the Internal Tax Customs Duties Act of 1870 and repealed the inheritance tax . During its enforcement, death-based taxes generated total tax receipts of $14 .8 million between 1863 and 1871 (Fiekowsky, 1959) . Although neither the 1862 nor the 1864 tax laws provoked significant public outcry, the War Revenue Act of 1898 produced considerable debate between populists and conservatives . The nation was just coming out of an economic depression during the mid-1890s and public concern was rising over increasing wealth concentration among a few families (Brownlee, 2000) . Though the 1898 Act was passed ostensibly to fund the Spanish-American War, sentiment to increase taxes on the wealthy grew among western and southern Congressmen . Unlike prior wealth transfer taxes, the Act stipulated that tax payment be a duty of the estate rather than the beneficiaries . As shown in Table 3, the size of the estate and the relationship of the legatee to the decedent determined the tax rate . Consistent with prior laws, small estates of less than $10,000 and bequests to the surviving spouse remained exempt from taxation, The 1901 amendments to the War Revenue Act exempted "certain gifts from inheritance taxation, including gifts to charitable, religious, literary, and educational organizations, and gifts to organizations dedicated to the encouragement of the arts and the prevention of cruelty to children" (War Revenue Reduction Act, 1901, page 69) . The end of the Spanish-American War led to the tax's repeal in 1902 (War Revenue Repeal Act, 1902) . The tax raised about $14 .1 million in tax receipts (Fiekowsky, 1959) . Public concerns increased in the early twentieth century over the concentration of wealth and power in the hands of a few families resulting from corporate mergers and growth in holding companies . Populist calls for an estate or wealth tax increased as the public became wary of an emerging economic elite (Brownlee, 2000) . Congressmen, particularly from the south and west, denounced excessive personal wealth accumulation and questioned the motives of monied families who controlled entire industries and eliminated industry competition . Just as non-monied interests became concerned with the effects of wealth concentration, so too did some of the wealthy . For example, industry titan Andrew Carnegie publicly voiced his opinion that inherited wealth reduced the incentive to work and produce (Carnegie, 1962) . All these concerns contributed to the passage of the Sixteenth Amendment to the Constitution in 1913 and the enactment of the federal income tax (Brownlee, 2000) . Moreover,
193
The Evolution of Estate Ta ation in the United States
Table 3.
Lineal issues, ancestors Descendants of siblings Uncle, aunt, and their descendants Great uncle, aunt, and their descendants All others
1898 Death Tax Rates .
$10,000 under $25,000
$25,000 under $100,000
$100,000 under $500,000
0 .75% 1 .50% 3 .00%
1 .125% 2 .25% 4 .50%
1 .50% 3 .00% 3 .00%
1 .88% 3 .75% 7 .50%
2 .25% 4 .50% 9 .00%
4 .00%
6 .00%
8.00%
10 .00%
12 .00%
5 .00%
7 .50%
10.00%
12 .50%
15 .00%
Note : Only personal pro rty was subject to taxation . Source: Federal estate, g t, and generation skipping taxes : current law (Zaritsky & ipsy, 1984).
$500,000 under $1,000,000
$1,000,000 or more
legislative history and description of
Congress again adopted an estate tax with the need for additional revenue caused by the elimination of tariffs and the sinking of the U .S . passenger ship Lusitania (Zaritsky & Ripy, 1984) . Wars motivated the adoption and repeal of the estate and other wealth taxes during the nineteenth Century . Although the amounts collected were modest by contemporary standards, the estate tax provided an important revenue source for the government, especially in the absence of an individual income tax . The lack of data creates difficulties in assessing the estate tax . However, the large tax base used (i .e . property transfers) and the low exemption amounts suggest a relatively high degree of tax incidence . Much like contemporary law, prior laws generally shielded surviving spouses and smaller wealth holders .
The Modern Era
Taxation, in reality, is life. If you know the position a person takes on taxes, you can tell their whole philosophy . The tax code, once you get to know it, embodies all the essence of life: greed, politics, power, goodness, charity . Sheldon Cohen (former IRS Commissioner)
Estate taxation's modern era began on September 8, 1916 when Congress passed the Revenue Act of 1916 . The Act included a provision introduced by Representative Cordell Hull to tax wealthy persons' estates . Hull was concerned that the growing economic divide between the rich and poor threatened our
194
DANIEL P . MURPHY AND ANN BOYD WATTS
social stability and viewed the estate tax as a means of shifting the cost of government to wealthier taxpayers . Changes to the Tax Base The Revenue Act of 1916 defined the estate tax base to include all property (real and personal) owned by a decedent at death, gifts made in contemplation of death, and life insurance payable to the estate . Similar to current law, the Act allowed deductions for administrative expenses, losses, and debts of the decedent . Although current law still reflects much of the original statute, a number of significant changes altered the estate tax base during this era . Among the more significant changes to the estate tax base was the allowance of the alternate valuation date election (Revenue Act of 1935) . This change allowed estates to value the decedent's property as of the date of death or elect to use a date six months after death . During the 1930s, asset values, particularly land, declined significantly, and this provision provided taxpayers relief from having their property valued higher for tax purposes than its ultimate value to the heirs . The Revenue Act of 1948 introduced a significant change in the estate tax base by allowing a marital deduction for amounts passing from the deceased to his or her surviving spouse . Prior to the 1948 Act, property held by the first-to-die spouse was subject to estate tax even if left to the surviving spouse, resulting in a particularly onerous impact on estates located in non-community property states . Usually, the husband owned most, if not all, of the family's property and upon death left a residual estate reduced by taxes paid on the entire estate to his wife and family . In community property jurisdictions, however, only one-half of the family's property was taxed, leaving a much larger residual estate . The 1948 Act addressed this inequity by providing the deceased's estate a limited marital deduction for bequests to the surviving spouse . Although important statutory changes to the estate tax base occurred during this era, considerably more estate tax law stability existed than in the current era . The 1916 Act provided a $50,000 estate exemption deductible by all estates and was set at a level to ensure that only wealthier estates paid tax . Figure 2 presents the estate tax exemption amounts permitted by statute from 1916 to the present on a nominal and inflation-adjusted basis . The exemption originally set at $50,000 in 1916 had an inflation-adjusted dollar value of over $800,000 and effectively protected most estates from taxation . Over the next few years, however, the inflation-adjusted value of the exemption dropped by almost one-half as a result of double-digit inflation in the years leading up to 1920 . Congress increased the exemption from $50,000 to $100,000 in 1926 in response to this erosion in value. Ironically, around this same time the economy entered
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from about $410,000 in 1921 to over $1 million in 1931 . Congress halved the allowable exemption in 1932 to $50,000 and for over 40 years the exemption remained between $40,000 and $60,000 . During this period, the inflationadjusted exemption amount fell from about $651,000 in 1942 to just over $180,000 in 1976. Changes to Tax Rates The rules defining the computation of the estate tax base remained relatively stable during the modern era . The same cannot be said for the estate tax rate structure. As shown in Figs 3 and 4, the original estate tax contained ten separate rates ranging from one to ten percent . Changes to the rate structure occurred frequently between 1916 and 1941 . World War I brought an increase in the maximum rate to 25% and the number of brackets to 14 . The maximum rate was reduced to 20% while the number of brackets increased to 20 in 1926 . This tax rate structure remained constant until the Depression, when maximum rates and the number of brackets increased significantly . The maximum tax rate more than tripled from 20% in 1931 to 77% in 1941 . The number of brackets also increased during this period from 20 to 28 before settling at 25 . Although the maximum rates were increased, the lowest rates ranged from one to three percent . After 1941, the tax rate structure remained stable through the remainder of the era . Despite the estate tax's modest beginning, increases in the level and number of tax rates during the 1920s and 1930s reflected the public's changing attitudes toward private wealth . As the Great Depression reduced the economy to shambles and populists such as Huey Long proposed "share the wealth" economic policies, redistributive tax policies became more popular in Congress . It appears that government tax policy focussed more on funding basic societal needs rather than allowing markets to operate more efficiently by keeping tax rates low . Tax Fairness The estate tax's fairness is measured in two ways : by measuring the degree of progressivity within the tax rate structure and by examining the tax's incidence . A progressivity ratio reflects the difference between the highest and lowest marginal tax rates as a percentage of the highest rate . Figure 5 presents these annually computed ratios . The tax ratio approached 90% in its first year and reached 98% in 1934 . Thereafter, the ratio decreased slightly and remained constant from the 1940s until 1976 . When one considers that the current income tax's progressivity ratio is 62%, the modem era estate tax rate structure was relatively progressive .
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The estate tax's incidence measures the proportion of estates subject to tax and the distribution of the total tax burden across taxable estates . Eight different periods are examined to measure trends in the level of and changes in tax incidence . As shown in Fig . 6, taxable estate tax returns filed for each period were partitioned by size into quartiles, and the total tax paid by quartile was estimated . The estate tax burden was originally skewed to tax the wealthiest decedents . Taxable estate returns filed from September 9, 1916 to January 15, 1922 show that the lower two quartiles paid less than one and one-half percent of total estate taxes ; whereas, the upper quartile paid slightly over 95% . The estate tax's incidence has changed markedly since that time . Although the lowest quartile's share of the tax burden has remained less than one percent, the highest quartile's share decreased to around 85% . Much of tax shifted from the upper quartile to the third quartile whose share of the tax burden increased from just over 3% to over 12% during the modem era . Budgetary Impact
The estate tax's budgetary impact on total federal tax receipts shows a marked change during the modem era . As shown in Fig . 7, the estate tax provided a non-trivial percentage of federal tax receipts particularly from the early 1920s through 1941 . After 1941, estate taxes as a percentage of total federal tax receipts dropped and remained relatively stable through the modern era . Although estate tax collections from 1941 through 1976 grew by 7 .76% per year, their relative importance declined as total tax receipts grew even faster . The growth in estate tax collections results from the increase in the tax's incidence . The combination of economic growth and a static exemption deduction resulted in a 672% increase in the number of taxable estate tax returns from about 18,000 in 1946 to over 139,000 in 1976 whereas adult deaths increased by only 48% during the same period (CDC/NCHS, 2001) .
The Current Era
It's a game. We teach the rich how to play it so they can stay rich - and the IRS keeps changing the rules so we can keep getting rich teaching them . John Grisham, novelist and attorney
Changes to the Tax Base
The Tax Reform Act of 1976 introduced fundamental changes to estate taxation . Prior to the 1976 Act, gift transfers made during life were taxed separately from estate transfers and at lower rates . The 1976 Act combined the
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estate and gift tax systems into a unified transfer tax system that defined the estate tax base to include property deemed owned by the decedent at death as well as taxable transfers made while alive. Taxation of this unified base uses a common rate schedule and a tax credit for prior period transfer taxes paid to avoid double taxing lifetime transfers included in the estate tax base . The generation skipping transfer tax represents another important change introduced by the 1976 Act . Prior to this tax, an elder could establish a testamentary trust upon death to which property was transferred . The children received trust income for life and on their deaths the trust principle passed to the grandchildren . Under prior law, the elder and grandchildren's interests remained subject to estate tax but the tax would `skip' the children's interest subject to the rule against perpetuities . The generation skipping transfer tax intended to expand the tax base by including the children' interest in their estate . The Economic Recovery Tax Act of 1981 introduced an unlimited marital deduction that removed many of the estate tax differences between community and non-community property states . The first-to-die spouse's estate received an unlimited deduction for bequests to a surviving spouse as well as a deduction for terminable interest property transfers in which the surviving spouse has limited ownership rights . Estate tax-related tax bills passed in 1987, 1988, and 1990 focused primarily on issues related to family-owned business interests transferred by the decedent. Estates were permitted a $60,000 estate tax exemption deduction from 1942 until 1976 . The 1976 Act repealed and replaced it with the unified tax credit . Like the exemption deduction, the credit serves to shield from tax a set amount of a decedent's taxable estate . The unified tax credit can be restated as an exemption deduction equivalent to provide comparability over time . As shown in Fig . 2, the exemption equivalent was $120,667 in 1977 and increased to $600,000 by 1987 . The 1987 exemption equivalent had a year 2000 inflationadjusted value of over $900,000, the highest value in the current era . The nominal exemption equivalent remained at $600,000 for 11 years during which time its inflation-adjusted value decreased about 30% from a high of $912,000 in 1987 to $635,525 in 1997 . The Taxpayer Relief Act of 1997 increased the exemption equivalent to $675,000 and scheduled periodic increases to reach $1 million in 2006 . The primary result of these tax base changes included reducing the number of taxpayers subject to tax by expanding the marital deduction and increasing the exemption equivalent . The tax base changes, particularly the unlimited marital deduction, shifted the estate tax burden from the first-to-die to the surviving spouse . The motivation for this change was two-fold. Most importantly, an unlimited marital deduction defers estate tax until the surviving spouse passes away and his or
20 4
DANIEL P. MURPHY AND ANN BOYD WATTS
her estate is better able to pay the tax . Prior to this change, if a couple's property was held in the name of the first-to-die spouse, a large estate tax would be paid and the surviving spouse's financial well being could be compromised . Second, an expanded marital deduction eliminated differences in each spouse's estate tax base caused by differences in property ownership rules between residents of common law and community property states . Changes to Tax Rates The 1976 Act changed the estate tax rate structure for the first time since 1941 . The number of brackets decreased from 25 to 21 ; the maximum tax rate was reduced from 77 to 70% ; and the minimum tax rate was increased from three to 18% . The 1981 Act and the Omnibus Budget Reconciliation Act of 1993 reduced the maximum rate to 55% . Although estate tax rates remain higher than individual income tax rates, the rate reductions brought them in line with decreases in the maximum individual rate during this period . Tax Fairness The more compressed tax rate structure resulted in a decrease in the progressivity ratio . As shown in Fig . 5, the ratio dropped from 96% in 1976 to 74% in 1977 . Subsequent rate changes further reduced the ratio to its present level of 67%, slightly higher than the individual income tax's ratio . As the progressivity ratio declined, the estate tax's economic incidence changed substantially . The lower two quartiles of estate tax payers accounted for about three percent of the total estate tax prior to the 1976 Act . After the Act, however, this percentage more than tripled to 11% by 1986 . The highest quartile's share of the tax burden decreased from about 85% in 1976 to 71% in 1986 . These tax burden shares remained fairly steady during the 1990s . Although the lower progressivity ratios and redistributed tax burden suggest a reduction in estate tax progressivity, the 1976 Act significantly reduced the number of taxable estate returns . Almost 140,000 taxable returns were filed in 1976 . By comparison, the number of taxable returns filed in 1986 was just over 20,000 and by the late 1990s had increased to around 50,000 . Although fewer estates were paying the tax, the tax burden on wealthy decedents increased . The number of returns filed by estates with a tax base over $3 million increased 67% between 1995 and 1998, and the amount of tax paid by these estates increased 90% . (Johnson & Mikow, 2000) . Thus, while tax progressivity among estate taxpayers has decreased from historical levels, the reduction in the overall number of filers suggests that tax progressivity among all estates has increased .
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Budgetary Impact Although the number of taxable estate tax returns filed during the current era decreased substantially from the modern era, the growth rate in estate tax collections increased . From 1987 to 1997, estate tax collections grew at an average annual rate of over nine percent . Consistent with historical averages, estate taxes as a percentage of total taxes collected remained around one percent
The Economic Growth and Tax Relief Reconciliation Act of 2001 Congress has cobbled together the strangest, most reckless, most - well - hilarious estate tax law ever. Laughter is the only rational response . Jane Bryant Quinn, The Washington Post (06/24/2001)
The Tax Relief Act of 2001 substantially changes the estate tax rates and base for years leading up to 2010 . The estate tax rates and base are reduced over the next few years until complete repeal in 2010 . After one tax-free year in 2010, the "sunset" provisions in the law require 2002 law to be reenacted in 2011 . Revision to the recently passed changes in the estate rules during the next few years is certain . However, these changes need assessment in light of historical trends . Changes to the Tax Rates and Base Table 4 provides a summary of the major changes to the estate tax rate and base . The maximum estate tax rate decreases from 55 to 50% in 2002 and gradually drops to 45% in 2009 . Reflecting a trend begun in 1977, the maximum estate tax rate is set to parallel more closely the maximum individual tax rate . The lower bracket tax rates are unaffected by the new law . The estate tax is repealed in 2010 only to be reenacted in 2011 using the year 2002 rates . As currently stipulated in the Act, the maximum estate tax rate from 2009 to 2011 are 45, zero, and 55% . Much of the congressional debate focused on changes to the maximum estate tax rate . However, Table 4 shows significant changes to the tax base . Most significantly, the unified credit exemption equivalent is scheduled to increase from its current $675,000 to $3 .5 million in 2009 . This scheduled change in the exemption equivalent marks the largest increase to the exemption equivalent in its history . Two other changes worth noting are the repeal of the Qualified Family Owned Business (QFOB) deduction in 2004 and the repeal of the state death tax credit in 2005 . Although not widely used, the QFOB deduction does allow qualifying estates to reduce their taxable base by up to $625,000 . Current law provides a tax credit for most state taxes paid by estates .
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DANIEL P. MURPHY AND ANN BOYD WATTS
Table 4.
Summary of Changes Made by the Economic Growth and Tax Relief Reconciliation Act of 2001 .
Year
Top Estate Tax Rate
Unified Credit Exemption Equivalent
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
50% 49% 48% 47% 46% 45% 45% 45% repealed 55%
1 million 1 million 1 .5 million 1 .5 million 2 million 2 million 2 million 3 .5 million N/A 1 million
Other Significant Changes
Qualified Family-Owned Business Deduction Repealed State Death Tax Credit Repealed
Modified Carryover Basis Rule Enacted Year 2002 Tax Law Re-enacted
The Act phases out the credit and replaces it with a deduction for these taxes paid . While this change will reduce the tax base by allowing a new deduction, it will increase the effective tax rate by replacing a credit with a deduction . Tax Fairness The impact of the Act on tax fairness remains unclear . The incidence of the estate tax will decrease due to increases in the exemption equivalent . Using 1998 return information, only eight percent of taxable estates had tax bases over $2 .5 million . As the exemption equivalent reaches $3 .5 million the number of taxable estates will likely decrease . Although the estate tax burden may drop, the capital gains taxes expected to be paid by heirs could increase as a modified carryover basis rule comes into effect in 2010 . Generally, inherited property assumes a tax basis equal to its fair market value at date of death . Thus, the capital gain on appreciated property held by the deceased is permanently deferred . The Act provides a new general rule that the basis of inherited property remains that of the deceased . The Act provides two exceptions to this general rule : (1) $1 .3 million of basis can be added to certain assets, and ; (2) $3 million of basis can be added to property transferred to a surviving spouse . The modified carryover basis rules will likely result in higher capital gains taxes being paid by more persons across more income classes than the savings realized by the reduction in the estate tax .
The Evolution of Estate Taxation in the United States
2 07
Budgetary Impact
The estimated ten-year cost of the recently enacted estate tax law changes to the U .S . Treasury is $138 billion (CCH, 2001) . The bulk of this cost will be realized in the latter part of the decade when the exemption equivalent is increased to $3 .5 million, tax rates are decreased, and the tax is repealed for one year . In the likely event the estate tax laws are revised, the cost to the Treasury will change . It is also not clear what fiscal impact the modified carryover basis rules will have on income tax receipts .
CONCLUSION The estate tax has a long and mixed history in United States tax policy . Despite its relative insignificance in the current federal budget, the estate tax produces intense and continuing debate . Estate tax policy will continue to be debated as federal budget surpluses grow, personal wealth increases, and American society ages . At the time of the original enactment of the estate tax, personal income taxation was in its infancy and marginal rates were low . Congress intended the estate tax to add fairness to the overall individual tax structure by increasing progressivity . While the tax rate structure reflects a high degree of progressivity, the tax incidence suggests an even more progressive structure by targeting the tax to be paid by only the most wealthy decedent taxpayers . As shown in the analysis, only a minority of taxpayers pay the vast majority of the estate tax . Despite recent changes made to the estate tax laws by the Tax Relief Act of 2001, the uncertainty surrounding the sunset provisions in the Act will force Congress to revisit this issue . When these deliberations begin, policymakers should consider the estate tax's original purpose and evaluate the effect of proposed changes on tax collections and tax fairness .
REFERENCES Blackstone, W . (1803) . Commentaries on the Laws of England. Oxford, U .K . : Carendon Press. Brownlee, W . E . (2000). Historical Perspectives on U .S . Tax Policy Toward the Rich . In : J . Slemrod (Ed.), Does Atlas Shrug?: The Economic Consequences of Taxing the Rich. Cambridge : Harvard University Press . CCH (2001) . CCH Tax Briefing : Tax Relief Reconciliation Act of 2001 . Commerce Clearing House . CDC/NCHS (2001) . National Vital Statistics System, Mortality, unpublished trend tables for 1968-1978 and 1940-1949 . Carnegie, A . (1962) . The gospel of wealth, and other timely essays. E. C . Kirkland (Ed .), Cambridge : Belknap Press of Harvard University Press, 1962 .
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Chester, R . (1982) . Inheritance, Wealth, and Society. Bloomington . Indiana : University Press . Chester, R. (1998). Inheritance in American Legal Thought . In : R. K . Miller & S . J. McNamee (Ede), Inheritances and Wealth in America . New York : Plenum Press . Eller, M . B. (1997) . Federal Taxation of Wealth Transfers, 1992-1995 . SOI Bulletin. Internal Revenue Service . Winter 1996-1997 . Washington, D.C . Fiekowsky (1959) . On the Economic Effects of Death Taxation in the United States. Doctoral Dissertation . Cambridge : Harvard University . Ibbotson Associates (2000) . SBBI 2000 Yearbook. Chicago : Ibbotson Associates . Johnson, B. W . . & Eller, M . B . (1998). Federal Taxation of Inheritance and Wealth Transfers . In : R . K. Miller & S . J . McNamee (Eds), Inheritances and Wealth in America . New York: Plenum Press . Johnson, B . W ., & Mikow, J . M. (2000). Elements of Federal Estate Taxation . Working paper. Washington, D .C . : Internal Revenue Service. Joulfain, D . (1998). The Fedral Estate and Gift Tax : Description, Profile of Taxpayers, and Economic Consequences. OTA Paper 80. U .S . Department of Treasury. Locke, J . (1988). Two Treatises of Government. Cambridge, U.K. : Cambridge University Press . Marx, K . (1963). The Communist Manifesto of Karl Marx and Freidrich Engels . New York: Russell and Russell . Pacheco, J. (1983) . The Legacy of George Mason. Fairfax : George Mason University Press. Rand, A . (1957) . Atlas Shrugged. New York : Random House Ricardo, D. (1819) . On the Principles ofPolitical Economy and Taxation. Washington, D.C . : Joseph Milligan, Smith, A . (1937) . An Inquiry into the Nature and Causes of the Wealth of Nations. New York : Random House. Zaritsky, H., & Ripy, T . (1984) . Federal Estate, Gift, and Generation Skipping Taxes : A Legislative History and Description of Current Law . Report No . 84-156A. Washington, D.C . : Congressional Research Service .
THE EFFECTS OF THE ALTERNATIVE MINIMUM TAX ON BANKS' MUNICIPAL BOND INVESTMENTS Buagu Musazi, B. Anthony Billings and Angela L. J . Hwang
ABSTRACT The replacement of the book-income adjustment (BIA) component of the corporate alternative minimum tax (AMT) formula with the adjusted current earnings (ACE) component in 1990 increased the effective tax rate on interest income from municipal bonds and lowered the yield on municipal bonds relative to taxable bonds . This study assesses the effects of the replacement of the BIA with the ACE on municipal bond holdings for a sample of 72 banks over the 1987-1993 period . Results show that banks that were likely to pay the AMT held significantly lower amounts of municipal bonds in the period following the enactment of the ACE adjustment than banks that were likely to pay the regular tax .
INTRODUCTION This study extends earlier studies (Henderson, 1996 ; Neubig & Sullivan, 1987 ; Leonard, 1998) regarding the effects of taxes on municipal bond investments by assessing banks' holdings of municipal bonds in the period after the replacement of the book-income adjustment (BIA) with adjusted current Advances in Taxation, Volume 14, pages 209-243 . © 2002 Published by Elsevier Science Ltd . ISBN : 0-7623-0889-3 209
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BUAGU MUSAZI ET AL .
earnings (ACE) adjustment under the Budget Reconciliation Act of 1989 (hereafter, BRA89) . The federal government and some state governments historically have subsidized local government financing by exempting interest earned on certain municipal bonds from federal/state taxation and by minimizing the regulatory requirements for municipal bond issuance .' However, the enactment of the Alternative Minimum Tax (AMT) under the Tax Reform Act of 1986 (TRA86) and the modification of the AMT under BRA89 are in conflict with federal tax policy toward subsidizing local government financing . While not aimed primarily at reforming subsidization of local governments financing costs, both pieces of tax legislation fundamentally changed the taxation of interest income from municipal bonds? TRA86 corporate minimum tax provisions made interest income from private activity and general obligation municipal bonds part of the AMT formula? BRA89 replaced the BIA with the ACE adjustment for taxable years beginning after 1989 . Revisions in the corporate AMT provisions under the BRA89 resulted in a five percentagepoints increase in the effective tax rate on interest income from general obligation municipal bonds when a firm pays AMT rather than the regular tax . The increase in the effective tax rate was due to the BRA89 increase, from 50 to 75%, in the statutory percentage of general obligation bond interest included in the AMT base . Table 1 shows how BRA89 increased the effective tax rate on municipal bond interest after the replacement of the BIA with the ACE adjustment. One policy question concerning the potential increase in the effective tax rate on interest income from municipal bonds is whether investors with significant holdings in tax-exempt bonds permanently reduced their holdings to avoid the AMT . Banks were significant investors in municipal bonds during the period of the AMT legislation.4 Leonard (1998) shows a decline in banks' share in total municipal bond holdings from 31% in 1984 to 7% by 1995 . Reductions in municipal bond holdings have implications for state and local government borrowing costs . Leonard (1998) shows that underwriters' re-offer yields for municipal bonds subject to AMT increased after the TRA86 tax law changes .' The increase in re-offer yields translated into a higher user cost of capital for state and local governments . In response, local governments called for changes in the AMT to restore the tax subsidy on municipal bonds (Green, 1994) . Many local governments depend on bond issues to finance infrastructure and other special public projects . Therefore, studying declines in municipal bond holdings is important for tax policy-makers at the federal level to assess long-term economic consequences of the AMT in the public sector .
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213
A sample of banks with self-disclosed municipal bond investments is used to regress the level of municipal bond holdings on the moderating effects of each bank's expected AMT status and an indicator variable for the enactment of the ACE adjustment in 1990, while controlling for other factors such as bond yield ratios and profitability .6 The scope of the study is limited to the banking industry because most firms in other financial and non-financial industries do not disclose tax-exempt investment activities in sufficient detail . The results of the study indicate that banks that were likely to pay the AMT lowered their holdings of tax-exempt municipal bonds to a greater extent than banks that were likely to pay the regular tax in the period following enactment of the ACE legislation in 1990 . The observed decline in municipal bond holdings is in accord with prior studies that banks lowered their municipal bonds holdings in the post-TRA86 period . The results also indicate that after enactment of the ACE provisions in 1990, the level of divesture in municipal bonds increased over post-TRA86 levels . The remainder of the article is organized as follows : The next section reviews the literature of tax law changes affecting municipal bonds . The third section examines banks' municipal bond investment behavior in light of the AMT and develops the hypotheses . The last two sections describe the research design, report the empirical results and provide remarks regarding the results .
PRIOR RESEARCH The effect of the AMT on the level of municipal bond holdings of financial institutions has been examined by Neubig and Sullivan (1987), Cummis and Grace (1994), Henderson (1996), and Leonard (1998) . In general, the studies agree that the AMT provisions diminished the role of financial institutions in the municipal bond market . However, except for Henderson (1996), the reviewed studies failed to address the effects of the ACE adjustment on municipal bond holdings . Thus, the findings of prior works regarding the AMT cannot be generalized to the current tax regime . Neubig and Sullivan (1987) used a simulation to assess the overall effects of TRA86 on banks' municipal bond holdings . At the time of the Neubig and Sullivan study, the ACE legislation was not under serious consideration in the U .S . Congress . The present study updates and re-tests Neubig and Sullivan's (1987) study by examining the situation retrospectively under the BIA and ACE regimes . Neubig and Sullivan's (1987) simulation included several major TRA86 tax changes affecting tax-exempt bonds . TRA86 tax law changes included not only the alternative minimum tax but also a reduction in the
214
BUAGU MUSAZI ET AL .
statutory corporate tax rate, and the disallowance of the deduction for interest incurred on municipal bonds funds . The interest expense disallowance complicated the isolation of the AMT effect on municipal bond holdings from the other tax law changes . Several other studies linked the decline in banks' municipal bond holdings to the disallowance of the interest expense deduction for financing municipal bonds (Scholes, Wilson & Wolfson, 1990; Hein, Koch & Macdonald, 1995 ; Leonard, 1998) . The fact that interest income from municipal bonds is included in the AMT formula as a tax preference item or as a component of the ACE is an additional, and probably a more important, explanation for the decline in banks' municipal bond holdings . The assessment of the effects of the inability to deduct interest expense to carry tax-exempt bonds is obscured by two factors . First, interest expense on municipal bonds acquired before 1987 is deductible for regular tax purposes in the post-TRA86 period . However, banks could divest such bonds to avoid their AMT effects . Second, 80% of interest expense on certain municipal bonds (i .e . qualified bonds) purchased after TRA86 is deductible for regular tax purposes . However, interest income on such bonds is included in the AMT computation . Banks can avoid owning such bonds to avoid their AMT effects . Leonard (1998) studied several municipal bond market segmentation factors including the AMT . He estimated regression models for both general obligation and private activity bonds using the re-offer yield of municipal bonds as the dependent variable .' The estimated models included AMT as an explanatory variable only for private activity bonds . Although Leonard found evidence that being subject to the AMT increases the re-offer yield of private-activity bonds, he did not include AMT status in the regression for general obligation bonds . AMT status should have been included as an independent variable in the regression for general obligation bonds because the sample was drawn from the ACE period when general obligation bonds were taxed at a rate of five percentage-points higher than under the pre-ACE period .' The present study extends Leonard's AMT conclusions to banks as well as to general obligation bonds . Estimation shortcomings were identified in a number of the reviewed studies, particularly Henderson (1996) . For instance, in a study of the impact of AMT on municipal bonds, Henderson (1996) failed to control for investment adjustment costs . Therefore, estimates of the AMT effects obtained by Henderson may be overstated (biased upwards) because the covariance between the current year's tax-exempt investments and the following year's AMT status is expected to be positive . The present study includes the lagged dependent variable in the estimation to control for investment adjustment costs .
The Effects of the Alternative Minimum Tax
215
Another methodological concern involves the use of financial reporting data, as opposed to actual AMT payment, to measure AMT exposure (Boynton, Dobbins & Plesko, 1992 ; Manzon & Plesko, 1999 ; Shevlin, 1999) . Some firms that pay AMT may not disclose such information in their financial statements . Therefore, the use of footnote disclosure to determine firms' AMT status may lead to misclassification of a firm's actual status . Like Henderson (1996), the present study uses self-disclosed AMT information from each bank's footnote disclosure to determine its likelihood of paying the AMT . Robustness tests also are conducted to check for potential misclassification by identifying AMT firms based on reported financial data as applied in Dhaliwal and Wang (1992) . The present study adds to the literature regarding the influence of taxes on municipal bond investments in several respects . First, the study analytically links the AMT with decisions regarding municipal bond investments . Second, the study uses both the actual AMT payment status as well as financial reporting data to proxy for expected AMT status instead of relying solely on self-disclosed information regarding each bank's AMT status as was done by Henderson (1996) . Third, the paper uses a lagged dependent variable in the empirical model to account for investment adjustment costs that was omitted in Henderson (1996) . Fourth, the study accounts for the replacement of the BIA with the ACE adjustment in 1989, which Neubig and Sullivan (1987) and Leonard (1998) did not consider .
THEORY AND HYPOTHESES Banks' Optimization of Tax-Exempt Bond Holdings A bank's expected AMT status is likely to influence its tax planning regarding the ACE component of the AMT formula . The increase in the effective tax rate on interest income from municipal bonds, as part of the ACE legislation under the BRA89, adds to a bank's tax liability only if the bank is already paying the AMT or if it is pushed into paying the AMT as a result of having municipal bond interest income . Otherwise, interest income from municipal bonds is of no tax consequence to banks that are less likely to pay the AMT . Assuming the tax-planning objective of a bank is to maximize after-tax earnings, a bank that is likely to pay AMT can avoid the AMT to minimize its tax cost by optimizing its municipal bond portfolio . Such a bank would face two major decisions when purchasing municipal bonds . The first is to determine the break-even yield ratios of municipal bonds, and the second is to determine the optimum quantity of tax-exempt securities to hold . 9
216
BUAGU MUSAZI ET AL . Determination of the Break-Even Yield Ratios of Municipal Bonds
A bank's marginal tax rate is a critical factor in determining the break-even yield of a municipal bond . When deciding between investing in municipal bonds or other types of investments (e .g . taxable bonds), a bank with a marginal tax rate of t will have an incentive to invest in municipal bonds as long as the tax-exempt yield (rex ) earned on municipal bonds is equal to or greater than the after-tax yield (re ) earned on taxable bonds . That is, at the margin rr, = (1-t)r x Therefore, the break-even yield ratio is : r,/ r x = 1-t
(I a)
The type of municipal bonds further complicates the determination of break-even yields for banks subject to the AMT. While 75% of interest income from general obligation bonds is subject to the AMT, all of the interest income from private activity bond is subject to the statutory AMT rate (m ) . 10 Therefore, the AMT adjusted rate of return is (1-0 .75m) r, for general obligation bonds . Banks subject to AMT will purchase general obligation bonds so long as (1-0.75m)r, exceeds (1-m)r x That is, the break-even yield ratio for each marginal dollar investment in general obligation bonds should be : 1-m rIx
1-0 .75m
(lb)
The break-even ratio for each marginal dollar investment in private activity bonds should be :
Several insights can be generated from Eqs lb and ic . First, Eq . lc implies that for banks that pay the AMT, private activity bonds are as good as other taxable bonds except that they are taxed at the AMT tax rate, m, rather than rate t . Second, private activity bonds are subject to a higher AMT rate than general obligation bonds . Given the prevailing AMT rate at 20%, private activity bonds are taxed at the full AMT rate of 20% . Because only 75% of interest income from general obligation bonds is subject to AMT, general obligation bonds are taxed at a lower rate of 15% (75% * 20% = 15%) . Therefore, a bank's investment in private activity bonds, general obligation bonds, or taxable bonds will depend on how the prevailing yield-ratios compare with the above analytical ratios . Third, general obligation bonds require a lower yield ratio (0 .94) than private activity bonds (i .e. 1 .00) because
The Effects of the Alternative Minimum Tae
217
1-m r,
1-0 .75m = 0
.94, given m=0.20
(1d)
Table 2 shows the differences between actual yield ratios and the above analytical ratios for the 1986-1993 period . For banks that paid the AMT, the actual yield ratios were below the break-even points as shown in Table 2 (Panel A) . Clearly, AMT banks earned lower rates of after-tax return across all maturity terms and bond classes than they would have earned from taxable securities . This observation implies that the municipal bond market may not have fully recalibrated the pre-tax rates of return to the AMT change, and provides an additional explanation for banks' divesture of municipal bonds . For non-AMT banks, the excess of observed yield ratios over the break-even points are tax bracket sensitive . Table 2 (Panel B) shows that a majority of the yield ratios were above the break-even points for banks in higher marginal tax brackets . This is consistent with the notion that taxpayers with high marginal tax rates usually hold higher amounts of municipal bonds . For taxpayers with marginal tax rates in mid-range of the statutory tax rate brackets, the excess yield ratio depended on the maturity term of the bond . The yield ratios on shortterm bonds were generally negative . Therefore, taxpayers with low marginal tax rates are not expected to invest in short-term municipal bonds based primarily on bond yields .''
Table 2.
Excess of Actual Yield Ratios Over Break-Even Ratio for Selected Maturities .
Panel A : AMT Exposed Banks General Obligation Bonds
Private Activity Bonds
Year
t-year
5-year
Over 10-year
I-year
5-year
Over 10-year
1986 1987 1988
0 .277 0 .276 0 .262
1989 1990 1991 1992 1993
0 .233 -0 .205 -0 .179 -0 .186 0 .193
0.203 0.237 0.225 -(1.191 -0.197 -0 .200 -0.166 -0.145
0 .135 0 .181 0 .187 -(1 .158 -0 .166 -0.176 -0 .149 -0 .135
-0.290 0.261 0.273 -0.252 -0.223 -0.155 -0.125 -0.1(14
-0 .190 0 .212 0 .242 -0 .208 -0 .215 -0 .195 -0 .139 -0 .099
-0 .096 0 .136 0.185 -0 .170 -0 .172 -0.168 -0 .124 -0 .089
Note : Excess yield = Actual yield -r AA The break-even yield ratio r i/r,I _ ( I -m)/(1 -0 .75m) = 0 .94 for general obligation bonds when the prevailing AMT rate m is 20% . The r,,/r„ ratio equals one for private activity bonds .
218
p a 0 U
m d CR 0 .
The Effects of the Alternative Minimum Tax Determination
of the
Optimum
Holdings of
219 Tax-Exempt
Bonds
If market yield ratios exceed the break-even yield ratios, as is the case for high tax bracket banks in Table 2 (Panel B) above, an appropriate decision is to determine the optimal level of municipal bonds that will minimize the total tax liability by avoiding the AMT . Otherwise, if the bank does not avoid the AMT, it would face negative excess yield ratios as empirical evidence demonstrates in Table 2 (Panel A) . A negative excess yield does not imply a negative yield : it simply implies that the bank is getting a lower after-tax yield than it would obtain from taxable bonds of equal risk . Therefore, it is still possible for some banks to optimize their portfolios even when they pay the AMT . This is particularly true if non-tax factors offset the tax (AMT) cost and/or the cost of implementing the AMT planning strategy is not worth the benefit of doing so - the foregone excess yield may be less than the AMT saved plus any other related costs . The focus of the present study is, however, on the effect of the AMT on banks' municipal bond investments . Therefore, in the analysis we must assume that avoiding the AMT is a decisive factor in a bank's portfolio selection . The influence of the non-tax factors can be determined empirically . Accordingly, non-tax factors such as profitability of a bank, excess yield ratios in the market, and the state of tax exhaustion are included in the empirical model . To obtain the optimal level of municipal bonds (a*) without paying the AMT, a bank should equate the tentative alternative minimum tax (TAMT) to the regular tax (t TI) . The resulting expression is solved for the proportion of general obligation bonds (a) and the proportion of private activity bonds (a t,) as shown in Appendix I to derive the following expressions for : (i) General obligation bonds proportion (a) :
a
(t-025m)r + O
[t(r,,(l-at,)+ .Q-m(0 .25((r,,(l-a„)+f) (2a) (f - f) + reca p) + 0 .75ACE} ]
(ii) Private activity bonds proportion (a„) : 1 an - (t-0 .25m)r,F+0 .25mr1,a
.[t(r,r(l a)+ f,) m{0 .25((r,x(1 a)+ f,) (2b)
+0(f-ft)) +0.7SACE}] such that - I <<-(a, a p) _< 1 .
220
BUAGU MUSAZI ET AL.
The proportion of private activity bonds should be equal to the proportion of AMT [t(r,,(1-a) + f)-m[0 .25((r,,(1-a) + f) + (3(f-f,)) + 0 .75ACE}] to tentative alternative minimum tax (TAMT) [(t-0 .25m)r,x + 0 .25mreX1 attributable to interest income without regard to private activity bonds interest income . The same principle applies to general obligation bonds . The computation formula for the ACE also includes interest income from general obligation bonds (a) . The condition (-1 <- (a, a,,) <- 1) should hold, otherwise the bank would be paying the AMT . When total TAMT [m[0 .25((r,x(1-a) + f,) + /3(f-f,)) + 0 .75ACE}] exceeds the regular tax, the respective municipal bond proportion is negative (i .e . (a, ar) < 0), implying that the bank should divest municipal bonds . Equation 2a shows that investments in general obligation bonds (a) decrease as investments in private activity bonds (a,,) increase . This is because interest income on private activity bonds is classified as AMT preferences which increase the likelihood of AMT . As a numerical demonstration for private activity bonds (see Appendix I for an illustration for general obligation bonds), assume : the AMT rate (m) = 0 .20 ; the marginal tax rate (t) = 0 .34 ; the tax-exempt bond yield (rex) = 0 .07 ; the taxable bond yield (r s) = 0 .08 ; the proportion of AMT sensitive timing differences (/3) = 0 .50 ; the non-interest financial income per unit of assets (f) = 0 .50 ; the non-interest taxable income per unit of assets (f,) = 0 .20 ; the level of general obligation bonds (a) = 0 .00, and the level of adjusted current earnings per unit of assets (ACE) = 0 .50. A bank with such parameters should hold about 16% of its assets in municipal bonds in order to avoid the AMT . The impact of any external stimulus on municipal bond investments is analyzed by examining the changes in the respective proportions (a, a ,,) as follows : Aa =
II
[tA(r, (1-a)+ f,)-m{0.25(A(r, (1-a)+ f,)+/3~(f-f,)) (3) + 0 .75AACE)-ar (tArr . + 0 .25mA(re,-rJ)]
where : II = (t- 0.25m)r„+ 0 .25mr" and A = change in the respective variable . The change in the general obligation bonds proportion (Aa) can be similarly determined . From Equation 3, four major factors are responsible for determining the changes in optimal tax-exempt holdings . First, increases in implicit taxes on municipal bonds (0.25ma,A(reX which can be presented as excess yield ratio changes (A(r"Iru l)), decrease any incentive to hold higher amounts of tax-exempt bonds . In terms of yield ratios, any increase in A(r,X r,,) implies a decrease in the yield ratio . The yield ratio induces additional tax-exempt
The Effects of the Alternative Minimum Tax
22 1
securities investment if it exceeds the respective analytical break-even yield ratios for general obligation and private activity bonds (and vice versa) . Second, the change in non-interest temporary differences D(f-f,) included in the AMT preferences affects how a bank changes its tax-exempt holdings . The presence of other non-interest book-tax differences, (f-f,), such as bad debt expense and depreciation reduce the incentive to invest in tax-exempt securities because such book-tax differences, on their own, increase the likelihood of paying the AMT . Third, the change in the profitability of a bank as represented by the change in taxable income (A(r, (1 -a c) + f,)) > 0) can increase a bank's demand for municipal bonds as investment assets, as well as tax shelters, so long as they are optimized for AMT . However, this argument would change for a bank with net operating losses (NOL), in which case 0(r, (l-a,,) + f)< 0 . Such a bank would have no book-tax differences to trigger the AMT and probably no regular tax liability . Therefore, the tax planning focus would shift from AMT and also from municipal bonds as a tax shield ; i .e . (a, a„) <_ 0. Fourth, the change in the amount of adjusted current earnings (DACE) (or the change in the book income adjustment (ARIA) prior to 1990] operates in the same manner as any other AMT item . A high level of adjusted current earnings (ACE) discourages investment in tax-exempt securities because interest income on tax-exempt bonds is included in the AMT formula . In addition to tax-exempt bond interest, typical items that increase ACE include life insurance proceeds, deferred gain on non-dealer installment sales, LIFO inventory adjustment, depreciation, and 70% of the dividend-received deduction . The presence or absence of the ACE items in a bank's portfolio may affect investment decisions in municipal bonds . 12 Hypotheses
The above analysis of the optimal holdings' formulation serves as the organizing principle for the following research hypotheses : HAI : Ceteris paribus, banks that were likely to pay the AMT (m t 0) had
lower levels of tax-exempt bond investments than banks that paid the regular tax (m = 0) . HA2 : Ceteris paribus, after the inclusion of ACE adjustments under the
BRA89 Act, banks that were likely to be subject to AMT had lower levels of tax-exempt bond investments than they did before the ACE legislation .
2 22
BUAGU MUSAZI ET AL .
To empirically test the above hypotheses, the following assumptions are made . First, municipal holdings (a) in the current year are assumed to be equal to municipal holdings at the beginning of the year (a,,_,) plus new purchases (a n) less any retirements (zaY ), where z is the retirement rate . Second, new municipal bond purchases are assumed to be a function of the difference between the desired optimal holdings a' and holdings from the prior year (a,,_,) . That is, a n = g(aY _ (1-z)_+*), where g is an investment adjustment parameter . The adjustment parameter (g) is influenced by factors such as deductible interest expense . TRA86 allowed banks to continue deducting interest expenses incurred on municipal bonds acquired prior to 1986 and to continue deducting interest on bank-qualified municipal bonds indefinitely . Divesture of the 1986 grand-fathered bonds would mean losing the interest expense deduction, which increases the implicit adjustment cost . Therefore, municipal bond holdings in year y are given by the identity : a,,= (1 + g)(1 - z)a,, ,
(4)
where; a* = a + a,, from Eqs 2a and 2b. Substituting the sum of Eqs 2a and 2b into Eq . 4 for a', the level of taxexempt holdings (a,) in year (y) is a function of the following arguments :
a,,=f(aY ,, AMT(ACE or BIA), (r,,(1-a)+f), (f-f), rrF /r,)
(5)
Except for a, _ , the effects of the remaining variables in Eq . 5 are as described in Eq . 3 above . The inclusion of the prior period's level of municipal bond holdings (a , ) into the demand equation (Eq . 5) allows us to properly assess the current demand for municipal bonds in light of investment adjustment costs .
RESEARCH DESIGN Empirical Model
The specification for the research model to test the above hypotheses is listed below in Eq . 6 . The model is based on Eq . 5 . The specification in Eq . 6 estimates the effect of AMT and ACE on municipal bond holdings using data over the 1987-1993 period . The sample period is limited to the three years before and after the ACE enactment to have an equal number of years before and after the ACE enactment .
The Effects of the Alternative Minimum Tax
223
TAXEMPT; ,,= /3ITAXEMPT,V i + g/32 ACEA + g/3,AMTX,, + g/34 (AMTX,, i *ACEA) + g/3 SNOL,,, , + g/36ROR, ,,
(6)
+ g/37 EXYIELD, + E,, l '
The coefficient Q,, for i=2 . . .7, represents constants relating the respective variables to optimal bond holdings and g is the adjustment parameter as defined in Eq . 4 . By assumption, the error term, e, is normally distributed with a mean of zero and standard deviation of one . The remaining variables are defined below . The dependent variable (TAXEMPT, V) was measured as the logarithm of the proportion of municipal bonds in total investments for bank i in year (y) . The logarithmic transformation was performed to minimize the variance in TAXEMPT' 4 The lagged dependent variable (TAXEMPT.,__ i ) was included to control for the effect of prior years' holdings on the current year's investment decisions . As discussed in Eq . 4, the coefficient fa t (if the dependent variable is the level of TAXEMPT,) should represent the net retention rate of municipal bond holdings ; i .e. the rate of adjustment (g) to the optimal level net of the retirement rate (z) . Ideally, the dependent variable to test the second hypothesis should be the change in municipal bond holdings due to net purchases of municipal bonds . However, the change in municipal bond holdings as measured herein would include the retirement of maturing bonds as well as net purchases . The retirement rate (z) is not tax motivated ; it depends on the maturity distribution of the municipal bonds portfolio . Net purchases, however, which are adjusted at rate g, fluctuate with the tax burden and other factors . Therefore, when the dependent variable is the level of municipal bonds instead of a change in municipal bonds, and the explanatory variable also is expressed in levels, the time-series regression coefficients should reflect both the period-to-period adjustment (g) as well as the level relation ()3,) between the dependent and independent variables . The adjustment parameter (g) can be empirically determined once the retirement rate (z) is given . For instance, given /3, _ (I + g) (1-z) in equations 4 and 6, if the retirement rate is 20% per year (i .e . z = 0 .20) and /3, is estimated to be 0 .70, then g = -0 .13 which would imply a net sale of municipal bonds .'= AMTX, i is the expected AMT status in the current year . The expected sign for the AMTX 1 coefficient g/3, is negative . The prior year AMT status was used as a proxy for the current year's expected AMT status . The current year's expected AMT status (AMTXh i ) was coded as AMTXV,_ i = I if the bank
224
BUAGU MUSAZI ET AL .
disclosed its AMT status in the previous year and AMTX,, = 0, otherwise . A bank that paid AMT in the prior year is likely to pay the AMT in the current year ; if not, at a minimum that bank's (municipal bonds) investment decisions are highly influenced by its recent AMT history . The relation between the current year and the prior year's AMT status can further be supported by their correlation. The correlation coefficient between prior AMT status and the current year's AMT status was 0 .40 and statistically significant (p < 0 .05) . Current year AMT status would be an intuitive measure of expected AMT status . However, this measurement of expected AMT status is associated with some econometric limitations . The co-dependence between current year municipal bond holdings and current year AMT status creates a simultaneity problem. The co-dependence is due to the fact that AMT exposure could cause changes in municipal bond holdings to avoid AMT or alternatively, the level of municipal bonds holdings can push banks into paying the AMT . Estimating Equation 6 by way of the two-stage regression technique or lagging one of the co-dependent variables to become a pre-determined variable can solve the simultaneity problem . Lagging the AMT status approach was selected for simplicity as well as for the conceptual argument made above . ACEA is a qualitative variable for the introduction of the adjusted current earnings in 1990 . ACEA measures the change in the intercept of tax-exempt investments as a result of the replacement of the BIA (book income adjustment) with the ACE . ACEA was coded as ACEA = 0 for 1987-1989 and ACEA =1 for 1990-1993 . ACEA tests whether a permanent shift in tax-exempt bond holdings occurred due to the enactment of the ACE provisions . The expected sign of the ACEA coefficient g(32 is negative . The interaction variable AMTX *ACEA captures the effect of the ACE regime on municipal investments for banks that paid the AMT (hypothesis HA2) . A negative coefficient (g)34) is expected . Net operating losses (NOL) is a dummy variable to control for the fact that a bank that had an NOL in the previous year will have no incentive to hold municipal bonds as a tax shield in the current year . The net operating losses dummy was coded as NOLY- , = 1 if a bank reported net operating losses in the previous year and as NOL Y I = 0 otherwise. A negative sign is expected for coefficient g/3 5 . The rate of return on assets (ROR) is an indicator of profitability to control for the fact that profitable banks would invest some of their earnings in municipal bonds as profits increase . The reasons for investing the surplus earnings in municipals bonds may be for regulatory purposes, for portfolio diversification or for shielding earnings from taxation . RORY was measured as reported net income divided by total assets in the current year . A positive sign for the coefficient g$6 is expected .
The Effects of the Alternative Minimum Tax
225
Similar to Neubig and Sullivan (1987), we control for the yield factor with the excess of the actual yield ratio over the break-even yield ratio (EXYIELD V) in a given tax year . 16 Prior findings on the effect of yields on banks' municipal bond holdings are not unanimous . Kidwell and Koch (1983) found that, in general, banks' investments in municipal bonds are not determined by yields . However, Nuebig and Sullivan (1987) found, based on a 1977-1984 sample (prior to AMT legislation) with simulated AMT, the excess yield ratios to be a determining factor in the level of tax-exempt holdings . A positive sign for the EXYIELD , coefficient is expected. For banks that pay the AMT, the excess yield ratios depend on whether the bonds are general obligation or private activity bonds . For banks that do not pay the AMT, the excess yield ratios depend on bank-specific marginal tax rates . A bank's marginal tax rate in any given year is ex-ante, however . Therefore, the lagged marginal tax rates were applied rather than rates in the current year . Banks' marginal tax rates were determined by the Shevlin (1990) trichotomous variable method . Banks with net operating loss carryovers and no pre-tax income were assigned a zero marginal tax rate . Banks with either negative pre-tax income or net operating loss carryovers (but not both) were assigned a marginal tax rate of 17 .5% (50% of the maximum statutory tax rate) . Banks with positive pre-tax income and no net operating losses were assigned the maximum statutory marginal rate of 35% .
(go)
Sample Description Due to limited data availability regarding tax-exempt investment activities, the sample was limited to firms in the banking industry with the two-digit SIC Code of 60. The Ibbotson Associates Web site was utilized to identify a list of 456 names of financial institutions that belong to this SIC Code . The National Automated Accounting Research System (NAARS, 1999) database then was utilized to identify financial reporting data disclosed in footnotes on investment activities . Other data such as assets, sales and cash flow were obtained from financial statements . A bank was included in the final sample if NAARS had information on the bank's tax-exempt investment holdings for at least four consecutive years in which at least two years are in the 1990-1993 period . This procedure reduced the sample to 91 institutions for the 1987-1993 period . The final number of banks used in the estimation was 72 out of the original 91 banks . Table 3 shows how various operations on the raw data reduced the sample size, An observation was counted only if data on the variable were available for all cross-sections in the same period . Out of a maximum number of 637 bank-years for the 1987-1993 period, 160 observations were dropped during
BUAGU MUSAZI ET AL.
226
Table 3 . Operation
Sample Selection .
Sample Size After Operation
Proportion of municipal bonds in total investments (TAXEMPT)
Bank Years Elimination Banks examined during 1987-1993 Lag and eliminate year 1986
Banks
Mean
Standard Deviation
Available
637
91
113
524
91
0.183
0.150
47
477
89
0.177
0.137
128
349
77
0.167
0.099
6
343
72
0 .166
0.100
Eliminate missing values for : TAXEMPT, AMTX, ROR, NOL
Eliminate extreme 5% with respect to logarithms of TAXEMPT, ROR, ASSETS
Eliminate banks with one year of data
Note: Several operations were performed on the original sample before the estimations were conducted. The operations reduced the sample from 637 bank-years to 343 but reduced the variance in the data . The year 1986 was included to allow for one-year lags in 1987 .
the estimation due to missing values . Some 128 observations were deleted by eliminating the extreme five percent of the respective logarithms of TAXEMPT, total assets (ASSETS), and the logarithm of the rate of return on assets (RORY) . ~' Information about banks' AMT status as well as the dollar amount of AMT paid was obtained from income tax footnotes for each of the sampled banks' annual reports. Banks report their AMT status in a variety of ways . A majority of the banks reported the amount of AMT paid in the computation of the effective tax rate for a particular year . In other situations, the information about the amount of AMT paid in a given year is presented in a separate statement . In several situations, however, the information was extracted from the section of the footnote disclosure on the computation of deferred taxes ." AMT self-disclosure in annual reports has additional limitations . Manzon and Plesko (1999) compared data from actual tax returns with data from the corresponding firms' annual reports' footnote disclosures regarding AMT . They
227
The Effects of the Alternative Minimum Tar
found that out of the 197 firms that reported AMT liability on their 1987 tax return, only about 42 disclosed AMT in the footnotes accompanying their annual reports . Because of the possibility that information from firms' footnote disclosure on AMT may result in the misclassification of actual AMT status, steps were taken to ensure that significant systematic effective tax rate differences exist between AMT and non-AMT sub-samples . Based on the statutory AMT rate of 20%, results in Table 4 supported the hypothesis that the mean effective tax rate of the AMT sub-sample is not significantly different from the 20% tax rate but that the rate for non-AMT banks is significantly above 20% . The t-tests in Table 4 indicate that the hypothesis could not be rejected at the 95% level of confidence for the years 1987 through 1990 . The hypothesis was, however, rejected for the 1991, 1992 and 1993 years . Because the t-tests support the hypothesis for a majority of the years included in the sample, the likelihood of mis-classification did not substantially affect the non-AMT sub-sample . Panel A of Table 5 shows the full sample summary statistics for the variables used in the estimated model . About 16% of the observations reported AMT in the previous year during the 1987-1993 period . The average rate of Table 4 .
t-Tests Comparing the Mean Effective Tax Rates (ETR) for AMT and Non-AMT Banks to the Statutory AMT Rate .
Dependent variable =*ETR 0 .20 Year AMT Banks
Mean t-test n
Non-AMT Banks
Mean t-test n
1987
1988
1989
1990
1991
0.051 (0.014)
-0 .003 (-0 .086)
0.022 (0 .760)
0 .001 (0 .035)
0.058 (2.378)
7 0 .079 (3 .651) 20
7 0 .079 (5 .905) 25
9 0 .078 (7 .570) 43
8 0 .067 (8 .537) 40
8
1992
1993
0.108
0 .145 (29 .000)
(4 .094) 4
0.090 0 .101 (7 .810) (16 .742) 44 51
2 0 .113 (18 .760) 48
Notes : 1 . *ETR=tax liability divided by pretax income . 2 . Some banks that paid AMT may be classified as paying the regulat tax because not all banks disclose their AMT payments . The effective tax rate for AMT banks is close to the statutory AMT rate . The t-tests confirm the reliability of AMT/non-AMT sub-sample classification . The null hypothesis was that the effective tax rates for the self-disclosed AMT sub-sample were not significantly different from the statutory AMT rate of 20% . The hypothesis could not be rejected at the 0 .05 level of statistical significance . The hypothesis was, however, rejected for the 1991, 1992 and 1993 years . Because the t-tests support the hypothesis for a majority of the years included in the sample, the conclusion is that the likelihood of mis-classification did not substantially affect the non-AMT sub-sample .
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BUAGU MUSAZI ET AL .
return on assets was 0 .90% for the 1987-1993 period . Sixty-one percent of the observations were in the ACE period . The average excess yield for 10-year general obligation bonds was ten percentage-points beyond the break-even yield and had a standard deviation of seven percentage-points . The corresponding ratio for private activity bonds was 17 percentage-points with a fairly similar standard deviation . Nine percent of the observations reported net operating losses (NOL) in the previous year. The significant negative correlation (r = -0 .76) between NOLY , and EXYIELDy in Table 5 Panel C imply that banks with net operating losses experience either low or minimal excess yields . A bank with net operating losses is presumed to have a zero marginal tax rate ; therefore, its break-even yield equals that of taxable bonds . Such banks have no incentive to invest in tax-exempt securities because they would be paying a high implicit tax . Table 5.
Descriptive Statistics for 1987-1993 Period .
PANEL A : Descriptive Statistics for 1987-1993 Period Variable
Definition
Mean
Std . Dev.
ACEA
Dummy variable for the ACE period. ACEA = 1 for 1990-1993, ACEA=0 for 1987-1989 . Dummy variable for actual AMT payment status . AMTX„=1 for banks that paid AMT in year y -1, AMTX~, 1 =0 otherwise . Dummy variable for actual AMT status based on financial income measures according to Dhaliwal and Wang (1992) . AMTXFy . =I for banks that paid AMT in year y-1, AMTXF„ i = 0 otherwise . Excess of actual yield ratio over break-even yield ratio in year y for the 10-year general obligation bonds .
0 .612
N/A
0 .163
0 .370
0 .283
0 .471
0 .099
0 .075
Excess of actual yield ratio over break-even yield ratio in year y for the 10-year private activity bonds .
0 .171
0 .080
Lagged dummy variable for net operating losses . NOL,, , = I if a bank reported net operating losses in the previous year, otherwise NOLr, ,=0. Return on assets measured as net income divided by total assets . Ratio of municipal bonds to total investments held by a bank .
0 .093
0 .291
0 .009
0.003
0 .166
0.100
AMTX J
AMTXT
EXYIELD y
(General obligation) EXYIELD y (Private activity) NOL,
ROR, TAXEMPT
Notes :
1 . Subscript y represents year y . 2 . Observations = 343 bank-years, Cross Sections = 72 banks .
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The Effects of the Alternative Minimum Tax Table 5.
Continued.
Panel B : t-tests Comparing the Mean Proportions of Municipal Bonds in Total Investments (TAXEMPT) for AMT and Non-AMT Banks in the pre-ACE (1987-1989) and ACE (1990-1993) periods . AMT Status was Based on Footnote Disclosure PRE-ACE Period ACE Period Between period significance AMT NON-AMT Between AMT status significance
0 .182 n =27 0 .195 n=95
0 .152 n=26 0 .149 n=166
t= 1 .110 p=0 .272 t=3 .740 p=0 .000
t=0.630 p = 0 .531
t=-0.090 p = 0.925
AMT Status was Determined Based on Financial Reporting Data PRE-ACE Period ACE Period Between period significance AMT
0 .176 n=31 0 .195 n=101
NON-AMT Between AMT status significance
0 .149 n=27 0 .150
t=1 .101 p=0 .316 r = 3 .580 p=0.000
n=184 t = 0 .060 p = 0.951
t = 0.970 p = 0 .336
Notes : I . From hypotheses HAI and HA2, the AMT-ACE sub-sample is expected to have the lowest TAXEMPT and the non-AMT-pre-ACE sub-sample is expected to have the highest TAXEMPT proportion . 2 . n =observations .
PANEL C : Pearson Correlation Coefficients (r) TAXEMPT TAXEMPT TAXEMPT, ACEA AMTX AMTX,. ROR
TAXEMPT i
ACEA
AMTX ,_ i ACEA
AMTX, i ROR ,
1 .000
0 .844 (< 0 .000) 0 .167 (0 .003) 5 ACEA -0 .080
1 .000
(0 .157) -0 .034 (0.574)
-0.188 (0.001) -0.020 (0.723) -0.004 (0 .949)
.000 1 0.269 (<0.000) 0.004 (0 .950)
0 .756 (< 0.000)
0.206 I<0.000)
0.156 (0 .006)
0 .107 (0 .058)
0.049 (0.384)
1 .000 .000 1 -0.110 (0.051)
1 .000
NOL,
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BUAGU MUSAZI ET AL .
Table 5.
Continued.
PANEL C : Pearson Correlation Coefficients (r) TAXEMPT, TAXEMPT NOL,
1 .000 -0.015 (0.793) 0 .074 (0 .190)
EXYIELD (10-year General Obligation Bonds)
TAXEMPT„ ,
-0.018 (0.757) 0 .056 (0 .325)
ACEA
-0.117 (0 .038) 0.166 (0.003)
AMTX, ,*ACEA
0 .042 (0 .455) -0 .077 (0 .173)
AM
_ i ROR , NOLI- ,
0.131 -0 .227 1 .000 (0.020) (< 0 .000) 0.390 -0 .759 0 .132 (0.020) (< 0.000) (0 .000)
Note: The p-values in parenthesis are for the null hypothesis that the coefficients (r) are zero .
The average percentage of tax-exempt holdings in total investments (TAXEMPT) is about 17% with a standard deviation of ten percentage-points . To assess whether the TAXEMPT average depends on how AMT banks are identified as well as whether there is a significant difference in the average between AMT and non-AMT banks before controlling for any other variables, AMT and non-AMT sub-samples were compared within and between ACE and pre-ACE periods for both AMT firms identified on footnote basis and financial data basis . Table 5 Panel B reports the mean TAXEMPT for the sub-samples . From hypotheses HAI and HA2, the ACE-AMT sub-sample is expected to have the lowest TAXEMPT, and the non-AMT-pre-ACE sub-sample is expected to have the highest TAXEMPT. This expectation was observed only in the sub-sample where expected AMT status was based on financial reporting data . However, the differences are not different statistically within the ACE period and within the pre-ACE period regardless of whether AMT status was based on footnote disclosure or on financial data .
RESULTS AND IMPLICATIONS Several regression estimation techniques were applied to assess the robustness of the results . Table 6 reports five different sets of estimates based on the empirical model specified in Eq . 6 .'y As implied in Eqs 4 and 5, banks do not carry a pre-determined amount of municipal bond or the default should be the previous year's bond holdings . Therefore, the estimations do not include an intercept term ."
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231
Column A in Table 6 reports the first estimation based on weighted pooled least squares estimation without controlling for any bank-specific effects or autocorrelation . The weighing was necessary to control heterocedasticity . Bank-specific effects arise from geographical, regulatory, financial and other factors that may not be industry-wide. For instance, some states tax out-of-state municipal bond interest and exempt in-state municipal bond interest income from state taxation . Other jurisdictions require banks to invest a portion of their deposits in local municipal bonds . This effect can make a difference in the way national, state, and thrift banks make their municipal bond investments decisions . In order to control for bank-specific factors, the model was reestimated with control for fixed effects to get the results in Column B of Table 6 . A test for the null hypothesis of no fixed effects was rejected because the obtained F-statistic was 3 .65 (p = 0 .000) compared to the critical value of 1 .22 at the 5% level of statistical significance. The fixed effects estimation made several improvements in the pooled regression (Column A) estimation . For instance, the positive serial correlation in the error term (DW = 1 .47) was corrected in the fixed effects model (in Column B, DW equals 1 .98 no significant serial correlation) . In addition, the respective independent effects of the ACE regime (ACEA), excess yield (EXYIELD ,,), and lagged net operating losses (NOL i ) became statistically significant with the expected signs but the rate of return (ROR , ) lost its statistical significance . If the fixed effects are random, they can be treated as another random variable that is then considered part of the intercept and the error term . In order to establish whether the effects are random, a Hausman specification test was conducted . The random effects (or error component) model was estimated with weighted generalized least squares (GLS) and reported in Column C . The Hausman specification test for the null hypothesis of random effects has a chi-square of 4 .42 (six degrees of freedom) . The Chi-Square (X'-) statistic is statistically significant (p < 0 .05) . Therefore, the null hypothesis of a random effects model is rejected in favor of the fixed effects model . Accordingly, the following discussion is based largely on the fixed effects model . Additional sensitivity tests were conducted to confirm the above results of the independent effect of expected AMT status and ACE . In order to ensure that the AMT and ACE independent effects were not obscured by the interaction term ACEA*AMTX, the coefficient on the interaction term was restricted to zero . The Wald test results reported at the bottom of Table 6 reveal that the null hypothesis of zero interaction coefficient (g)3, = 0) cannot be supported . The results of this test are critical to support hypothesis HA2, that ACE significantly affected the divesture trend in municipal bond holdings .
BUAGU MUSAZI ET AL.
232 Table 6.
Regression Results Using Lagged AMT Payments to Proxy for Expected AMT Status .
Variable
Expected Sign
Ln (TAXEMPT,,_,) ACEA AMTX,, AMTK,, *ACEA NOL, , Ln(ROR) EX YIELD
Goodness of fit tests Adjusted R-squared F-statistic Durbin-Watson statistic Fixed Effects Tests Hausman-statistic for random effects F-statistic for no fixed effects Wald-tests for Chi-square
A
B
C
D
E
Pooled (Weighted OLS)
Fixed Effects (OLS)
Random Effects (GLS)
Fixed Effects (OLS) Without NOL
Fixed Effects (OLS) Without Excess Yield
0.827* 0 .432* (17 .155) (12 .057) -0 .048 -0 .201(-0 .789) (-11 .751) 0 .109 -0 .013 (1 .552) (-0 .367) -0 .207** -0 .121* (-1 .983) (-2 .955) 0.159 -0.070 (1 .215) (-1 .417) 0.112* 0 .017 (5 .842) (0 .895) 0 .814 0 .261** (1 .510) (1 .769)
0.73 152 1 .47
0.98 2228 1 .98
0 .661* 0 .438* 0 .424* (16946) (12 .654) (13 .370) -0 .197* -0 .142* -0 .200* (-2 .762) (-12 .905) (-11 .881) -0 .030 0 .034 -0 .013 (0 .356) (0 .863) (-0 .384) -0 .175 -0 .111* -0 .125* (-1 .477) (-2.870) (-3 .053) 0 .046 -0 .098* (0 .368) (-4 .541) 0 . 102* 0 .020 0 .020 (2 .999) (1 .069) (1 .082) 0 .812** 0 .439* (1 .714) (5 .692)
0.80 N/A 1 .76
0 .98 3485 1 .97
3 .39
3 .33
0 .98 4561 1 .97
4 .42 3 .34
go,= 0 3 .934 8 .732 (p=0.047) (p=0.003)
2 .180 8 .236 9 .324 (p=0 .140) (p=0 .004) (p=0 .002)
Estimated Model: Ln(TAXEMPT) =)3,Ln (TAXEMPT , ) + gf3rACEA+ g p AMTX~ , +gfa (AMTX,,*ACEA) +g(i5 NOL . +g9 6Ln (ROR,,)+g)3,EXYIELD,* +e,* Notes: Variables are defined in Panel A of Table 5 . t-statistics are in parentheses . *Significant at one-tailed probability < 0 .01, * `Significant at one-tailed probability < 0 .05 .
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233
Further tests were conducted to compare financial reporting data based measures of expected AMT status as opposed to footnote disclosure about AMT payments . Specifically, the Dhaliwal and Wang (1992) method was applied to estimate expected AMT status . Because the AMT tax base is broad and the statutory AMT rate is flat, the effective tax rate of AMT banks is close to the AMT statutory rate of 20% . Therefore, Dhaliwal and Wang (1992) considered firms with an effective rate below 20% likely to pay the AMT . In the present study, effective tax rates were computed as the ratio of taxes paid to pre-tax income . The coding was AMTXF, , = 1 for banks with effective tax rate below 20% in prior year and AMTXF„ = 0 otherwise . This coding increased the proportion of firms likely to pay AMT to 28% compared to 16% if a bank's expected AMT status is based on AMT payment as reported in the footnotes of the annual reports . Table 7 reports the results when expected AMT status is determined based on financial reporting data . No fundamental differences exist between the results based on the two AMT proxies . The exception is that when AMT status is based on financial reporting data, its independent effect becomes statistically significant (t=-1 .792) only in the fixed effects model . Discussion The major thrust of this study is to determine whether that the replacement of the BIA with the ACE adjustment intensified banks' divesture in the municipal bond market. The support for this expectation is derived from the support for hypotheses HAI and HA2. The intensification aspect is supported only if the interaction coefficient (test for HA2) is significant and negative ." Finding support for HAI and failing to support HA2 would mean that ACE never had an additional effect on municipal bond investments beyond that of TRA86 . On the other hand, support for HA2 and the lack of support for HAI would have either of the following explanations : (1) the AMT did not significantly affect banks' municipal bond holdings until the introduction of ACE or (2) banks had already re-balanced their financial portfolios to account for the impact of the AMT . Support for the first hypothesis (HAI) is mixed . Table 6 (Column B) reveals that AMTX (t = -0 .367) is not statistically significant but Table 7 (Column B) shows that AMTXF (t = - 1 .792) is significant. In Table 6, expected AMT status (AMTX) was based on firms' footnote disclosure while in Table 7 expected AMT status (AMTXF) was based on financial reporting data . The difference in statistical significance of the independent effect of expected AMT status epitomizes the controversy in measuring AMT status as discussed in the prior
234
BUAGU MUSAZI ET AL .
Table 7.
Regression Results Using Financial Reporting Data Proxy for Expected AMT Status .
Variables
Expected Sign
Ln (TAXEMPT,, _,) ACEA AMTXE, AM7XF,, , *ACEA NOL,, Ln(ROR ,) EXYIELD
Goodness of fit tests Adjusted R-square F-statistic Durbin-Watson statistic Fixed Effects Tests Hausman-statistic for random effects F-statistic for no fixed effects Wald-test for g(,,=0 Chi-square
A
B
C
D
E
Pooled (Weighted OLS)
Fixed Effects (OLS)
Random Effects (GLS)
Fixed Effects (OLS) Without NOL
Fixed Effects (OLS) Without Excess Yield
0 .826* 0 .513* (17 .521) (12 .377) 0 .007 -0 .172* (0 .102) (-10 .897 0 .103 -0 .032** (1375) (-1 .792) -0 .218** -0 .076* (-1 .836) (-3 .498) 0 .147 0 .023 (1 .061) (0 .512) 0 .118* 0 .028 (5 .422) (1 .255) 0 .676 0 .669* (1 .244) (4 .415)
0.727 153 t .43
0 .973 2039 1 .91
0 .693* 0.508* (19 .167) (13.032) -0 .093 -0.172* (-1 .584) (-11 .406) 0 .050 -0 .026 (0 .641) (-1 .575) -0 .164 -0 .078* (-1 .558) (-3.674) 0 .086 (0 .694) 0 .105* 0 .031 (3 .128) (1334) 0 .822** 0 .634* (1 .690) (5 .866)
0 .791 1 .63
0 .509* (12 .452) -0 .163* (-9 .453 -0 .033** (-1 .921) -0.092* (-4 .452) -0 .063* (-2 .502) 0 .033 (1 .454)
0 .97 2630 1 .91
0 .97 2497 1 .93
3 .33
3.33
4 .42 3 .34
3 .372 12 .233 (p=0.066) (p=0.000)
2 .428 (p=0.119)
13 .495 19 .820 (p=0 .000) (p=0 .000)
Estimated Model .' Ln(TAXEMPTr )=/3 1 Ln(TAXEMPT,, ~)+g$,ACEA+g/3,AMTX I +gf4(AM7X~ i *ACEA)+g/3,NOL, i +g$6Ln(ROR,,)+g/3,EXYIELD,, +e,, Notes: Variables are defined in Panel A of Table 5 . t-statistics are in parentheses . *Significant at one-tailed probability < 0.0 1, *'Significant at one-tailed probability < 0 .05 .
The Effects of the Alternative Minimum Tax
235
research section . Boynton, Dobbins and Plesko (1992) obtained AMT information from firms' tax returns and compared it with AMT proxies based on financial reporting data as applied by Gramlich (1991) . Gramlich (1991) measured AMT status as the ratio of taxes paid to tax expense .''-'- The Boynton et al 1992 comparison revealed that AMT proxies based on financial reporting data were not good at detecting AMT payments, but such proxies were good at identifying firms exposed to AMT . Based on the Boynton et al . 1992 finding, one can plausibly conclude that the independent effects of expected AMT status in the present study are statistically significant . On the other hand, given that the significance of AMTXF is unstable across various estimation techniques in Table 7, questions arise regarding the reliability of its significance . Some studies that compared the pre- and post-AMT period (e .g . Cummis & Grace, 1994 ; Henderson, 1996 ; Neubig & Sullivan, 1987) found AMT to be statistically significant in determining financial institutions' investment behavior . As mentioned above, the lack of statistical significance for the independent AMT effect would not be surprising because the entire estimation was conducted in the post 1986 AMT regime . The inconsistency between the present findings and prior research regarding the independent AMT effect would imply that by the time the ACE adjustment was enacted in 1989 most banks had already rebalanced their investment strategies in response to AMT provisions introduced in 1986 by TRA86 . Therefore, the 1986 AMT provisions as promulgated under TRA86 were no longer a significant factor affecting the tax-exempt holdings of banks . The second hypothesis (HA2) that banks subject to AMT reduced their municipal bond holdings after the ACE to a greater extent than before is fully supported . As discussed earlier, an additional sensitivity test restricted the interaction coefficient to zero, but the hypothesis of a zero coefficient value was rejected as revealed by the Wald statistics in Table 6 and Table 7 . One explanation for this outcome is that only banks that were likely to pay the AMT would incur the additional tax from the increase in the amount of municipal interest income included in determining the ACE adjustment . Therefore, only banks that were likely to incur AMT reduced their holdings in municipal bonds in the period following the ACE legislation . The independent effect of the ACEA variable is statistically significant. The implication is that the ACE provisions created a permanent shift in all AMT and non-AMT banks' tax-exempt securities investments . Because the implementation of the ACE occurred between 1990 and 1992, the ACE variable was re-tested by coding it as ACEA = 1 for 1987-1990 and ACEA = 0 otherwise . The results were invariant to the alternative coding of ACEA for implementation in 1991-1992 ."
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BUAGU MUSAZI ET AL.
Non-tax factors such as the excess yield on bonds (EXYIELD), net operating losses (NOL) and profitability (ROR) that could offset adverse tax effects had mixed results . The excess yield and net operating losses are highly correlated (p = -0.76, see Table 5 Panel C) . To control for multicollinearity, the regression was estimated in turn with either the NOL, , or EXYIELD,,, but not both, in columns D and E of Table 6 and Table 7 . The NOL,, , and EXYIELD,, variables are statistically significant well below the 0 .05 level . In each of the estimations the excess yield variable was tested, but not reported, for the 1-year, 5-year, and 10-year general obligation and revenue bonds . The reported yield results are for 10-year bonds . The maturity effects were uniform and statistically significant except for the 1-year private activity bonds .' No significant differences were observed between general obligation and private activity bonds . These results regarding excess yields are in support of Nuebig and Sullivan (1987) finding that bond yields do significantly influence the demand for municipal bonds across term structures except for one-year yields . The net operating loss (NOL) variable is statistically significant at the 0 .05 level . Therefore, consistent with Scholes et al . 1990, our results show that firms with net operating losses have little incentive to buy municipal bonds . The profitability variable (ROR) is not statistically significant for models with fixed effects ; therefore, no conclusions can be drawn for profitability effects on the demand for municipal bonds . However, lack of significance may be attributable to the fact that municipal bonds no longer provide a tax shelter for some profitable firms .
CONCLUSIONS The present study extended prior research regarding the changes in banks' investment behavior due to tax law changes affecting the interest income from municipal bonds by assessing moderating effects of the ACE adjustment (adjusted current earnings) on municipal bond holdings . After controlling for non-tax factors such as excess bond yields from different maturity terms and profitability, the results indicate that banks that were likely to pay the AMT held lower levels of municipal bonds after the replacement of the BIA with the ACE provisions under the Budget Reconciliation Act of 1989 . The reported results also indicate that the divesture was more pronounced after the 1989 revision in the AMT formula than previously documented . One explanation for the observed reduction in municipal bond holdings by AMT banks is the increase in the amount of municipal bond interest income that is included in the AMT formula .
The Effects
of the
Alternative Minimum Tax
237
The primary purpose for the federal government granting tax-exempt status to municipal bond interest is to subsidize local government financing . The observed reduction in municipal holdings by banks would result in a higher cost of borrowing unless the proportion of assets allocated to tax-exempt securities by the household sector increased . Further research is needed to address this question . The extension of the findings herein to other industries is complicated by the segmentation in the market for municipal bonds discussed in Kidwell and Koch (1983) and Leonard (1998) . Segmentation factors, namely, region, term structures, default risk, and state tax treatment of municipal bond interest income preclude any generalization of the results . Banks' municipal bond investments are influenced by the nature of their financial liabilities, tax liabilities, and in some cases, legal requirements . The demand for municipal bonds by other major investors such as insurers and households is predicated on a different set of factors that may be irrelevant to the banking industry . Further research is needed on an industry basis to assess the AMT effect on municipal bonds demand beyond the banking industry .
NOTES l . The term "municipal bonds" is used to indicate both state and local bonds . 2 . The AMT was enacted as part of Public Law No . 99-514 in 1986 . The AMT formula was modified to replace the book-income adjustment (BIA) with the adjusted current earnings (ACE) adjustment under the Budget Reconciliation Act in 1989 (Public Law No . 101-239) . Section 7611(g) of Public Law No 101-239 authorized the Secretary of the Treasury or her delegate, to prescribe, not later than March 15, 1991 the initial items to be included in the adjusted current earnings under Internal Revenue Code (IRC) 56(g)(4)(B)(i) . The Secretary of Treasury effectively included general obligation municipal bonds under Treasury Regulations Section 1-56(g)1-(c)(6)ii . 3 . Private activity bonds are bonds issued by states or municipalities with more than 10% of the proceeds being used for private business use . General obligation bonds are paid off with general tax revenues of the respective local government . General obligation bonds were approximately 35% of the municipal issuance in 1998 (see Table 3 in Leonard, 1998) . 4 . In its portfolio re-balancing discussion, Comerica Bank reports that "The decline in (its) U .S government and agency securities principally resulted from sales and payoffs, while the tax-exempt portfolio of state and municipal securities continued to decrease as reduced tax advantages for these types of securities deterred additional investment ." pp . 29-30, Comerica Incorporated (Annual Report), 1997 . 5 . Re-offer yields are yields underwriters ask to resell municipal bonds in the secondary markets . 6 . See Table 1 for the description of ACE . 7 . See Note 5 for the definition of re-offer yield .
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BUAGU MUSAZI ET AL .
8 . Probably the author assumed that only private activity bonds were subject to AMT when actually general obligation bonds also were indirectly subject to AMT through the book income adjustment in the 1986-1989 period . 9 . The break-even yield is the municipal bond yield that equals the after-tax yield of taxable bonds . 10 . See Note 3 for the difference between general obligation bonds and private activity bonds. 11 . However, there is always the option of investing in bank-qualified municipal bonds . Bank qualified municipal bonds are from issues of less than 10 million dollars of new debt annually . The IRC allows the deductibility of interest expense on funds used to buy such bonds . 12 . For example, a bank that wishes to keep its ACE below $100 but that has $90 from life-insurance proceeds on the life of a corporate officer can only earn $10 from tax-exempt securities to avoid exceeding the $100 in ACE . A similar bank without the $90 in insurance proceeds can earn $100 from tax-exempt securities . 13 . Non-interest temporary differences (f-f,) are not easily obtained ; therefore, they are excluded . 14 . Therefore, the obtained regression coefficients represent the percentage changes in TAXEMPTt for a unit change in the respective variable . 15 . For instance, Neubig and Sullivan (1987) Table 4 shows that based on the maturity distribution of tax-exempt bond holdings by commercial banks, 13 .4% of the bonds were maturing in less than one year . 16 . The excess yield ratio over the break-even ratio is what makes municipal bonds more attractive than taxable bonds . Otherwise, the break-even yields would make municipal bonds just as attractive as taxable bonds . 17 . The rate of return was measured as pre-tax income over assets, and size was measured as the logarithm of total assets . 18 . In analyzing deferred taxes in banks' footnote disclosures, we investigated changes in the amount of AMT credit to determine whether a bank paid the AMT (as well as a dollar amount of AMT) in a given year . For instance, if in any year a bank had AMT credit x, and in year y + I the same bank had AMT credit d, the bank was assumed to be subject to AMT in year y + I if d was greater than x and the amount of AMT paid was computed as d-x. If d was less than or equal to x . then the bank was assumed to pay regular tax in year y + 1 with x-d being a dollar amount of AMT credit utilized to reduce regular tax for year y + 1 . 19 . Estimations were performed with EVIEWS 3 .0 econometrics software . 20 . Wald tests failed to reject the hypothesis that the intercept equals zero . Chi-square (X2) = 0 .080 and p = 0 .766 for the pooled weighted OLS in Table 6A, and x 2 =0 .708, p = 0 .400 for the pooled weighted OLS in Table 6B . For the random effects model, x 2= 2 .037, p =0 .153 in Table 6A, and x 2 = 1 .688, p=0,194 in Table 6B . The zero intercept test is not applicable to fixed effects models. 21 . A partial derivative of the model with respect to AMT (aln(TAXEMPT) / dAMTX = g/33 + g/34) indicates the AMT impact . If g/34 2 0, then ACE intensified the AMT impact on municipal bonds . 22 . Data limitations prevented us from using the ratio of taxes paid to tax expense . Instead, we used the proxy used in the Dhaliwal and Wang (1992) study . 23 . The Treasury Regulations for the ACE became effective as of December 31, 1989 but some provisions related to the ACE became effective after December 31, 1992 with
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the option of earlier implementation by taxpayers (U .S . Department of Treasury, Treasury Decision 8454) . It was not until March 31, 1991 that the Internal Revenue Service (IRS) published in the U .S . Federal Register a Notice of Proposed Rule Making on the ACE computation (U .S . Federal Register, 11122) . 24 . Only the results for the 10-year general obligation bonds are reported . 25, Refer to Federal Tax Form 4626 . In full, TAMT=m[PAMTI+0.75(ACEPAMTI)-NOL-AE]-FTC . 26 . This was tax deductible before TRA86 but the deduction was gradually phased out .
REFERENCES Board of Governors, Federal Reserve System (1986-1993) . Flow of Funds Accounts for the United States: Annual Flows and Outstanding . Boynton, C. E., Dobbins, P . S ., & Plesko, G. A . (1992) . Earnings management and the corporate alternative minimum tax . Journal of Accounting Research, 30, 131-159 . Budget Reconciliation Act of 1989 . Public Law No . 101-239, Sec . 7611(g) . Comerica Incorporated (1997) . Annual Report . Cummis, I . D ., & Grace, E . (1994) . Tax management and investment strategies of property-liability insurers . Journal of Banking and Finance, 18, 43-72 . Dhaliwal, D ., & Wang, S . (1992) . The effect of book-income adjustment in the 1986 alternative minimum tax on corporate financial reporting . Journal of Accounting and Economics, 15, 7-26. Gramlich, J . D. (1991) . The effect of the alternative tax book income adjustment on accrual decisions . Journal of American Taxation Association, 13, 36-56. Green, M . J . (1994) . Envisioning a tax-exempt future . American City and County . Hein, S . E ., Koch, T ., & Macdonald, 5 . (1995) . The changing role of commercial banks in the municipal securities market . Journal of Money, credit, and Banking, 27, 894-906 . Henderson, B . C . (1996). The corporate alternative minimum tax : tax burdens and investment and financing decisions of commercial banks . Unpublished doctoral dissertation, Arizona State University, Arizona . Ibbotson Associates (1999) . Web site, www.Jbbotson .cam Kidwell, D., & Koch, T . (1983). Market segmentation and the term structure of municipal yields . Journal of Money, Credit and Banking, 15, 40-55 . Leonard, P. (1998). Tax-induced segmentation in the tax-exempt securities market. Quarterly Journal of Business and Economics, 37, 27-47 . Manzon, G . B ., & Plesko, G. A . (1999) . Strategic disclosure for political gain: the case of the corporate alternative minimum tax . Working Paper 2000. Massachusetts Institute of Technology . National Automated Accounting Research System (1999) . Neubig, T. S ., & Sullivan, M . A . (1987) . The implications of tax reform for bank holdings of taxexempt securities . National Tax Journal, 60, 403-418 . Scholes, M ., Wilson, P ., & Wolfson, M . A. (1990) . Tax planning, regulatory capital, and financial reporting strategy for commercial banks . The Review of Financial Studies, 3, 625-650 . Shevlin, T . (1990) . Estimating corporate marginal tax rates with asymmetric tax treatment of gains and losses . Journal of American Taxation Association, 1, 51-67 .
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Shevlin, T . (1999) . A critique of Plesko's "An evaluation of alternative measures of corporate tax rates" . Working Paper, Seattle, WA . : University of Washington . Tax Reform Act of 1986 . Public Law No. 99-5/4 . Washington D.C ., U .S. Government Printing Office. U .S Department of the Treasury, Internal Revenue Service (1999) . Treasury Regulations. U .S . Department of the Treasury . 12/21/1992 Treasury Decisions. TD 8454. U .S . Federal Register (1991) . 11122 .
APPENDIX 1 In general, a firm pays the alternative minimum tax (AMT) when its tentative alternative minimum tax (TAMT) exceeds its regular tax (tTI) . That is, AMT =TAMT-tTl, if positive, where t is the regular statutory corporate tax rate and TI is the regular taxable income . To avoid the AMT, a firm can structure its transactions in such a way that the TAMT just equals the regular tax (tTI). In other words,
TAMT = tTI.
(Al)
Assuming no net operating losses (NOL) ; no foreign tax credits (FTC), and that the ACE adjustment is positive, the statutory formula 25 for TAMT per unit of assets is m (0 .25PAMTI + 0 .75ACE - AE), where = statutory corporate alternative minimum tax rate . m PAMTI = pre-adjustment alternative minimum taxable income per unit of assets . ACE = adjusted current earnings per unit of assets . AE = AMT exemption per unit of assets . Assume TI =ro(l-a-a,)-r,,+fr, where ru = return on a unit of taxable securities . a = proportion of assets invested in general obligation municipal bonds . a9 = proportion of assets invested in private activity municipal bonds . rr = interest expense on funds invested in a unit of municipal bonds ." f, = non interest taxable income per unit of assets . From Equation Al,
The Effects of the Alternative Minimum Tax at (0 .25PAMTI+0 .75ACE-AE)=t(r,,(1-a-a,,)-r +f )
241 (A2)
Assuming that PAMTI equals taxable income plus some statutorily determined AMT adjustments and preferences (AP), then PAMTI = TI + AP = [r,,(l -a-a,)-r + f ] + [(r a„+(3)f-f,p), where r = return on a unit of tax-exempt (municipal) securities, f non-interest financial income per unit of assets, (3 = proportion of AMT timing differences in (f-f,) e .g . depreciation . Substituting for PAMTI in A2, and assuming AE = r = 0, then m (0 .25{ r,,(I-a-a„) + f, + (r, a,, + Off -f,))} + 0 .75ACE) (A3) = t(r,,(1-a-a) + f t)) Collecting similar terms in A3 and solving for a and athe optimal level of general obligation (a) and private activity bond (a ,,) ratios are as follows for AMT firms : General obligation bonds proportion (a) :
a - (t-025m)r„ [t(r,r(1--a„) + f,)-m{0 .25((r,,(l-aP) + f) (A4a) + (3(f-f) + r"a„) + 0 .75ACE) I Such that -I<_a<_1 The proportion of general obligation bonds should be equal to the ratio of AMT (difference between regular tax [t(r„(I-a,,) + f,)] and the TAMT without income from general obligation bonds) to total tentative minimum alternative tax (TAMT) attributable to interest income (t-0 .25m)r . Note that investments in general obligation bonds (a) decrease as investments in private activity bonds (a,,) increase . This is because private activity bonds interest income, which is included in AMT preferences, increase the likelihood of AMT ; therefore, purchasing additional general obligation bonds would make matters worse off.
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As a numerical demonstration, assume : AMT rate (m) = 0 .20 ; marginal tax rate (t) = 0 .34 ; tax-exempt bond yield (rfz) = 0 .07 ; taxable bond yield (r) = 0 .08 ; proportion of AMT sensitive timing differences (/3) = 0 .50; non-interest financial income per unit of assets (f) = 0.50 ; non-interest taxable income per unit of assets (f) = 0 .20 ; private activity bonds (aP) = 0 .00, and the level of adjusted current earnings per unit of assets (ACE) = 0 .50. A bank with such parameters should hold about 19% of its assets in general obligation municipal bonds in order to avoid the AMT . Note that if the ACE ratio is excessive, the right hand side becomes negative implying that such a bank should not hold any municipal bonds if it has to avoid or minimize its AMT . Private activity bonds proportion (a) : 1 aP
.25mr,,[t(r"(1-a) + f,)-m(0 .25((ru(1-a) + f) - (t-0 .25m)r, r + 0
(A4b) +(3(f-f) )+0 .75ACE)]
Such that -1
Similarly, the proportion of private activity bonds should be equal to the proportion of AMT to TAMT attributable to interest income without private activity bonds . Note that the ACE elements also include general obligation (a) interest income . The condition should hold, otherwise the bank would be paying the AMT . When TAMT exceeds the regular tax, the proportion is negative (a, < 0) implying that the bank should divest municipal bonds . As a numerical demonstration, assume : AMT rate (m) = 0 .20 ; marginal tax rate (t) = 0 .34; tax-exempt bond yield (rax) = 0 .07 ; taxable bond yield (r,,) = 0 .08 ; proportion of AMT sensitive timing differences (/3) = 0 .50; non-interest financial income per unit of assets (f) = 0 .50 ; non-interest taxable income per unit of assets (f) = 0 .20 ; general obligation bonds (a) = 0 .00, and the level of adjusted current earnings per unit of assets (ACE) = 0 .50. A bank with such parameters should hold about 16% of its assets in private activity municipal bonds in order to avoid the AMT . Note that if the ACE ratio is excessive, the right hand side becomes negative implying that such a bank should not hold any municipal bonds if it has to avoid or minimize its AMT . The impact of any external stimulus on municipal bond investments is analyzed by examining the changes in the respective proportions (a, a„) as follows :
243
The Effects of the Alternative Minimum Tax
Assuming no changes in tax rates (t, m) and the proportion of AMT sensitive temporary differences (/3) (i .e . At = Am = A/3 = 0), then ;
Aat,=
tA(r, r (1-a)+ f) -m(0 .25(A(r„(1 - a) + f) L + (3A(f -
(A5)
,Q) + 0 .75AACE)
- a,,(tAr,, + 0 .25mA(r,,-r,,))]
where II = (t-0 .25m)r,, + 0 .25mrC, and A represents a change in the respective variable . The changes in general obligation bonds proportion (Aa) can be similarly determined .
THE EFFECT OF CAPITAL GAINS TAX POLICY ON INVESTMENT COMPANY CAPITAL GAINS REALIZATIONS Claire Y . Nash, W . Mark Wilder and Morris H . Stocks
ABSTRACT Investment companies dominate U .S. equity markets, both in terms of the large proportion of equity capital they control and the sizable trading volume they generate. This shift in the ownership of U.S . equity securities could lessen the impact of changes in U .S. capital gains tax policy which are aimed at individual investors . This paper examines the effect of capital gains tax rates on investment company capital gains realizations . Empirical tests on cross-sectional, time-series data provide evidence of an unlocking effect of lower marginal capital gains tax rates. Investment companies exhibit economic response behavior consistent with the lock-in effect characteristic of individual investors . Capital gains realized are higher during periods of low marginal capital gains tax rates. The significant permanent tax effects estimated in the analysis are strengthened when transitory effects are introduced into the model.
Advances in Taxation, Volume 14, pages 245-270. Copyright © 2002 by Elsevier Science Ltd . All rights of reproduction in any form reserved . ISBN : 0-7623-0889-3 245
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INTRODUCTION The Taxpayer Relief Act of 1997 reduced the maximum marginal capital gains tax rate from 28% to 20%, significantly increasing the after-tax return on investment. The enacted change codifies the belief that preferential treatment of capital gains helps alleviate the lock-in by investors to appreciated assets in an effort to avoid the capital gains tax . The effects of taxation on the realization of capital gains in the United States have been the subject of considerable controversy and debate . Brazer (1978), summarized the distortive effects of taxing capital gains in the following statement before the House Ways and Means Committee : Subjecting capital gains to tax tends to induce investors who hold appreciated assets to refrain from selling them, even when wise portfolio management might, in the absence of tax considerations, suggest selling . This 'lock-in' effect reduces liquidity, impairs the mobility of capital and may be conducive to a wider amplitude of fluctuations in market prices (p . 134) .
Since Brazer's address to the Congress, numerous studies have been conducted investigating whether individuals unlock unrealized capital gains in response to lower marginal capital gains tax rates . However, during the past two decades, dominance in the U .S . equity markets has shifted from individual investors, who own equity securities directly, to investment companies who own equity shares on behalf of individuals . Between 1975 and 1993, the share of the U .S . equity market owned through open-end investment companies nearly tripled, from approximately 4% to approximately 11% (U .S . House of Representatives, 1995) . In 1995, investment company assets rose to $2 .7 trillion, an investment equal to approximately 34% of U .S . equity market capitalization (U .S . Senate, 1996). Open-end investment companies have accounted for as much as 96% of the new money flowing into exchange listed stocks (U.S . House of Representatives 1993) .' Because of this ownership shift, the recent change in capital gains tax policy aimed at individuals may not have the intended unlocking effect 2 Prior empirical investigations of the lock-in effect have largely focused on individual capital gains realization behavior. These analyses have ignored the fact that capital gains realized by investment companies are an increasingly important determinant of the aggregate effects of changes in capital gains tax policy . Predictions about the economic effects of changes in capital gains tax rates must be viewed as tenuous if the effects of policy changes on all market participants are not considered (Auten et al ., 1989) . The purpose of this paper is to determine whether : (1) investment company capital gains distributions are responsive to marginal capital gains tax rates ; and (2) investment companies "lock-in" in response to enacted changes in capital
The Effect of Capital Gains Tax Policy
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gains tax policy . Since investment company ownership of securities traded in the U .S . capital markets has increased dramatically, this study implicitly investigates the extent to which reinstating the preferential tax treatment of realized capital gains achieves the objectives of tax policy makers . The analysis employs a panel data set to follow a sample of open-end investment companies . Investment company capital gains distributions during a 15-year period are regressed on marginal capital gains tax rate variables as well as economic control variables . The study uses an error-components regression model to observe the relationships across the three capital gains tax policy regimes in effect during the 15-year period . This study hypothesizes that changes in the marginal capital gains tax rate would have no effect on investment companies, which are not subject to direct taxation on their capital gains . Contrary to this hypothesis, the findings indicate that changes in marginal capital gains tax rates influence the level of investment company capital gains distributions . Specifically, a statistically significant unlocking of capital gains by investment companies occurs during periods of lower marginal capital gains tax rates . This study extends econometric and tax research that examines the response of individual investor capital gains realizations to changes in capital gains tax policy . It examines the effects of such changes on an industry that has grown in importance to the capital markets . Knowledge about investment company response to capital gains tax policy is important to tax policy-makers who consider the broader question of the economic efficiency of the tax system . Prior research provides convincing evidence that changes in the capital gains tax rate affect the level of capital gains realized by individuals, and of the unlocking effect of lower capital gains tax rates (Feldstein et al ., 1980 ; Minarik, 1981 ; Amen & Clotfelter, 1982 ; Cook & O'Hare, 1987 ; Burman et al., 1994 ; Burman & Randolph, 1994) . The next section of this article provides the background for the study and reviews the prior research . The third section develops the hypothesis and describes the research methods . The fourth section discusses the research results . The final section provides a summary of the research as well as concluding remarks .
BACKGROUND AND PRIOR RESEARCH Background
Investment companies play a significant role in opening the securities markets to millions of Americans . However, their expansion represents a shift in and a
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concentration of capital investment decisions . Markets generally evaluate investment company performance, capsuled in its reported net asset value (NAV) on a pre-tax basis . Investment company fund managers have little incentive, other than concern for shareholder tax consequences, to lock-in to appreciated assets yielding less than optimal returns to delay the recognition of capital gains . 3 The wealth of an investor who holds a share of an investment company also is evaluated on a pre-tax basis . An extension of the investor model developed by Auerbach (1991) is used here to illustrate the benefit to shareholders when an investment company defers capital gains . An investment company shareholder will have pre-tax wealth (W,) at the end of the period of: WPI = NAVt i + (NAV, I * r)
(1)
where NAV,_ 1 is the net asset value of a share in the investment company at the beginning of the year t, and the annual return of the fund, r, is the yield from dividends net of fund expenses (r), plus unrealized and realized capital gains per share (r) . The success of an investment company manager typically is measured in terms of pre-tax return or net asset value . However, the return on a substantial percentage of investment company assets is subject to taxation, and the economic return to investors is much lower when returns are adjusted for the effect of taxes . Adjusting Eq . (1) for taxes, the end-of-the-period wealth of a shareholder (W) of the fund subject to a tax rate of t > 0 is :'
W,=NAV,
1 + [NAV1
[(1-t) * r)]]
(2)
When capital gains are taxed at preferential rates, the shareholder's end-of-theperiod wealth is increased by the rate differential between t8 , the tax rate on capital gains, and to , the tax rate on ordinary income . A shareholder who has a dividend return of r,, and capital gains of r g and who is subject to taxation at a rate of tR , to > 0 will have an end-of-the-period wealth (W,,,) of: Wdg,=NAV, + [NAV, , [( 1-tg) * rx)]1 + [NAV, [(I-to ) * r1,]]
(3)
The marginal benefit (MB) to the investor of preferential tax treatment of capital gains is : MB = NAVt i *
[( to -Q* r8 ]
(4)
The Effect of Capital Gains Tar Policy
249
The decision to realize capital gains rests solely with investment company managers . When investors relinquish the ability to defer capital gains they give up this marginal benefit . For many, the resulting payment of taxes on the capital gains distributed by investment companies may be an economic consequence of investing through these companies .
Prior Research The Lock-in Effect Econometric and tax studies show that there is an inverse relationship between capital gains realizations and the capital gains tax rate (Feldstein et al ., 1980 ; Minarik, 1984 ; Auten & Clotfelter, 1982 ; Burman & Randolph, 1994) . Extant research includes convincing evidence that demonstrates the existence of both transitory and long-run lock-in effects (Amen & Clotfelter, 1982 ; Minarik, 1981 ; Burman & Clausing, 1994 ; Burman & Randolph, 1994) . Transitory effects result from temporary fluctuations in taxpayer capital gains tax rates that may be due to variations (increases or decreases) in taxable income or changes in individual tax minimizing strategies . Long-run effects are permanent effects that result from variations in the capital gains tax rate over time and expected differences in the sources and characters of taxpayer incomes . Prior research generally shows that when the marginal tax rates on capital gains are high, the lock-in effect is quite large (Feldstein & Yitzhaki, 1978 ; Feldstein et al ., 1980 ; Cook & O'Hare, 1987) . Evidence from crosssectional and time-series studies investigating individual capital gains realization responses is consistent regarding the significance of the responsiveness of capital gains realizations to capital gains tax rates . Feldstein and Yitzhaki (1978) found that the portfolio rebalancing decisions of investors were quite sensitive to tax considerations . Evidence from that study suggested that marginal tax rates on long-term capital gains affect the level of capital gains realizations . Interestingly, Feldstein and Yitzhaki found that the capital gains marginal tax rate was a less important factor in investment decisions influenced by consumption constraints . The research of Feldstein et al . (1980) provided the first evidence of the inverse relationship between capital gains marginal tax rates and capital gains realizations . They found that high rates of tax on capital gains substantially reduced sales of appreciated corporate stock . Later econometric investigations of investor capital gains realization behavior attempted to provide more precise estimates of the change in capital gains realizations attributable to a change in
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the capital gains tax rate . The relationship between capital gains tax rates and capital gains realizations was found to be inelastic in several studies (Minarik, 1981 ; Amen & Clotfelter, 1982) . Minarik (1981) found that the estimates in cross-sectional studies overestimated the lock-in effect. Much of the effect observed could be attributed to the response of taxpayers to fluctuations in their own effective income tax rates, as opposed to the statutory level of capital gains tax rates . Minarik separated transitory effects by including several independent variables to measure taxpayer propensity to engage in gains trading . The independent variables for transitory influences reduced the measured effect of the capital gains tax . Both the Feldstein et al . (1980) and Minarik (1984) studies used cross-sectional databases which did not permit capital gains realizations responses to be identified as either temporary responses (due to changes in investor tax position) or permanent "unlocking" responses (due to changes in tax rates) . Cross-sectional studies do not permit researchers to separate transitory effects that are due to the variability in individual tax positions from the permanent effects of lower tax rates . Cook and O'Hare (1987) used time-series data to overcome biases associated with relying on a single cross-sectional sample of taxpayers to make inferences about permanent effects on capital gains realizations . Their findings were consistent with earlier cross-sectional studies . Studies by Auten and Clotfelter (1982), Burman and Randolph (1994), and, Burman et al . (1994) show that the level of capital gains realizations is positively related to temporarily low marginal capital gains tax rates . They examine the impact of changes in tax rates on the economic behavior of a sample of taxpayers using a panel data set . These studies provide evidence of the responsiveness of taxpayers to transitory variations in capital gains tax rates . In related studies that examine the extent to which anticipated tax rate changes impact capital gain realizations, Auerbach (1988, 1989) showed that future tax rate changes also are relevant to investors' current capital gain realization decisions . Burman et al . (1994) examined taxpayer responses to the temporary variation in tax rates existing between the enactment of the Tax Reform Act of 1986 (TRA 86) and its effective date . The significant effects noted in both studies provide additional evidence of the responsiveness of taxpayers to transitory variations in their capital gains tax rates . Tax Policy and Investment Company Trading Decisions Investment company capital gains distributions have become a larger part of the net capital gains realized by taxpayers . Yet, there is little academic research which examines the impact of tax policy on the trading decisions of investment company managers . In an empirical study investigating the tax
The Effect of Capital Gains Tax Policy
25 1
efficiency of mutual funds, Jeffrey and Arnott (1993) examined after-tax investment company growth and constructed a relationship between portfolio turnover and investment company after-tax growth . They suggest that taxes represent the greatest source of investment company portfolio management inefficiency, and they conclude that taxes on capital gains consumed a larger percentage of a fund's pretax return than dividends . In addition, they find that high portfolio turnover is associated with lower after-tax returns to shareholders .' More recent research has attempted to examine whether mutual fund managers consider the tax consequences of capital gains distributions to individual investors . Barclay, Pearson and Weisbach (1998) derive and test a model which specifies that unrealized gains in the fund's portfolio (i .e . "built-in" gains or capital gains overhang) increases expected future taxable distributions . Such unrealized gains, therefore, increase the present value of a new investor's tax liability . If mutual fund managers consider investor tax consequences, they must trade off the interests of current investors versus potential investors . Specifically, all else being equal, current investors prefer deferral of capital gains (i .e . resulting in a larger overhang) while potential new investors prefer a smaller overhang (i .e . resulting in a lower present value of the new investor's tax liability) . Barclay et . al . (1998) find that funds appear to manage their portfolios based on a target overhang . Kraft and Weiss (1998) also consider overhang and investigate whether mutual fund managers are tax sensitive by testing whether changes in capital gains tax rates influence capital gains distributions . Of particular interest in the Kraft and Weiss study is whether managers balance the conflicting capital gains tax implications, due to overhang, for current versus potential investors . They provide descriptive evidence that average capital gains yield for open-end stock funds is highest (lowest) when marginal capital gains tax rates are lowest (highest) . However, in tests examining only years in which significant tax rate changes occur, their results differ . Specifically, when the capital gains tax rate is decreasing (increasing), the average capital gain yield is decreasing (increasing) . The Kraft and Weiss (1998) analysis is not directly comparable to the present study due to differences in the time periods under investigation and the sources of mutual fund data . In addition, their measure of capital gains realization (capital gains yield) is different from the one used in the current analysis . Other research has considered the issue of whether investors structure their investment holdings in a tax efficient manner . The findings have been mixed . For example, Bergstresser and Poterba (2000) investigate whether investors consider the effects of taxation on mutual fund share returns when making
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CLAIRE Y . NASH ET AL .
decisions on which fund shares to purchase or redeem . Their findings suggest that taxation may play a role in the way investors select their funds (e .g . funds with higher after-tax returns attract greater inflows than ones with lower after-tax returns) . The results of Barber and Odean (2000), however, suggest that many taxable investors holding equity mutual funds do not pursue trading strategies that result in maximization of after-tax retums . 6
RESEARCH METHOD Hypothesis It appears that investment company managers may not be highly motivated to engage in tax minimizing strategies because investment companies are not subject to a corporate level income tax .' However, a significant number of investment company shares are held in taxable accounts and a tax efficient investment company should consider the tax consequences to shareholders when implementing its investment strategies .' The extent to which investment company capital gains distributions are influenced by changes in capital gains tax policy is summarized, in null form, in the following hypothesis : HI : The level of investment company capital gains distributions is unrelated to the capital gains tax rate and therefore is not significantly different across tax regimes . The structural consistency of investment company response to capital gains tax rates across three distinct tax regimes is tested to determine whether the level of investment company capital gains distributions is significantly related to capital gains tax rates . These regimes are pre-TRA 86, TRA 86, and post-TRA 86 . Table 1 presents the time period included in the sample and indicates the years in which tax law changes separate the time series investigated into these three tax regimes . Model A pooled cross-sectional, time-series single equation regression model that includes a set of dummy variables (MTR) is developed to measure the permanent effects. Prior research shows that parameter coefficients estimated
The Effect of
Capital
Gains
25 3
Tax Policy
Marginal Tax Rates on Capital Gains (1982-1996) .
Table 1 .
Year
Tax Rate (%)
1982 1983 1984 1985 1986 1987' 1988 2 1989 1990 1991' 1992 1993 1994 1995 1996
20 20 20 20 20 28 33 33 33 28 28 28 28 28 28
Tax Policy Regime
Pre - TRA 86 (1982-1986)
TRA 86 (1987-1990)
Post -TRA 86 (1991-1996)
Source : Internal Revenue Code .
Notes : ' The TRA 86 tax rate increase was phased in over two years, resulting in a cap of 28% for capital gains realized in 1987 . '-The marginal tax rate on capital gains is 33% for taxpayers with income in the range in which the benefits of personal exemptions and the 15% tax rate are phased out . ' The Omnibus Reconciliation Act of 1990 reinstated the 28% cap on capital gains .
solely from cross-sectional data may reflect transitory variations in the circumstances of individual investment companies as much as they may indicate a response to changes in capital gains tax policy . In this study, the characteristics of earlier cross-sectional and time-series studies are combined to investigate investment companies' responses to legislated changes in the capital gains tax rate . The single equation model is assumed to be linear and is estimated in the following form : g ;, = or,, + /3 1 MTR,
+ 13,X, + u,,
(5)
where : g1,
= represents the per share capital gains distributions of an investment company, i, at time t ; = is the intercept ;
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CLAIRE Y. NASH ET AL .
MTR,
= is the marginal capital gains tax rate (20%, 28%, 33%) at time t represented by two dummy variables for the distinct tax regimes
during the observation period : MTR1 (pre-TRA 86) = "1" if t = 1982 through 1986, "0" otherwise MTR3 (post-TRA 86)="I" if t=1991 through 1996, "0"
u it
otherwise ; = is a vector of independent variables (control and exogenous) included to measure transitory effects ; and = is a random error term .
A semilog functional form of the model is used . The semilog functional form, log of the capital gains dependent variable and log of micro- and macroeconomic independent variables, has been used in prior research examining individual capital gains realization response (Auten & Clotfelter, 1982 ; Lindsey, 1987 ; Auerbach, 1988 ; Auerbach, 1989 ; Burman et al ., 1994) . In these studies, a semilog model explained a significant portion of the variation in capital gains . The marginal tax rates of individuals are endogenous, reflecting a level of income that includes capital gains . Unlike individuals, investment companies are not taxed directly on capital gains . Investment company managers have limited knowledge about the tax positions of their shareholders . Therefore, the marginal tax rate on long-term capital gains (MTR) at time t is the variable used to represent the tax rate investment company managers consider when making capital gains realization decisions . Transitory effects, alternative explanations for realizing capital gains, and systematic non-tax factors that may influence investment company capital gains realizations, are considered and controlled for in X . The inclusion of X in the regression model (a vector of company-specific characteristics, and micro- and macro-economic variables) permits an analysis of the separate permanent effects of changes in capital gains tax policy measured by MTR. Inclusion of transitory micro- and macro-economic variables in X also reduces the probability of overstated permanent effects . X is a vector of the following exogenous variables affecting investment companies' capital gains distributions at time t . Each observation in the sample is identified by its cross-section, i, and time-series, t, component . NAV, 1 - per share net asset value at the end of the previous year DIV - per share dividends distributed to shareholders during the year
TURN - annual turnover rate of the investment company SIZE - total net assets at the end of the year
The Effect of Capital Gains Tax Policy
255
LOAD
- dummy variable indicating load or no-load status during time
MGR
- dummy variable indicating a change in portfolio manager during
DJIA
- percentage change in the Dow Jones Industrial Average stock
t (0 = no-load, 1 = load) time t (0 = no change, 1 = change) market index during time t REDM - redemption rate, an industry measure of the percentage of
investment company shares redeemed (bought back) during time t by growth and growth-and-income investment companies SHARE - an industry measure of the percentage of investment company assets held in taxable accounts of individuals during time t by growth and growth-and-income investment companies COMP - a measure of competition calculated as the percentage change in the number of open-end stock and bond-and-income investment companies during time t . Description of Variables in Vector X Investment company net asset value at the beginning of the period, NAV, , is a proxy for the stock of accrued unrealized capital gains at the beginning of the period . The stock of accrued capital gains may be a determinant of the level of subsequent capital gains distributions . NAV, , represents the per share value of the securities that could have been sold during time t . Capital gains distributions during time t should be positively related to the net asset value of the investment company at the end of the previous year . Investment company return is a combination of dividends (net of fund expenses), and realized and unrealized capital gains . Investment company managers, concerned with maximizing net asset value, should increase trading activity when the level of dividends, DIV, has not met fund income objectives . The probability of incurring capital gains should decrease (vary inversely) with dividend income . The DIV coefficient therefore should be negative . Turnover rate, TURN, the ratio of the lesser of sales or purchases to assets, is a measure of investment company asset turnover during the year . Jeffrey and Arnott (1993) examined the relationship between turnover and investment company after-tax returns and found a statistically significant positive correlation between investment company average turnover and the amount of taxes that would be due on investment company capital gains distributions . The level of capital gains distributed by an investment company to its shareholders should be directly related to its turnover ratio . Growth and growth-and-income investment companies have large diversified equity portfolios . The probability of selling securities should be directly related
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CLAIRE Y . NASH ET AL .
to the level of investment company security holdings, SIZE . Capital gains distributions should be an increasing function of portfolio size and the coefficient of SIZE should be positive . While the load/no-load status, LOAD, of an investment company may affect the level of investor interest in the fund and therefore its size, there is no reason to expect a priori that this firm characteristic would be systematically related to investment company capital gains distributions . The LOAD variable is included because it is one of the most frequently used characteristics differentiating investment companies . The behavioral differences among investment company portfolio managers, such as their attitudes toward risk, could influence the propensity of the fund to realize gains . MGR is a dummy variable that represents a change in portfolio manager during the year . A change in the portfolio manager may reflect a change in the investment company's propensity for risk taking or result in portfolio rebalancing . There is no prediction for the direction of the MGR coefficient . Capital gains are realized in years of high prosperity (Seltzer 1951) and should vary directly with national economic growth. Minarik (1988) used the annual average value of the Dow Jones Industrial Average (DJIA) index as a measure for economic growth and found significance . The DJIA variable in this study is a market return measure that captures economic growth and proxies for other unobservable macro-economic influences . The DJIA coefficient is expected to be positive . Investment company capital gains realizations may be viewed as a function of portfolio rebalancing and consumption decisions . Redemption of shares on demand is the largest consumption item of investment companies . Redemptions in excess of cash flowing into investment companies will cause investment companies to sell assets to meet redemption requirements . Transactions executed in response to shareholder redemptions result in the realization of capital gains or losses . REDM is the annual redemption rate for all investment companies characterized as growth and growth-and-income investment companies during the year . The annual redemption rate is the dollar redemption volume as a percentage of average assets (Investment Company Institute, 1996) . Investment company capital gains distributions will vary directly with the annual redemption rate, REDM, for growth and growth-and-income funds . The extent to which investment company assets are held in accounts owned by individuals who are subject to taxation on an annual basis (taxable accounts) may affect the company's investment strategies . When a significant percentage of assets are held in taxable accounts, investment company portfolio managers may give greater consideration to capital gains tax policy affecting the return
The Effect of Capital Gains Tax Policy
257
to shareholders . While the deferral of capital gains generates no tax burden for shareholders, returns in the form of capital gains should be preferred when capital gains are taxed at preferential rates . SHARE is an estimate of the percentage of growth and growth-and-income investment company assets held in taxable accounts each year.' The annual percentage of all growth and growth-and-income investment company assets held in taxable accounts is estimated from data contained in the annual Investment Company Institute Mutual Fund Fact Book. The relationship between SHARE and investment company capital gains distributions is not predicted a priori . The competition created by the entry of new investment companies in the market may force existing (as well as the new) investment companies to be more responsive to shareholder concerns . A significant percentage of investment company assets are held in taxable accounts owned by individuals . Competition for investment dollars among investment companies could cause the firms to be more sensitive to shareholder tax consequences . The competition measure, COMP, captures the growth in the investment company market . It is the percentage change in the number of investment companies in the market from year to year . The change in the number of open-end investment companies existing at the end of each year will be taken from the annual Investment Company Mutual Fund Fact Book . The direction of the COMP coefficient is unpredicted .
Statistical Method To alleviate statistical problems associated with cross-sectional correlation, the Fuller-Battese generalized least-squares regression method (Fuller and Battese 1974) is used to estimate the model given by equation 5 . The Fuller and Battese approach is a variance components model that : (i) estimates a covariance matrix ; (ii) transforms the variables in the model, and ; (iii) employs ordinary least-squares regression on the transformed data . The random errors of the classical regression model are decomposed into the three elements contributing to individual investment company error (u) . The elements of individual company error, u, in the random error vector a can be written as : u,, = v, + e, + e,,, where i = 1, 2, . . ., N and t=1,2, . . ., T
(6)
The v , components represent the net result of individual investment company effects, the e, components are the time period effects, and the e n are remaining random effects of omitted variables which vary over both time and
25 8
CLAIRE Y . NASH ET AL .
cross-sectional dimensions . The remaining e a effects are measures of the effect of omitting unmeasurable or unobservable variables which may be important to the analysis (Dielman, 1989) . Fuller and Battese assume that each of the decomposed error terms is independently distributed with zero means and variances a', a', and o- 2 (Fuller & Battese, 1974) . Fuller and Battese give sufficient conditions for the generalized least squares estimates to be unbiased if the errors are symmetric around zero, have fourth moments and the expectation of (a') - ' exists (Fuller & Battese, 1974) . Sample Selection and Data The sample is comprised of 149 open-end investment companies with inception dates prior to January 1, 1982, that are classified as growth or growthand-income funds in the Morningstar Mutual Funds database as of December 31, 1996. In order to observe and contrast investment company responses during the three tax regimes, investment companies in the sample must have been in continuous operation during the 15-year period from 1982 through 1996 . The sample is limited to investment companies with growth or growth-andincome as portfolio objectives because of their significant equity securities portfolios and their propensity to engage in capital gains trading . The investment companies included in the sample represent approximately 58% ($454 billion) of the total net assets of all growth and growth-and-income funds as reported by the Investment Company Institute (1997) as of December 31, 1996 . 10 The estimates that are obtained from these data are intended to represent the capital gains distributions for the 15-year period . The panel data set constructed for the 15-year period provides a total of 2,235 observations . Data collected from the Morningstar database include g, DIV, TURN, SIZE, NA V, and MGR . The capital gains distributions reported by Morningstar were adjusted when they included short-term gains distributed to shareholders . Changes in LOAD status were determined by reference to Wisenberger Investment Company Year Books . Annual information published in the Investment Company Institute Mutual Fund Fact Book was used as the source for REDM, SHARE, and COMP. Descriptive Statistics Table 2 presents the ranges, means and standard deviations for capital gains distributions, dividend income, turnover ratio, total net assets and net asset values for the sample across the 15-year time-series . Large variation exists among g, DIV, NA V, and SIZE. This is not unexpected, given the range of the variables, the size of the sample, and the time period . Investment companies
25 9
The Effect of Capital Gains Tax Policy Table 2.
Characteristcs of Investment Companies (1982-1996) n = 149 .
Capital gains distributions (g) Dividend Income (DIV) Turnover ratio% (TURN) Total net assets (SIZE) Net asset value (NAV)
Range
Mean
Standard Deviation
0.00-10.64 0,00-10.00 0-679 0 .0009-53 .98 2 .13-85 .98
0 .91 0.36 79 1 .05 14 .33
1 .08 0 .37 69 2 .99 8 .69
Note : Capital gains distributions, dividend income, and net asset value are per share dollar amounts . Net assets are as of the beginning of the period and are in billions .
in the sample grew considerably during the 15-year period . The mean net asset size of the sample was $219 million in 1982 compared with $3 .05 billion in 1996 . On average, investment companies included in the sample are 22 times larger in 1996 than they were in 1982 . Table 3 presents the characteristics of the investment companies summarized by portfolio objective (growth or growth-and-income), load status, and total net asset size (large : equal to or greater than one-half $billion ; small : less than one-half $billion) . Growth funds have paid out a larger percentage of their combined dividend income and capital gains distributions as realized long-term capital gains (78%) than their growth-and-income (64%) counterparts . Table 4 presents the average annual capital gains and dividend income distributions for the entire sample and for the sample classified by portfolio objective for 1982-1996 . The dividend income distributions of growth funds have been lower than those of growth-and-income funds, as expected, given their portfolio objectives . Similarly, as expected, capital gains distributions for growth funds have been consistently higher, on average, than their respective dividend income distributions . It is apparent from Table 4 that capital gains distributions were larger in 1986 and 1987 than any other years across the three regimes ." The higher capital gains distributions in 1986 may have resulted from a response by investment companies to an increase in the marginal tax rate on capital gains from 20% to 28% beginning in 1987 . Similarly, higher capital gains distributions in 1987 are likely due, in part, to the phase out of lower capital gains tax rates continuing through the year as well as to heightened trading activity surrounding the stock market crash in the last quarter of the year . Alternatively, or in addition to the above, the 1986 increase in capital gains
260
CLAIRE Y. NASH ET AL. Table 3.
Growth Companies Growth-andIncome Companies No-load Companies Load Companies Largest > one-half billion Smallest < one-half billion
Investment Company Group Characteristics (1982-1996) .
Mean CG Dist.
Mean Dividend Income
CG Dist. As a % of Total Dist. (CG+ dividends)
Mean Turnover Ratio (%)
Mean Total Net Assets
Meam Net Asset Value
n = 89
0.98
0.28
0 .78
86
0 .90
14 .41
n = 60
0.81
0.46
0 .64
69
1 .26
14 .21
n = 70
0.99
0.41
0 .71
83
0 .86
16 .96
n=79
0.83
0.30
0 .73
77
1 .21
12 .03
n=93
0.94
0.39
0 .71
83
1 .61
15 .33
n=56
0.85
0.31
0 .73
74
0 .12
12 .68
Note : Capital gains distributions, dividend income and net asset values are per share amounts .
Total net assets are in billions .
distributions could have been the result of increased portfolio sales activity necessary to meet shareholder redemption activity which occurred in response to the change in marginal tax rates . The possibility that capital gains resulted from this consumption activity is controlled for in the analysis by including a variable capturing the effect of net redemption activity (on capital gains distributions) .
EMPIRICAL RESULTS Three specifications of equation 5 were estimated using a log functional form and these results are referred to as the "semilog" models . Specifically, the following three regression equations are estimated for each transformation : Model I - a parsimonious model estimating permanent effects alone ; Model II
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The Effect of Capital Gains Tax Policy Table 4.
Average Annual Capital Gains Distributions and Dividend Income (per share amounts) : 1982-1996 . Entire Sample n=149
Growth Cos . n=89
Growth and Income Cos . n=60
Year
Capital Gains
Income
Capital Gains
Income
Capital Gains
Income
1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996
0.51 0.70 0.92 0.60 2 .03 1 .67 0 .40 0 .82 0 .46 0 .57 0 .76 1 .03 0 .79 0 .97 1 .40
0 .45 0 .39 0 .37 0 .40 0 .37 0 .42 0 .38 0 .44 0 .40 0 .33 0 .34 0 .26 0 .22 0 .27 0 .26
0 .55 0 .69 1 .01 0 .54 2 .14 1 .87 0 .33 0 .83 0 .47 0 .68 0 .84 1 .14 0 .95 1 .06 1 .53
0.37 0 .29 0 .30 0 .32 0 .29 0 .35 0 .30 0 .37 0 .32 0 .27 0 .32 0 .19 0 .14 0 .21 0 .21
0 .46 0 .72 0 .78 0 .69 1 .87 1 .37 0 .50 0 .80 0 .44 0 .42 0 .65 0 .85 0 .57 0 .82 1 .22
0 .59 0 .54 0 .52 0 .52 0.50 0 .53 0 .49 0 .55 0 .53 0 .43 0 .38 0 .36 0 .34 0 .36 0 .34
- a model isolating permanent effects, but also including the transitory effects
of micro-economic variables and fund-specific characteristics ; and, Model III a full model that considers permanent effects and the transitory effects of microand macro-economic variables, as well as fund-specific characteristics .
Model 1 :
g1, = .a,, + /3 IMTR, + u 1 ,
(7)
Model 17:
g„= a,,+ /3 1 MTR±/3,X1,+u 1,,
(8)
where X1, is a characteristics . Model III:
vector of micro-economic variables and fund-specific
g1, = a1 , + f3 1 MTR,+/32X1, + u it
(9)
where X1 , includes the variables in Model II and other macro-economic variables .
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CLAIRE Y. NASH ET AL. Permanent Effects of Capital Gains Taxation
The semilog model estimates are shown in Table 5 where the restricted model, Model I, is presented first. The coefficients for both of the tax rate dummy variables, MTRI and MTR3, are positive and significantly different from zero in Model I in which transitory effects are not included. The effect of increasing the marginal tax rate from 20% (MTRI, representing pre-TRA 86) to 33% (TRA 86) is a decrease in the mean amount of capital gains distributions of $1 .25 per share." The effect of decreasing the marginal tax rate from 33% (TRA 86) to 28% (MTR3, representing post-TRA86) is an increase in the mean amount of capital gains distributions of $1 .25 . The direction of the permanent effects observed are consistent with evidence presented in empirical studies investigating the responses of individuals to capital gains tax rates (Feldstein et al ., 1980 ; Minarik, 1984 ; Amen & Clotfelter, 1982 ; Burman & Randolph, 1994) . When micro- and macro-economic variables and fund-specific characteristics are introduced into the semilog model to control for transitory effects, the coefficients of the MTRI variable continue to be significant (Model II and Model III) . The effect of introducing transitory effects into the equation is an increase of $1 .72 (Model III= e054) in the mean amount of capital gains distributions during MTRL However, the coefficient for MTR3 becomes insignificantly different from zero . The coefficient for MTR3 declines to $0.11 in Model II before rising to $0.24 in the fully unrestricted model . This rise and decline in the MTR3 coefficient in Model 11 and Model III, respectively, suggests that the variability in investment company capital gains distributions during the postTRA 86 tax regime may be due, in greater part, to transitory effects . Minarik (1981) and Burman and Randolph (1994) found a similar overestimation of permanent effects when transitory effects were ignored . The increases in capital gains distributions observed during MTRI and MTR3 indicate that lower marginal capital gains tax rates not only provide an incentive to individual taxpayers to engage in gains trading, but influence the level of investment company capital gains distributions as well . The increase in capital gains realized by investment companies during periods of relatively low marginal capital gains tax rates adds further credence to the arguments of tax policy makers who advocate preferential taxation of capital gains . Therefore, the null hypothesis that the level of capital gains distributions is not significantly different across tax regimes is rejected . The variability in the significance of the increase in investment company capital gains distributions during MTRI and MTR3 is expected . It suggests that the modest reduction in the marginal tax rate (from 33 to 28) had a much smaller effect on investment company capital gains distributions than the more
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The Effect of Capital Gains Tax Policy
Table 5.
Semilog Models Estimated Coefficients of Variables Included in Model .
Dependent Variable - In g - per share capital gains distributions of an investment company, i, at time t
Variable
Expected Sign
Constant
Model I
0 .0375 (3 .882)****
Model 11
Model III
0 .963 (8 .852)****
-0 .490 -(0 .258)
MTRI(D) Coded I when year is pre-TRA 86
0 .222 (1_799)*
0 .227 (2 .260)**
0.541 (2 .690)***
MTR3 (D) Coded I when year is post TRA 86
0 .221 (1 .723)*
0 .106 (1 .05)
0 .245 (1 .311)
NAV (L) Per share net asset value at end of the previous year
0 .527 (17 .395)****
0.524 (17 .271)****
DIV (L) Per share dividends distributed to shareholders during the year
0 .061 (--1.131)
0 .059 ( 1 .091)
TURN Annual turnover rate of the investment companv
0 .00 (1 .968)**
0.000 (1 .950)**
SIZE (L) Total net assets at the end of the year
-0 .082 ( 3 .780)****
-0 .083 (-3 .80)****
LOAD (D) 0-no-load fund 1=load fund, during time t
0 .140 (4 .858)****
0 .)40 (4 .844)****
MGR (D) Change in Fund Manager 0=no change 7=change, during time t
0 .036 (1 .910)*
0.036 (1 .893)*
DMA change in the Dow Jones industrial Average stock market index during time t
0 .000 (0 .256)
REDM - redemption rate An industry measure of the% of investment company shares redeemed (bought hack) during time t by growth and growth-and-income investment companies
.035 0 (0 .997)
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CLAIRE Y . NASH ET AL .
Table 5.
Continued .
Dependent Variable - In g - per share capital gains distributions of an investment company, i, at time t Expected Model I
Model II
Variable
Model Ill
Sign
SHARE an industry measure of the percentage ? of investment company assets held in taxable accounts of individuals during time t by growth and growth-and-income investment companies COMP A measure of competition calculated as the percentage change in the number of open-end stock and bondand-income investment companies during time t. MSE df R2
-0.016 (-0.763)
-0.006) (-0.752)
0 .113 2,232 0 .00
0 .099 2,226 0 .14
0 .099 2,222 0 .14
Note : t-statistics are in parentheses . * significant at the 0 .10 level; ** significant at the 0 .05 level ; *** significant at the 0 .01 level ; **** significant at the 0 .001 level. Logarithmic variables are indicated by "(L)" ; dummy variables are indicated by "(D) ."
dramatic 65% increase from 20% to 33% . The MTR1 effect is significant across all models specified in the analysis . The significance of this structural change suggests a significant lock-in by investment companies during TRA 86 . While investment company capital gains distributions rose during MTR3, the effect of unlocking capital gains is less significant during this period and its significance does not hold across the less restrictive models . The less significant effects of MTR3 provide evidence that the lock-in effect is larger when marginal tax rates on capital gains are high . Transitory Effects
Transitory effects are introduced into the model to reduce the possibility that the permanent effects of changing marginal tax rates are overstated . Table 5,
The Effect of Capital Gains Tax Policy
265
Model II and Model III, captures the effects of variations in investment company gains distributions that are due to other temporary variations and fund characteristics . The positive relationship between NAV, i and g provides evidence that, on average, investment companies with large baskets of unrealized capital gains distribute higher levels of capital gains . Burman and Randolph (1994) found a similar wealth effect, The DIV variable is not statistically significant . However, the inverse relationship observed is consistent with the theory that investment company portfolio managers increase trading activity to reposition securities portfolios when the return from income and unrealized capital gains has not met fund objectives (Jeffery & Arnett, 1993) . The expected positive relationship between TURN and capital gains distributions was tenuous at best . The turnover variable explains little of the variability in capital gains realized . This result does not support the relationship argued to exist by Jeffery and Amott (1993) . Capital gains distributions decrease as the size of an investment company increases . The SIZE relationship suggests that smaller funds engage in portfolio activity to a greater extent for rebalancing and consumption . Larger investment companies generally experience positive net cash flows and therefore are able to adjust their portfolios using uninvested cash . Absent sufficient positive cash flows, smaller funds must engage in portfolio transactions to meet redemptions and to reposition their portfolios . Investment companies that charge a sales fee (LOAD) distribute more capital gains to shareholders . The load policy adopted by a fund can serve as a cash flow management tool . Investment companies implement or switch to a load policy for a number of reasons . Smaller funds use LOAD to encourage investors to be longer term . Increasing the transaction costs of acquiring or selling investment company shares encourages investors to lock-in to an investment company and thus slows down the flow of cash out of a fund . Larger funds can use LOAD to control cash inflows . Investment company shares selling at a price above NAV may appear less attractive to investors . As the size of an investment company increases, a fund will switch to a load policy to slow down the flow of cash into the investment company . This change in fee policy also causes existing shareholders to lock-in . The lock-in by investors to LOAD funds provides portfolio managers with more discretion in implementing fund portfolio strategies . A change in portfolio manager, MGR, does signal an increase in investment company capital gains distributions . The repositioning that occurs as a result of the change in the investment strategies used to meet portfolio objectives generates capital gains distributions above what would otherwise be expected .
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CLAIRE Y . NASH ET AL .
The macro-economic variables introduced in the model have little explanatory power. The insignificant coefficients of DJIA show that the increases in capital gains distributions observed was not simply the result of the strong economic growth that occurred during the period . Consumption activity, measured by redeeming investment company shares presented on demand (REDM), has little explanatory power. Having a greater percentage of investment company assets owned by individuals who are subject to taxation on an annual basis does not have an important effect on capital gains distributions . While the phenomenal growth in investment companies, captured by COMP, increased the choices for investors and competition among investment companies, no significant change in the level of capital gains distributions can be attributed to the competitive pressure of this growth . Alternative Model Specifications Various alternative specifications of the models were performed to test the robustness of the results . All specifications produced the same conclusions as the primary analysis . First, a set of estimations using the specifications of equation 5 were calculated using inflation-adjusted measures . This inflation-adjusted version of the model is comparable to the analysis conducted by Lindsay (1987) in which capital gains are adjusted using GNP . The magnitude of the inflation-adjusted effects is larger, relative to the semilog effects, across each model . The consistent relationships noted are further evidence of the robustness of the semilog results . Next, the model was estimated with OLS regression without the natural log transformation . The relationships are consistent using this estimation . A third specification of the model excluded the turnover variable from the analysis . Again, the findings were unchanged . Finally, we included a variable to determine whether the potential excise tax of 4% (as enacted in the Tax Reform Act of 1986) affected the conclusions of our analysis . Recall that the excise tax is assessed (on the undistributed portion) when funds distribute less than 98% of ordinary income and capital gains . As with prior alternative specifications, inclusion of the excise tax variable produced the same results as the primary analysis .
SUMMARY AND CONCLUSIONS Although a preferential tax rate on capital gains is enacted to induce individual investors to unlock gains on appreciated assets, it appears to also be effective
The Effect of Capital Gains Tax Policy
267
in unlocking investment company capital gains . Investment company portfolio managers are not evaluated on after-tax returns, yet the results of this study indicate that portfolio decisions are not entirely insensitive to capital gains tax rates . When the capital gains distributions of investment companies are examined across tax regimes, there is evidence that investment company capital gains distributions are significantly higher during tax regimes with lower marginal capital gains tax rates . Taxable individual accounts still hold the largest percentage of investment company shares and an increase in capital gains distributions during periods of lower capital gains tax rates suggests that portfolio managers consider the tax consequences to these investors . The observed increase in capital gains distributions during periods of lower marginal tax rates also should alleviate concerns that a tax policy aimed primarily at individuals will not have the intended effects . Portfolio managers have replaced individuals as dominant participants in the equity capital markets, but their trading behavior with respect to capital gains realizations is consistent with the realization response targeted by legislators . The unlocking effects of lower marginal capital gains tax rates observed in this study show that investment company growth has not had a negative impact on capital gains tax policy . The objectives of capital gains tax policy can still be achieved even though the decisions of many individual investors are concentrated in the trading activities of a comparatively few portfolio managers . While it would appear that tax minimizing strategies would conflict with a portfolio manager's objective of maximizing the return to shareholders, this study provides evidence that investment companies are more tax efficient than Jeffery and Arnott (1993) suggest . These observed structural shifts in the level of investment company capital gains distributions benefit short-term investors, and investors who hold shares across tax regimes . Other variables that influence the tax efficiency of an investment company include its size, beginning net asset value, turnover ratio, sales fee policy, and changes in portfolio managers . High net asset values indicate a high percentage of unrealized capital gains . A build-up in unrealized gains suggests an increased potential for current capital gains distributions . The turnover ratio of a fund accounts for little or none of the variation in capital gains distributed . As with all research, there are limitations on the generalizability of the results of the study . The independent factors included in the model are not an exhaustive list of possible determinants of realization behavior . In addition, the sample selection technique imposes a clear survivor bias . However, the analysis is concerned with investment company response to capital gains tax rate changes and not with quantifying capital gains distributions of a representative fund over
CLAIRE Y. NASH ET AL .
268
a particular period . There is no reason to believe that the non-survivors would have had a different capital gains distribution strategy than the 149 companies included in the sample . There is also no reason to believe that the non-survivors would have reacted differently to changes in capital gains tax rates .
NOTES l . Mutual funds are either open-end or closed-end . Open-end funds can always issue more shares . Investors are continuously buying (and redeeming) shares from open-end funds when adding (or withdrawing) money from the fund . In general, open-end fund shares are bought and sold directly through the fund itself, or its agents . In contrast, closed-end funds have a finite number of shares which are publicly traded. Investors can buy closed-end fund shares either in a stock offering or in the secondary market . 2 . We recognize that mutual funds may be considered conduits . However, they are not subject to direct taxation on their capital gains (i .e . capital gains flow through to the investor) . Therefore, changes in the marginal capital gains tax rate may have a lesser impact on mutual funds than on direct individual investors . 3 . Investment companies are not allowed to pass through capital losses to shareholders, but are allowed to carry forward these capital losses to offset future capital gains. 4 . The example assumes investment company turnover of 100% or greater and that the fund realizes all capital gains during the period . 5 . This finding is not surprising given that portfolio turnover indicates buying and selling of shares . As selling of shares occurs, capital gains are realized (for shares which have appreciated), which results in lower after-tax returns . 6 . Porcano and Shull (1997) considered the effects of changes in capital gains tax rates on a variety of entities (such as individuals, corporations, and private foundations) . Their findings indicate that the capital gains realization behavior of individuals and corporations (around tax law changes) generally was consistent with expectations . Of particular note was the result that entities such as private foundations also increase their capital gains-taking upon the enactment of lower capital gains tax rates . 7 . Prior to TRA 86, mutual funds were required to distribute at least 90% of the fund's ordinary income and realized capital gains to avoid taxation (if all income and capital gains were not distributed, the fund would be taxed on the undistributed portion) . Additionally, TRA 86 required that if funds did not distribute at least 98% of their capital gains and ordinary income, they would be subject to an excise tax of 4% of the undistributed portion . 8 . A relatively recent phenomenon has been the growth of tax-efficient mutual funds which are marketed to taxable individual investors . While these funds have enjoyed modest growth rates, as of the end of 1999 they represented a small fraction (less than one percent) of mutual fund equity assets . 9 . The taxable status of the shareholder impacts that shareholder's interest in the tax efficiency of the fund. Accordingly, the percentage of the fund held in individual taxable accounts may provide explanatory information about capital gains distributions of that fund . However, our data sources do not provide information on the percentage of each individual fund held in individual taxable accounts . Further evidence that such data are
The Effect of Capital Gains Tax Policy
269
widely unavailable is noted by Bergstresser and Poterba (2000), "we would like to measure the fund inflows attributable to taxable individual investors and to study how those flows are related to various factors . However, we are not aware of any data source that provides the requisite information on fund flows ." Therefore, in the current research we have attempted to consider the taxable status of funds by including the variable (SHARE) in the analysis. 10 . The possibility of family fund concentrations among the investment companies included in the sample was investigated . By referring to the fund family relationships identified in the Morningstar database, it was determined that there are no investment company family concentrations of 5% or more in the sample . 11 . Consistent with our findings, the Kraft and Weiss (1998) measure of capital gains (capital gains yield), is also highest in 1986 and 1987 . 12 . Taking the antilog of the estimated coefficient of MTRI (i .e . e""= 1 .25) .
REFERENCES Auerbach, A . J. (1988) . Capital gains taxation in the United States : Realizations, revenue and rhetoric . Brookings Papers on Economic Activity, 2, 595-637 . Auerbach, A. J . (1989) . Capital gains taxation and tax reform. National Tax Journal, (September) . 391-401 . Auerbach, A . J . (1991). Retrospective capital gains taxation, The American Economic Review, 81(1), 167-178 . Auten, G . E ., & Clotfelter, C. T . (1982) . Permanent versus transitory tax effects and the realization of capital gains . The Quarterly Journal of Economics, 96, 613-632. Amen, G . E., Burman, L . E ., & Randolph, W . C . (1989) . Estimation and interpretation of capital gains realizations behavior : evidence from panel data . National Tax Journal, 42, 353-374 . Barber, B ., Odean, T ., & Zheng, L. (2000) . The behavior of mutual fund investors . Working Paper (University of California Davis) . Barclay . M . J ., Pearson, N . D ., & Weisbach, M . S . (1998) . Open-end mutual funds and capitalgains taxes . Journal of Financial Economics, 49, 3-43 . Bergstresser, D ., & Poterba, J . (2000) . Do After-Tax Returns Affect Mutual Fund Inflows? Working paper (MIT and NBER) . Bloom, 1 . L ., Raedy, J . S ., & Shackelford, D . A . (2001) . Capital Gains Taxes and Equity Trading : Empirical Evidence. Working Paper (University of North Carolina) . Brazer, H . (1978) . Gains and losses on capital assets . In : G . F. Break & B . Wallin (Eds), Taxation Myths and Realities . Addison-Wesley Menlo Park, California . Burman, L . E ., Clausing, K ., & O'Hare, J . R. (1994) . Tax reform and realizations of capital gains in 1986 . National Tax Journal, 47, 1-18 . Human, L . E ., & Randolph, W . C . (1994) . Measuring permanent responses to capital-gains tax changes in panel data . The American Economic Review, 84(4), 794-809 . Cook, E . W ., & O'Hare, J . (1987) . Issues relating to the taxation of capital gains. National Tax Journal, 40, 473-488 . Dielman, T, E. (1989) . Pooled Cross-sectional and Time Series Data Analysis . NY, New York : Marcel Deckker, Inc . Feldstein, M ., & Yitzhaki, S . (1978) . The effects of the capital gains tax on the selling and switching of common stock . Journal of Public Economics, 9, 17-36,
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Feldstein, M . S ., Slemrod, J ., & Yitzhaki, S . (1980) . The effects of taxation on the selling of corporate stock and the realization of capital gains . Quarterly Journal of Economics, 94, 777-791 . Fuller, W . A., & Battese, G . E. (1974) . Estimation of linear models with crossed-error structure . Journal of Econometrics, 2, 67-78 . Investment Company Institute (Various years) . Mutual Fund Fact Book . Jeffrey, R . H ., & Arnott, R . D . (1993) . Is your alpha big enough to cover its taxes? Journal of Portfolio Management, (Spring), 15-25 . Kraft, A., & Weiss, 1 . (1998) . Tax planning by mutual funds . Unpublished working paper . Lindsey, L. B . (1987) . Capital gains rates, realizations, and revenues . In : M . Felstein (Ed .), The Effects of Taxation on Capital Accumulation . Chicago, IL : The University of Chicago Press . Minarik, J . J . (1981) . Capital Gains . In : H . J. Aaron & J. A . Pechman (Eds), How taxes affect economic Behavior . Washington, D.C . : Brookings Institution . Minarik, J . J . (1984). The effects of taxation on the selling of corporate stock and the realization of capital gains : Comment . The Quarterly Journal of Economics, (February), 118-119 . Myers, M . M ., Poterba, J ., Shackelford, D ., & Shoven, J. (2001) . Copycat Funds : Information Disclosure Regulation and the Returns to Active Management in the Mutual Fund Industry . Working Paper . Porcano, T . M., & Shull, D . M . (1997) . A Comparative Analysis of Capital Gains-Taking . Advances in Taxation, 14. 137-151 . U.S . Congress. Committee on Energy and Commerce (1994) . Mutual fund industry : Hearing before the Committee on Energy and Commerce . 22 July 1993, 146 . GPO: Washington, D .C. U.S . Congree . Committee on Commerce (1996) . Capital markets deregulation and liberalization act of 1995: Hearing before the Committee on Commerce . 14 November 1995, 283 . GPO : Washington, D.C . U.S . Congress (1996). Senator D'Amato of New York speaking on introduced bills and joint resolutions. D'Amato, Alfonse . Congressional Daily Record, (23 May).
THE EFFECT OF TAX RATE CHANGES ON THE YIELD SPREAD BETWEEN CORPORATE AND MUNICIPAL BONDS Elizabeth Plummer
ABSTRACT This study examines the effects of personal and corporate tax rate changes on the spread between pre-tax corporate bond yields and municipal bond yields, and provides evidence of tax clientele differences across bonds of different maturities and across bonds of different risk levels . Implicit tax theory suggests that the personal and corporate tax rate reductions of ERTA and TRA86 should reduce the yield spread between corporate and municipal bonds . The sample consists of 2,770 newly-issued taxable corporate bonds over the period 1979-1989 . Each corporate bond issue is matched with a similar municipal bond issue . The implicit tax rate (ITR) is used to measure the spread between corporate and municipal bond yields, and is equal to the yield spread divided by the corporate bond yield. For the, full sample, reductions in the personal and corporate tax rates both decrease ITR. However, the results differ across tax regimes . Prior to TRA86, changes in the personal and corporate tax rates have similar effects on ITR . Subsequent to TRA86, changes in the personal tax rate
Advances in Taxation, Volume 14, pages 271-307 . Copyright © 2002 by Elsevier Science Ltd. All rights of reproduction in any form reserved. ISBN : 0-7623-0889-3 271
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become more important and have a greater effect on ITR than changes in the corporate tax rate . The sample is also divided across time-to-maturity (short/long) and risk level (low/medium) . Evidence suggests that: (1) prior to TRA86, the marginal investors in medium-risk, short-term bonds were corporations, while the marginal investors in low-risk, short-term bonds were both individuals and corporations ; (2) prior to TRA86, the marginal investors in long-term bonds were both individuals and corporations, regardless of risk level ; and (3) subsequent to TRA86, the marginal investors in both short-term and long-term bonds are individuals, regardless of risk level .
1 . INTRODUCTION This study examines the effects of personal and corporate tax rate changes on the yield differential, or spread, between taxable corporate bonds and nontaxable municipal bonds, and provides evidence of tax clientele differences across bonds of different maturities and across bonds of different risk levels . Economics-based tax research assumes that, in equilibrium, different assets of similar risk have equivalent after-tax returns . This implies that if these assets are subject to different tax rates, then their pre-tax returns must differ . Specifically, the more favorably-taxed asset will have a lower pre-tax return . The difference in the pre-tax rates of return is the implicit tax borne by the favorably-taxed asset (Scholes & Wolfson, 1992) . Implicit tax theory suggests that personal and corporate tax rate reductions should reduce the spread between taxable and municipal bond yields required by investors . Consistent with this hypothesis, prior research finds that tax rate reductions do reduce the spread between U .S . Treasury bonds and municipal bond yields (e .g . Poterba, 1986, 1989) . The current study examines the effects of tax rate reductions on the spread between pre-tax corporate bond yields and municipal bond yields . Specifically, the effects of the personal and corporate tax rate reductions provided by the Economic Recovery Tax Act of 1981 (ERTA) and the Tax Reform Act of 1986 (TRA86) are examined . The results indicate that the ERTA and TRA86 tax rate reductions reduce the spread between corporate and municipal bond yields . This is consistent with prior research that uses treasury bonds . However, this study provides empirical evidence that the results differ across tax regimes . Prior to TRA86, results suggest that changes in the personal and corporate tax rates both reduced the yield spread and their effects were not significantly different from one another . Subsequent to TRA86, changes in the personal tax rate become more important and have a greater effect on the yield spread than
The Effect of Tax Rate Changes on the Yield Spread
273
changes in the corporate rate . The increased importance of personal tax rate changes subsequent to TRA86 is most likely attributable to the changes made by TRA86 that restricted the tax benefits that banks received when investing in municipal bonds . Poterba (1989) conjectures that, because TRA86 largely eliminated the tax incentives for banks to invest in municipal bonds, individuals would play an increasingly important role in municipal bond investment . Accordingly, individual tax rates would likely become the primary determinant of the yield spread between taxable and municipal bonds . The results in this study provide empirical support for this conjecture . This study also examines whether the effects of tax rate reductions on yield spreads vary across bonds of different maturities, and provides evidence on differences in tax clienteles between short-term and long-term bonds . In the early 1980s, over 90% of all tax-exempt debt held by banks had a maturity of five years of less . This concentration of bank ownership suggests that banks will play a relatively larger role in setting short-term bond yields . Consistent with this hypothesis, prior to TRA86, the results indicate that corporate tax rate changes are more important for the yield spreads of short-term bonds, while personal tax rate changes are more important for long-term yield spreads . These results complement and extend those reported in Poterba (1986, 1989) who finds similar evidence using U .S . Treasury bonds . However, like the full sample results, this study provides new evidence that the effects of changes in the personal tax rate increased after enactment of TRA86, and provides empirical evidence that, subsequent to TRA86, the marginal investors in both short-term and long-term bonds are individuals . Lastly, this study provides new evidence that the marginal investor differs across bonds of different risk levels . Scholes and Wolfson (1992) show that the pre-tax yield spread between a taxable and nontaxable investment of equivalent risk increases as risk increases . If the pre-tax yields do not both increase proportionately, this will cause differences in the marginal investor for bonds of different risk levels . Prior studies do not allow for possible differences in the marginal investor across risk level . This study examines whether the effects of the tax rate reductions on yield spreads vary across low-risk and medium-risk bonds, and provides evidence on differences in tax clienteles across bonds of different risk levels . This study makes several contributions to our understanding of the effects of tax rates and tax rate changes on corporate and municipal bond prices . First, few studies examine the effects of tax policy on the corporate bond market . However, the corporate bond market is important because bonds provide large amounts of financing for U .S . companies . During 1991, for example, corporate bonds represented 53% ($263 billion) of the total dollar value of all security
274
ELIZABETH PLUMMER
registrations filed with the U .S . Securities and Exchange Commission (Annual Report of the Securities and Exchange Commission, 1992) . Common stock comprised 34% ($168 billion) . This study provides evidence on the sensitivity of pre-tax bond yields to personal and corporate tax rate changes . The yield spread is modeled as a function of the personal and corporate tax rates, and the coefficient estimates from the model approximate the effect of tax rate changes on the yield spread . Second, this study provides empirical evidence that supports Poterba's (1989) conjecture that, subsequent to TRA86, individual tax rates would become the primary determinant of the yield spread . These findings are important to policymakers who must predict how tax law changes will impact the government's revenues and its cost of borrowing .' Third, this study provides new evidence on differences in tax clienteles across bonds of differing risk levels, and on how the marginal investor differs across maturity level and across time . This increases our understanding of the factors that affect the marginal investor and potential variables one must control for when examining such issues . In addition, this study uses corporate bonds as the taxable benchmark, while prior studies use treasury bonds . Therefore, this study provides additional, validating evidence on the relation between tax rates and pre-tax bond yields across bonds of different maturities . Also, this study provides new evidence on post-TRA86 tax clienteles for short- versus long-term bonds . Lastly, the findings not only increase our understanding of the relative importance of personal and corporate tax rates on bond yields, but also increase the confidence with which the relation between tax rate changes and bond yields can be generalized across different bond markets and bond types . The sample used in this study consists of 2,770 newly-issued taxable corporate bonds over the period 1979-1989 . Each corporate bond issue is matched with a municipal bond issue using criteria such as bond rating, issuance date, and time-to-maturity . Accordingly, there are 2,770 matched pairs . The implicit tax rate (ITR) is used to measure the yield spread between corporate and municipal bonds . ITR is equal to the difference between the corporate and municipal bond yields, divided by the corporate bond yield . ITR provides an estimate of the tax rate of the marginal investor (i .e . the investor who is indifferent between investing in either the corporate or municipal bond because his or her after-tax return will be the same) . ITR across the different years and maturity levels is first estimated . As expected, ITR decreases over the sample period, and is greater for short-term bonds than for longer-term bonds . ITR then is modeled as a function of the personal and corporate tax rates, corporate bond issue-specific variables, and other explanatory variables . For the full sample, results indicate that reductions
The Effect of Tax Rate Changes on the Yield Spread
275
in both the personal tax rate and the corporate tax rate decrease ITR . Prior to TRAM the effects of personal and corporate tax rate reductions on ITR are comparable . After TRA86, changes in the personal tax rate have a greater effect on ITR than changes in the corporate tax rate . As discussed above, the increased importance of personal tax rate changes subsequent to TRA86 is most likely attributable to the changes made by TRA86 that decreased banks' incentives to invest in municipal bonds . The model across maturity groups then is estimated . Prior to TRAM, for the shortest-term bonds (0-5 years), changes in the corporate tax rate had more of an effect on ITR than changes in the personal tax rate . For the three other maturity groups with time-to-maturities greater than five years, prior to TRAM, both personal and corporate tax rate changes affect ITR and their effects are not significantly different from one another . After TRAM, regardless of time-to-maturity, changes in the personal tax rate have a greater effect on ITR than changes in the corporate tax rate . These results are consistent with the hypotheses and suggest that : (I) prior to TRAM, the marginal investors in short-term bonds were corporations, while the marginal investors in longer-term bonds were both individuals and corporations ; and (2) after TRA86, the marginal investors in both short-term and long-term bonds are individuals . Finally, the model across low- and medium-risk bond groups is estimated . Results suggest that, on average : (1) prior to TRAM, the marginal investors in medium-risk, short-term bonds were corporations, while the marginal investors in low-risk, short-term bonds were both individuals and corporations ; (2) prior to TRA86, the marginal investors in long-term bonds were both individuals and corporations, regardless of risk level ; and (3) subsequent to TRAM, the marginal investors in both short-term and long-term bonds are individuals, regardless of risk level . The remainder of this article is as follows . The next section discusses the relation between tax rates and pre-tax returns, and develops the hypotheses . Section 3 discusses the sample and research design, while Section 4 provides the results . Conclusions are provided in Section 5 .
2. BACKGROUND AND HYPOTHESES Examining the relative yields of taxable and nontaxable bonds provides an estimate of the marginal investor's tax rate (t,,) . The marginal investor is the investor who is indifferent between investing in the two bonds because the after-tax returns from both bonds will be equivalent .' The marginal investor's tax rate also is referred to as the implicit tax rate (ITR) and is defined as :
276
ELIZABETH PLUMMER Y,(1-t m) = Y„
(1)
tm = (Y, - Y„) / Y,
(2)
where y, is the taxable bond's pre-tax yield, and y. is the non-taxable bond's yield. The value tm provides evidence on the tax clientele attracted to the taxable bond, and the implicit tax borne by the nontaxable bond . Ceteris paribus, taxpayers with a tax rate greater than tm would prefer to invest in the nontaxable bond because it will result in a higher after-tax return, while taxpayers with a tax rate less than tm would prefer to invest in the taxable bond . Prior studies almost exclusively focus on U .S . Treasury bonds when estimating implicit marginal tax rates and examining yield changes in response to tax rate changes . Guenther (1994) provides evidence that the 1981 and 1986 tax rate reductions reduced one-year U .S . Treasury bill yields . Poterba (1986) examines the implicit tax rate for U .S . Treasury bonds with maturities of one, five, ten, and twenty years for the period 1955-1983 . In each of those years, he finds that the implicit tax rate for the one-year bond was greater than that for any of the longer-term bonds . In addition, the implicit tax rate for 20-year bonds, and to a lesser extent for one-year bonds, declined between 1979 and 1982 (i .e . around the time of ERTA) . His results also provide evidence that both personal and corporate tax rate changes affect the relative yields on taxable Treasury bonds and tax-exempt municipal bonds, and some evidence that corporate tax changes are relatively more important for short-term yield spreads while personal tax changes are more important for long-term yield spreads . He attributes his results to the idea that commercial banks are the marginal investor in short-term Treasury bonds, while individuals are the marginal investor in long-term Treasury bonds . Poterba (1986) does not examine tax changes subsequent to 1983 . Poterba (1989) uses an event study method to examine the influence of federal tax policy on the tax-exempt bond market for the period 1969-1988 . He examines news events about Congressional tax policy debates and identifies months in which investors were likely to revise their expectations about future personal and corporate tax rates . His results provide evidence that the yield spread between Treasury and municipal bonds responds to changes in expected individual tax rates . His results also support the idea that, prior to 1986, the municipal bond market was segmented, with corporations being the marginal investor in short-term bonds and individuals being the marginal investor in long-term bonds . Because TRA86 largely eliminated the tax incentives for banks to invest in municipal bonds, Poterba (1989) conjectures that individuals would play an increasingly important role in municipal bond investment . However,
The Effect of Tax Rate Changes on the Yield Spread
2 77
his study does not provide evidence on changes in the marginal investor subsequent to TRA86 3 Fortune (1988) and Feenberg and Poterba (1991) both use representative U .S . Treasury and municipal monthly bond yields to calculate implicit tax rates . Fortune (1988) provides evidence that the implicit tax rate is related to statutory personal income taxes for the period 1976-1985 . Although not the focus of their study, Feenberg and Poterba (1991) report the trend in annual implicit tax rates for one-year and 20-year bonds . For one-year bonds, prior to 1986, the implicit tax rate was very close to the statutory corporate tax rate . After 1986, it more closely tracks the individual tax rate . For 20-year bonds, the ITR shows no clear trend over time . Although it appears to drop in the years immediately following TRA86, it increases again in the late 1980s . Feenberg and Poterba (1991) provide only descriptive evidence on the marginal investor's tax rate (ITR) for one-year and 20-year bonds . They do not examine short-term and long-term bonds for differences in the marginal investor's type (i .e . individual or corporation) and whether that type changes after TRA86 . Ang, Peterson, and Peterson (1985) provide evidence on the average implicit tax rate for 200 corporate bonds over the period 1973-1983 . However, they do not examine whether the implicit tax rate varies across time or across maturities, and provide no evidence on the effects of tax rate changes on corporate bond yields . As discussed earlier, none of these prior studies examine differences in the marginal investor across bonds of varying risk levels . The current study examines the yields for a large sample of newly issued taxable corporate bonds over the period 1979 through 1989 . This period is chosen because it contains two major tax acts that significantly affected both personal and corporate tax rates . ERTA decreased the maximum personal statutory tax rate from 70% to 50%, effective January 1, 1982, but did not change the maximum corporate statutory tax rate . TRA86 reduced the maximum personal statutory tax rate from 50% to 38 .5% in 1987, and from 38 .5% to 28% in 1988 . It reduced the maximum corporate statutory tax rate from 46% to 34%, effective for tax years beginning on or after July 1, 1987 .4 Tax rate reductions will not affect the required rate of return on non-taxable bonds (y), but will reduce the required return on taxable bonds (y,) . Therefore, a reduction in explicit tax rates will reduce the implicit tax rate through its effect on y, Equation (2) above shows that the implicit tax rate is defined as : t,n = (y, - y) / y,
(2)
Therefore, the change in the implicit tax rate due to a change in the explicit tax rate is :
278
ELIZABETH PLUMMER
dtm = [y, / y,2 ] dy,
(3)
It is hypothesized that the implicit tax rate (ITR) will decrease in response to the lower personal and corporate tax rates .' TRA86 largely eliminated the tax incentives for banks to invest in municipal bonds . Until this time, banks were permitted to borrow money, invest the proceeds in municipal bonds, deduct the interest expense payments from their taxable income, and recognize no tax liability from the municipal bond interest income. This contrasted to the general rule that did not allow an interest expense deduction on funds acquired to purchase tax-exempt securities . TRA86 changed the preferential treatment afforded to banks so that, subsequent to TRA86, banks are no longer permitted to deduct interest expense incurred on debt that is used to acquire municipal bonds . Poterba (1989) predicts that, because of this change, individuals would play an increasingly important role in the municipal bond market . Statistics regarding changes in the ownership of municipal bonds over time appear to support this prediction . In 1979, households owned approximately 26% of the outstanding tax-exempt bonds, while commercial banks owned approximately 43% . By 1988, the proportion of tax-exempt debt owned by households had increased to about 45%, while that owned by commercial banks had decreased to approximately 22%' Therefore, consistent with Poterba's (1989) conjecture, changes in the personal tax rate are expected to be relatively more important for explaining changes in ITR after TRA86 . The marginal investor is expected to vary across bonds based on their time-to-maturity . In the early 1980s, 52% of the tax-exempt debt held by banks had a maturity of one year or less, and 92% of banks' tax-exempt investment had a maturity of five years or less (Seek, 1982) . This pattern of ownership suggests that banks will play a relatively more important role in the short-term municipal bond market than in the long-term market . Poterba's (1986) and (1989) results are consistent with this . He finds evidence that, prior to TRA86, corporations are the marginal investor in short-term bonds and individuals are the marginal investor in long-term bonds . Therefore, the sample is divided into four maturity groups : 0-5 years, 6-10 years, 11-20 years, and 21-30 years . If corporations are the marginal investors in short-term bonds and individuals are the marginal investors in long-term bonds, then corporate tax rate changes will be relatively more important for explaining changes in ITR for short-term bonds . In contrast, changes in the personal tax rate will be relatively more important for explaining changes in ITR for longer-term bonds . Lastly, the marginal investor is expected to vary across bonds of different risk levels . Scholes and Wolfson (1992) show that the pre-tax yield spread
The Effect of Tax Rate Changes on the Yield Spread
27 9
between a taxable and nontaxable investment of equivalent risk increases as risk increases because the risk premium on the corporate bond is taxed whereas that on the municipal bond is not . For example, assume that a low-risk corporate and municipal bond have pre-tax yields of 10% and 7%, respectively . For this pair of bonds, the yield spread is 3%, and the marginal investor's tax rate is 30 .0% . Now assume a higher-risk corporate and municipal bond . For the marginal investor's tax rate (and thus ITR) to remain at 30%, each pre-tax yield must rise proportionately . For example, the corporate and municipal bond yields each must rise by 50%, to 15 .0% and 10 .5%, respectively . At this higher level of risk, the yield spread is now 4 .5%, but ITR is still 30 .0% . If the corporate and municipal pre-tax yields do not both rise proportionately, this will cause the marginal investor to differ from the low-risk bond . Therefore, the sample is divided into low-risk and medium-risk bonds, and tests for differences in the marginal investor across the two risk groups are run . This analysis also provides evidence on how the marginal investor changes across time for bonds of different risk. Prior studies do not provide evidence on differences in the marginal investor across bonds of differing risk levels .
3. SAMPLE AND RESEARCH DESIGN Sample The sample consists of all new corporate bond issues on the Fixed Income Database (FIDB)' that meet the following criteria : (1) issued by a corporation over the period 1979 through 1989 ; (2) issued within $3 of $100 ; (3) have a Moody's bond rating of Baa or higher ; and (4) have the variables on the database necessary to estimate the model discussed below . The second criterion assures that the bond is issued close to par in order to minimize potential effects on bond yields of tax-timing options . Tax-option effects arise from taxpayers' abilities to optimally time the recognition of capital gains and losses for tax purposes, potentially causing bond prices to deviate from their hold-to-maturity values (see Constantinides & Ingersoll, 1984) . In addition, the IRC rules regarding amortization of bond discount and premium for corporate bonds differ from the rules for municipal bonds . Therefore, eliminating bonds with substantial discount and premium also helps minimize the possibility that differences in the amortization rules might impact the results ." New bond issues are used for two reasons : this helps to minimize the
280
ELIZABETH PLUMMER
potential effects on bond yields of the tax-timing options, and avoids potential problems with out-dated bond ratings . The third criterion is imposed because municipal bond issues, discussed below, are only available for Baa ratings or higher . Because of the relatively small number of corporate bonds with a life greater than 30 years (only 80 bonds over the eleven-year period), they were excluded from the final sample . To obtain estimates of implicit tax rates and to control for differences in rates of return across time, each corporate bond issue is matched with a nontaxable municipal bond issue . Salomon Brothers' Analytical Record of Yields and Yield Spreads is used as the source for municipal bond data. 9 Salomon Brothers provides the average yield-to-maturities for a sample of par value municipal bonds issued at the beginning of each month . They provide the yields for bonds of seven different maturities (1, 2, 5, 10, 15, 20, and 30 years) and three different ratings (prime, good, and medium) . "Prime" is the highest rating awarded to municipal bonds by Moody's and is equivalent to Aaa . "Good" corresponds to An to high A, while "medium" corresponds to A to high Baa . 10 The corporate bond is matched with the representative municipal bond based on bond rating, date of issue, and number of years to maturity . Specifically : (1) the corporate bond and representative municipal bond must be in the same rating class ; (2) the corporate and municipal bond yields must be measured as of the same date ; and (3) the corporate bond is matched with the representative municipal bond that is closest in terms of years-to-maturity . These requirements attempt to ensure that the taxable corporate bond and nontaxable municipal bond are as similar as possible ." Several measures were taken to help control for differences in risk between the corporate bond and its matched municipal counterpart . First, corporate bonds that are subordinated and those with put options are excluded . These features would affect the corporate bond's risk . However, none of the representative municipal bond issues have such features, and these risk differences cannot be controlled for through the matching process . Second, as described in step (1) above, the corporate and municipal bond issues are matched on bond rating . Third, only newly-issued bonds are used . This helps minimize the risk that the bond ratings are outdated and do not reflect an entity's current credit risk ." For purposes of analysis, the sample is divided into two risk groups : low-risk bonds (i .e . rating of Aaa to high A), and medium-risk bonds (i .e. rating of A to high Baa) .
281
The Effect of Tax Rate Changes on the Yield Spread
Table l, panel A, provides information on the sample selection criteria, while panels B and C provide information on the sample breakdown by time-tomaturity, risk level, and industry . The final sample consists of 2,770 new bond issues . The largest group in terms of years-to-maturity is bonds with a 6 to 10 year life (41 .4% of the sample), followed by 21-30 year bonds (26 .4%) and 0-5 year bonds (24 .6%) . In terms of risk level, the sample is almost evenly
Data on corporate bond sample .
Table 1 .
Panel A : Sample selection criteria New corporate bond issues on the FIDB (1979-1989) Less : No yield data Not issued within $3 of $100 No bond rating available
4,877 216 916 57 435 194 80 209
Bond rating lower than Bus Municipal yield data not available Time-to-maturity greater than 30 years Subordinated and/or put option feature Total sample
Panel
B:
2 .770
Sample breakdown
by
bond risk level and by years-to-maturity
0-5 years 6-10 years 11-20 years 21-30 years Total Percentage of sample
Percentage of sample
Low-risk
Medium-risk
Total
468 492 77 326
214 654 135 404
682 1,146 212
24 .6% 41 .4% 7 .7%
730
26 .4%
1,363
1,407
2,770
100 .0%
49 .2%
50 .8%
100 .0%
Panel C : Sample breakdown by industry and by years-to-maturity Industrial
Utility
Financial
Total
Percentage of sample
0-5 years 6-10 years 11-20 years 21-30 years
145 386 64 224
44 314 42 415
493
682
24.6%
446 106 91
1,146 212 730
41 .417, 7 .7 26.4%
Total
819
815
1,136
2,770
100 .0%
29.6%
29 .4%
41 .0%
100.0%
Percentage of sample
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ELIZABETH PLUMMER
divided between low- and medium-risk bonds (49 .2% and 50 .8% of the sample, respectively) . In terms of industry, bonds issued by firms in the financial industry are the most prevalent (41 .0%) . Bonds issued by industrial firms and utility firms make up 29 .6% and 29 .4% of the sample, respectively . Model
The ITR, or variants of it, has been used in several earlier studies (e .g . Peek & Wilcox, 1986 ; Heaton, 1986 ; Buser & Hess, 1986 ; Hochman et al ., 1993) . To estimate the differential effects of the personal and corporate tax rate reductions on the yield spread between corporate and municipal bonds, this study models ITR as a function of the personal and corporate tax rates, corporate bond issue-specific characteristics, and economic-related variables . The equation estimated is : tm„ = (y ;, - y . ;,) / y a = /30 + Ro'D86 + $, tp, + R 2 tc , + 0,T) 86 * tpt + /33CALL, + /34 SINK. + F35ISSUESZ, + /36 YRMATi + /37MEDIUMRTG j + /3 8 1JTILITY. + /3Y FINANCE,
+ P 10RISKGVsP, ,+ /3 11 RISK M " SG, , + /3,2 MUNI_ALL, + error„
(4)
where tma y„ y,, tp, t1t D 86 CALL,
SINK I ISSUES ; YRMAT,
MEDIUMRTG,
= implicit tax rate on municipal bond issue i, measured at time t ; = yield-to-maturity of corporate bond issue i, issued at time t ; = yield-to-maturity of the nontaxable municipal bond issue matched to corporate bond issue i, measured at time t ; = the personal tax rate at time t (defined below) ; = the corporate tax rate at time t (defined below) ; 13 = dummy variable equal to 1 if the year is 1986 or later, and equal to zero otherwise ; = 1 if bond issue i is callable, 0 otherwise ; = I if bond issue i has a sinking fund, 0 otherwise ; = log of issue size of bond issue i, in thousands of dollars ; = years to maturity of bond issue i, defined as number of days from date of issuance date until maturity date, divided by 365 ; = 1 if bond issue i is rated "medium" (A to Baa), and 0 otherwise ;
The Effect of Tax Rate Changes on the Yield Spread UTILITY .
FINANCE ., RISK CWsr
RISK MVyct
MUNt AIL,
2 83
= I if firm issuing bond issue i is in the utility industry, 0
otherwise ; = 1 if firm issuing bond issue i is in the financial industry, 0 otherwise ; = yield spread between newly-issued, one-year good-grade (GI) and prime-grade (P1) municipal debt, divided by PI [i .e . (Gl-Pl)/Pl], measured at time t ; = yield spread between newly-issued, one-year mediumgrade (Ml) and good-grade (Gl) municipal debt, divided by GI [i .e . (Ml-Gl)/Gl], measured at time t ; and = the supply of new municipal debt divided by the supply of new aggregate U .S . market debt, measured at time t .
The coefficient (3, provides an estimate of the effect on ITR of a change in the personal tax rate, while /3z provides an estimate of the effect on ITR of a change in the corporate tax rate . This estimation decomposes the effects of the personal and corporate tax rates on ITR. A dummy variable (D R6) also is included to examine whether the effects of changes in the personal tax rate differ after enactment of TRA86 . TRA86 significantly affected banks' incentives to purchase municipal bonds . Prior to 1982, banks were permitted a tax deduction for the interest they paid on deposits that were used to purchase municipal bonds . This tax advantage was reduced by TEFRA in 1982, further reduced by DEFRA in 1984, and totally eliminated by TRAM . Accordingly, TRA86 is likely to have affected the marginal investor not only by reducing tax rates but also by reducing banks' participation in the municipal bond market . If bank demand for municipal bonds decreased significantly after TRAM, individuals (and thus personal tax rates) may play a relatively larger role in determining ITR ." Personal and corporate tax rates are estimated using both : (1) the maximum statutory tax rate for the current year (i .e. the year the bond is issued) ; and (2) the maximum statutory tax rate for the next year (i .e. twelve months after the bond is issued) . Table 2 provides the personal and corporate maximum statutory tax rates for the years 1979-1990 . For comparison purposes, Table 2 also provides the maximum effective personal and corporate tax rates for the same period . 15,16 Differences in the non-tax costs of municipal and corporate bonds are controlled for through the matching criteria, and by including issue-specific variables and economic-related variables in the model . The issue-specific variables have been identified by prior research (e .g . Ziebart & Reiter, 1992) as affecting the non-tax cost of corporate bonds (and thus y,) . The economicrelated variables have been identified by prior research (e .g . Buser & Hess,
284
ELIZABETH PLUMMER Table 2.
Maximum statutory tax rates and effective tax rates (in percentages), 1979-1990a .
Year
Max Individual Statutory Rate
Max Corporate Statutory Rate
Effective Individual Rate
Effective Corporate Rate
1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990
70 .0 70 .0 70.0 50.0 50 .0 50 .0 50 .0 50.0 38 .5 28 .0 28 .0 28.0
46 .0 46 .0 46 .0 46 .0 46 .0 46 .0 46 .0 46 .0 46 .0 34 .011, 34 .0 34 .0
64.5 62.9 59 .9 49 .5 49.0 50.6 49 .1 51 .2 34.0 28 .1 27 .9 27 .8
45 .44 45 .43 45 .11 45 .66 45 .57 44 .91 44 .71 42 .52 39 .78 35 .23 35 .33 35 .88
"The maximum statutory rates are taken from the Internal Revenue Code. The effective tax rates are taken from the U .S . Treasury Department's Statistics of Income: Corporate Income Tax Returns and Statistics of Income: Personal Income Tax Returns .
TRA86 reduced the maximum corporate statutory tax rate from 46% to 34%, effective for tax years beginning on or after July 1, 1987 . Corporations having a tax year that straddled July 1, 1987, were subject to a blended rate for that year . b
1986) as affecting the non-tax cost of municipal bonds (and thus yai ) . The predictions made regarding the relation between the issue-specific variables and ITR (a measure of the yield spread) are based on the expected relation of these variables with the corporate bond yield . The coefficients on CALL and SINK are expected to be positive, while the coefficient on ISSUESZ is expected to be negative." A call option (CALL) allows a corporation to retire the bond issue if interest rates drop significantly . Accordingly, the corporation is expected to pay a higher yield for the right to retain this option . Sinking fund agreements (SINK) are undertaken to increase the bondholders' security . Therefore, Sink is expected to be positively associated with corporate bond yields because the necessity of entering into a sinking fund agreement is related to a riskier bond issue . The log of the issue size (ISSUESZ) proxies for the corporate bond issue's marketability and is expected to be associated with lower corporate bond yields . The number of years to the corporate bond's maturity (YRMAT) is expected to be negatively associated with ITR because, as discussed earlier, the implicit tax rate is expected to decrease as Yrmat increases . II To help control for systematic differences across bond risk levels, an indicator variable (MEDIUMRTC) is included if the bonds are rated medium . 19 Industry indicator variables (UTILITY
The Effect of Tax Rate Changes on the Yield Spread
285
and FINANCE) are included to control for any systematic differences in ITR across industry . 20 Three economic-related variables that have been found by prior studies (e.g . Buser & Hess, 1986) to influence yield spreads across time (RISKCV}p, RISKMVSC' and MUNI_ALL) are also included . These variables affect the yield spread because of their effects on the cost of municipal debt (y,,,) . Poterba (1986) and Trczinka (1982) argue that municipal interest rates include a default premium that varies with the level of municipal default risk . They argue that the yield spread between taxable and municipal bonds varies because of variations across time in the perceived riskiness of municipal bonds . To help control for possible changes in the default risk of municipal bonds across time, the yield differential between newly issued, one-year good- and prime-grade municipal bonds (RISK a1`p ), and the yield differential between newly issued, one-year medium- and good-grade municipal bonds (RISKM "SC, ,) are included (see Buser & Hess, 1986) . Both RISK O „ SP , and RISK MVSG increase as municipal bonds' default risk increases . If the perceived riskiness of municipal bonds increases, the municipal yield will increase relative to the taxable yield, thereby decreasing the yield spread . Therefore, if the perceived riskiness of municipal bonds varies across time, there will be a negative relation between ITR and the risk variables (RISK,,,,,,, and RISK MVyo ) . These data are taken from Salomon Brothers' Analytical Record as of the same date as the corporate bond issue . Both risk measures are computed in the same manner as Buser and Hess (1986) . Consistent with prior research, MUNI ALL is included to control for changes in ITR attributable to changes in the relative size of the municipal bond market (see Peek & Wilcox, 1986 ; Poterba, 1986 ; Hochman et al ., 1993) . This is particularly important because of the changes that occurred during the sample period that significantly decreased banks' incentives to invest in municipal bonds (discussed above) . Muni All is expected to be negatively associated with ITR . As the relative supply of municipal debt increases, the municipal yield will increase relative to the taxable yield, thereby decreasing the yield spread . The supply data are taken from the Federal Reserve Bulletin, Flow of Funds accounts . 21 22 Appendix 1 contains a summary of the variables used in the study .
4. RESULTS Descriptive Information
Table 3 contains descriptive statistics regarding the sample's characteristics . The median corporate bond yield is 10.05%, while the median municipal bond
286
ELIZABETH PLUMMER Table 3.
Variable tmii .1 Y y nLt
Issunsz. (in 000s) YRMAT; CALL . $INK .
Descriptive information for selected variables (N = 2,770) . Mean
Median
1st quartile
3rd quartile
30.12% 10.70% 7.43% $134,158 13 .67 yrs
29 .30%
24.34% 9 .04% 6.25% $75,000 6 .01 yrs
35 .72% 12 .03% 8 .40% $150,000 25 .01 yrs
10.05%
7 .10% $100,000 10 .01 yrs
Proportion of sample
64.55% 24 .26%
Note: Variable definitions are in Appendix 1 .
yield is 7 .10% . The median ITR is 29 .30% . The corporate bond issues are large, with a median value of $100 million . The median maturity for all corporate bond issues is a little over 10 years . About 64% of the corporate bonds have call options, while about 24% have sinking fund agreements . Correlation values for the full sample are presented in Table 4 . As hypothesized, ITR (I id is positively correlated with both the personal (t pt) and corporate (tit) tax rates . The Pearson and Spearman correlation values for tmh with tp, are 0 .368 and 0 .311, respectively, and for tmh with t it are 0 .132 and 0 .134, respectively . Also consistent with expectations, ITR is negatively correlated with the number of years to maturity (YRMAT), suggesting that the implicit tax rate decreases as the bonds become longer-term . This is consistent with Poterba's (1986) evidence on the marginal tax rate for U .S . Treasury bonds of differing maturities . As predicted, the size of the corporate bond issue (IssuEsz) is negatively correlated with t mlt , but it is not significant . Contrary to expectations, t mit is negatively correlated with the existence of a call option (CALL) and a sinking fund agreement (SINK) . Recall that predictions regarding the relation of tm¢ and the issue-specific variables are based on the variables' predicted relation with corporate bond yields . The correlations between the corporate bond yield and CALL and SINK, however, are consistent with expectations . As predicted, CALL and SINK are positively correlated with the corporate bond yield .' Marginal Investor in Corporate and Municipal Bonds To provide descriptive evidence on differences in the marginal investor in corporate bonds across tax regimes and across maturities, Table 5 presents the
Effect of Tax Rate Changes on the Yield Spread
r ti O Orn cc N -- w : t~ 080° '0- 08=808
d
SC 5 O
M1 .
J
O p
v
co
0 0 0 0 0 0 0 0 0 0 0
0 fs p p W 0 en Oi p -T p 0 N 0 M O- 0 0 0 0 0 v~ 8 ^~ pI 0 0 0 .J 0 0 0 0 O O C 0
n O'-rn -0 -cc0C 0 0 N 0 00~ 0 00 0O0 00b 00
O O m -O 0 0 00 00 0
II
z~5 v
vet
.d CO N v r L ~_ W ~
i O 4 a L d
7 LO O~ O
m
C 5 S O C O U A m ~ .a v Y p UO L
7,
o
~0-omo O O O O C o
J _8 en 000000
0 O0 VO0-1 0O O0 0O
M8-8-8-8 00000000
N C o 0 0 C 0 6 o O 06c60 N - OG -
.^, 7 - V ^ Vl
288 Table 5.
ELIZABETH PLUMMER Median implicit tax rate by tax regime and by time-to-maturity ."
Bond Group 0-5 Year Maturity 6-10 Year Maturity 11-20 Year Maturity 21-30 Year Maturity Full Sample
Pre-ERTA (1979-1980)
ERTA (1981-1985)
TRA86 (1986-1989)
All Years (1979-1989)
47 .68 (23) 44 .95 (133) 41 .88 (23) 37 .06 (139) 41 .17 (318)
39 .11 (220) 30.34 (499) 25 .57 (82) 23 .42 (244) 29.24 (1,045)
33 .25 (439) 26 .88 (514) 22 .78 (107) 23 .26 (347) 27 .27 (1,407)
34.87 (682) 29.47 (1,146) 25.46 (212) 24.55 (730) 29 .30 (2,770)
"The first number is the median implicit tax rate, while the second number in parentheses is the sample size N. Differences across tax regimes and across time-to-maturity groups are significant at p < 0 .001 by the Jonckheere test of ordered alternatives (Hollander & Wolfe, 1973) .
median ITRs for the years corresponding to pre-ERTA, ERTA, and TRA86 for the full sample and for the four different maturity groups ." For all years combined, the median ITR for the full sample is 29 .30% . Consistent with Poterba's (1986) evidence on U .S . Treasury bonds, the median ITR is highest for the short-term, 0-5 year bonds (34.87%), and is considerably lower for the longer-term bonds (about 25% for bonds with greater than a 10-year life) . In all tax regime periods, the median ITR for the 0-5 year bonds is greater than that for any other maturity group . Generally for each tax regime, the median ITR decreases monotonically as the time-to-maturity increases . For all years combined and for each tax regime period, the ITR differences across time-tomaturity groups are significant at p < 0 .001 by the Jonckheere test of ordered alternatives (Hollander & Wolfe, 1973) 25 For the full sample and within each maturity group, the median ITR decreases monotonically across the three different tax regimes (all differences are significant at p < 0 .001 by the Jonckheere test) . This pattern across tax regimes is consistent with the decreases in the personal and corporate tax rates that occurred over this period . The median ITR for the full sample is 41 .17% for the pre-ERTA period and only 27 .27% for the TRA86 period, a decrease of fourteen percentage points . Across maturity groups, the median ITR decreases from between fourteen to nineteen percentage points .
The Effect of Tax Rate Changes on the Yield Spread
28 9
Full Sample
The pattern of implicit tax rates in Table 5 provides descriptive evidence on the effect of tax rate reductions on the yield spread between corporate and municipal bonds, as well as the tax rates of marginal investors across time and across time-to-maturities . However, it is difficult to discern the type of marginal investor (i .e. individual or corporation) by simply examining the ITR or its trend . That is, the ITR merely tells us the marginal investor's tax rate, not the type of marginal investor . To provide evidence on whether the marginal investor is an individual or a corporation, equation (4) described above is estimated . Equation (4) models t m -, (the ITR) as a function of the personal and corporate tax rates, as well as other explanatory variables . Evidence on the marginal investor's type is provided by examining the relation of ITR with t P and t, (i .e . the (3, and (3, coefficients) . Equation (4) is estimated for the full sample, and results are provided in Table 6 . All t-statistics are computed using White's (1980) covariance matrix . The p-values are one-sided if a directional hypothesis is predicted, and two-sided if no direction is predicted . Poterba (1986), among others, shows that the yield spread between taxable and non-taxable bonds depends upon the market's expectations about tax policy . Therefore, results presented in Table 6 are based on setting t P and t , equal to the maximum statutory tax rates for the year after the bond is issued . This assumes that bond yields are based on investors' expectations about future personal and corporate tax rates, and that the realized maximum statutory tax rates one year after the issuance date provide an unbiased estimate of investors' expectations at time t 17 The adjusted RI for the full sample is 0 .499 . The coefficient /3 i provides an estimate of the effect on ITR of a change in the personal tax rate, while /3, provides an estimate of the effect on ITR of a change in the corporate tax rate . R, and 0, are both hypothesized to be positive, suggesting that reductions in the personal and corporate tax rates both decrease ITR . For the full sample, /3 i = 0.498 and is highly significant (t= 18 .77, with a p-value < 0 .001), while (3 2 = 0 .431 and is also significant (t=7 .04, with a p-value < 0 .001) . Although /3 i is greater than /3,, tests indicate that the difference is not statistically significant . These results are consistent with the hypothesis and suggest that, on average, reductions in the personal and corporate tax rates both decrease ITR . Specifically, a decrease of one percentage point in the personal (corporate) tax rate would reduce the implicit tax rate by 0 .498 (0 .431) percentage points . Also hypothesized is that changes in the personal tax rate will have an increased effect on ITR after TRAM . The coefficient /3' i provides evidence on
290
ELIZABETH PLUMMER
Table 6. Full sample regression results of the marginal investor's tax rate on the personal tax rate, corporate tax rate, and other explanatory variables . [.,~ = a+ u ss+ +)$,CALL,
1Ip1 +
i~,1 +
,
es
I t,
+ /34 S1NK + $ 5 ISSUESZ, + /36 YRMAT .,
+ /37MEDIUMRTG; + /3sUTILITY. + #,FINANCE, + /3 IORISKcvsp, , + /3,,RISK MV,,J ,
Variable
Predicted sign
intercept xe t, *tpi CALL SINK . ISSUESZ. YRMAT MEDIUMRTGI D96
UTILITY.
FINANCE. RISKGvsP,, RIsxMvsG,, MUNI_ALL, Adjusted R2 Sample Size N
? + + + + + 7 7 ? -
+
P 12MUNI-ALL, + error,
Estimated coefficient value 0.826 -1 .793 0 .498 0.431 0 .558 -0.168 0.100 0.002 -0.360 -2 .151 0.918 0 .917 -1 .912 -2 .317 -2 .330
White's t-statistic 0 .14 -1 .96 18 .77 7 .04 11 .48 -5 .74 2 .90 0.01 -22 .31 -4.95 2 .83 3 .04 -2 .50 -0.42 -2.59
p-value" us . (0 .050) (0.001) (0.001) (0 .001) " (0 .002) n.s . (0 .001) (0 .001) (0.005) (0 .002) (0 .006) n .s . (0 .005)
0 .499 2,770
Note : Variable definitions are in Appendix 1 . -p-values are one-sided if a directional hypothesis is predicted, and are two-sided if no direction is predicted . I,' Estimated coefficient is not in the predicted direction and is significant at the p=0 .01 (p=0 .05) level . n .s . Estimated coefficient is not significant at the p=0.10 level .
whether the effect on ITR of changes in the personal tax rate is different after enactment of TRA86. For the full sample, f3' 1 = 0.558 and is highly significant (t = 11,48, with a p-value < 0 .001) . Consistent with the hypothesis, this result suggests that changes in the personal tax rate have had more of an effect on ITR subsequent to TRA86 . The sum of f3, +)3', provides an estimate of the effect on ITR of a change in the personal tax rate after TRA86. The
The Effect of Tax Rate Changes on the Yield Spread
291
coefficient estimates suggest that, after TRAM, a decrease of one percentage point in the personal tax rate reduces ITR by 1 .056 percentage points 2 8 This is consistent with the idea that, after TRAM, the marginal investors in corporate and municipal bonds are individuals . With respect to the issue-specific variables, the coefficient for Sink is significantly positive as expected (t = 2 .90), while Yrmat is negative as expected and highly significant (t = -22 .31) . lssuesz is negative but not significant (t = 0 .01) . Contrary to predictions, Call is significantly negative (t=-5 .74) . Consistent with expectations, implicit tax rates are negatively associated with the size of the issue and are positively associated with the presence of a sinking fund agreement. The estimated coefficient for MEDIUMRTG is significantly negative (t=-4 .95) . This suggests that, after controlling for the other factors in Eq . (4), the ITR for medium-risk bonds is lower than the ITR for low-risk bonds . This suggests that the marginal investors in low- and medium-risk bonds differ . Therefore, a later section of the paper explores the possibility that changes in tax rates have differential effects on the ITRs of low- and medium-risk bonds . The utility and finance industry indicator coefficients are both significantly positive at conventional levels (p-value < 0 .010) . However, in sensitivity analysis (not reported here), there is no evidence that the effects of changes in to and t vary across industry 29 The coefficient on the risk variable RISKCVsp , is significantly negative as predicted (t=-2,50), but the coefficient on RiSK MV C,, , is not significant . These results suggest that variations over time in the perceived riskiness of the lower grade municipal bonds, but not the higher-grade municipal bonds, have had a detectable effect on the ITR . Lastly, the coefficient on MUM-ALL, is significantly negative as predicted (t=-2 .59), suggesting that decreases in the supply of municipal debt decrease ITR . By Time-to-Maturity Groups Corporate tax rate changes are hypothesized to be relatively more important for affecting the yield spread of short-term bonds, while personal tax rate changes are expected to be relatively more important for long-term bonds . To examine this hypothesis, equation (4) is estimated separately for each time-to-maturity group, and results are presented in Table 7 . The adjusted R2 s for the different maturity groups range from 0 .552 to 0 .742 . For the shortest-term bonds (0-5 years), the coefficient on the personal tax rate (/3) has a value of 0 .340, and the coefficient on the corporate tax rate (0 2) has a value of 0 .577 . Both values are significantly greater than zero (p-values < 0 .001) .
292
ELIZABETH PLUMMER
Tests also indicate that t'2 is significantly greater than 6, (p-value < 0 .001) . A decrease of one percentage point in the personal (corporate) tax rate would reduce the implicit tax rate by 0.340 (0.577) percentage points . These results suggest that, prior to TRA86, changes in corporate tax rates were more important than changes in personal tax rates for determining the spread on short-term bonds . However, evidence suggests that the effects on ITR of changes in the personal tax rate increased after enactment of TRA86 . The coefficient /3', has an estimated value of 0 .545 and is significantly greater than zero (p-value < 0 .001) . The sum of /3, +,6', is 0 .885 and implies that a one percentage point decrease in the personal tax rate
Table 7. Regression Results of the Marginal Investor's Tax Rate on the Personal Tax Rate, Corporate Tax Rate, and Other Explanatory Variables, by Time-to-maturity Groups . tmll -
I'O
+ RII DBE+RItp,+R2tn +
I'I
DAfi
tpt
+ #,CALL, + /3,SINK, + $S ISSUESZ, + /36YRMAT. + I37,MEDIUMRTG, + /35UTILITY, + /39FINANCE, +l3, 0RISKey, +(i, RISK,,, ct +$ 12MUNI_ALL, +error,
Variable
Predicted sign
Intercept D86 tr, to D86*tr, CALL SINK. Issuesz, YRMAT. MEDIUMRTC,
?
UTILITY
7
FINANCE , RISKGvsP,, RIsKMvsG, MuNLALL
9
Adjusted R2 Sample Size N
0-5 years: Estimated coefficient White's value t-statistic 0 .217 0 .993 0 .340 0 .577 0 .545 -0 .489 0.882 -0 .783 -1 .755 -2 .559 0.491 0.546 2 .500 2.327 -3 .236 0.552 682
2 .29 1 .25 6.53 7 .00 5 .71 -1 .18 0.79 -3 .20 -12.94 -4.60 0.65 1 .32 1 .17 0.93 -2.90
p-value' (0.022) n .s . (0.001) (0 .001) (0.001) Its.
n.s. (0.001) (0.001) (0.001) Its .
as. n.s. n.s. (0.002)
6-10 years : Estimated coefficient White's value t-statistic 3 .999 0.879 0 .506 0 .534 0 .184 1 .448 -0 .357 -0 .963 -2.162 -2 .802 0 .782 0 .753 -2 .669 1 .077 -2 .937 0 .572 1,146
1 .69 1 .37 14.62 5 .79 10.68 3 .62 -0.57 -3 .40 -17.55 -3 .73 1 .70 1 .88 -2.40 1 .40 -2.39
p-value° (0.090) n .s . (0.001) (0 .001) (0.001) (0.001) ns. (0.001) (0.001) (0.001) (0.090) (0.060) (0.008) n.s. (0.008)
The Effect of Tax Rate Changes on the Yield Spread Table
7.
293
Continued .
tm,,=RF+P DKR+P,tp,+0,t,,+$,'DNR*I,, + R,CALL ., + 0,SINK .. + $, ISSUESZ.. + /3R YRMAT ., + 0,MEDIUMRTG ., + PSUTILITY ., + /3Q FINANCE ., +/3 IO RISK
cvIFI
+(3,,RISK MVSO ,+0, 2MUNI ALL, +error, ,
11-20 years :
21-30 years :
Estimated Variable
Predicted sign
Intercept D86
D86*t ,~ CALL SINK . Issueszs YRMAT . MEDIUMRTa. UTILI Y, FINANCE. RISKGvsP,, RISKMvSG,, MUM Au, Adjusted R'Sample Size N
+ +
s
Estimated
coefficient value
White's t-statistic
-3 .520 -2 .122 0 .900 0 .739 0 .064 -1 .689 0 .609
-1 .45 -1 .59 7 .73 2 .97 3 .68
1 .545 -0 .419 -0 .265 0 .644 1 .197 -2 .809 -1 .031 -3 .317
2.20 -2 .90 -1 .16 1 .71 3 .61 2.23 0 .43 0.90
-1 .20 4 .02
0637 . 212
p-value" as . ns . (0 .001) (0 .002) (0 .001) n .s . (0 .001) c (0 .002) n .s . (0 .088) (0 .001) (0 .013) n .s . n.s .
coefficient value
White's t-statistic
p-value'
3 .936 -2 .399 0 .563
0 .56 .62 1 19 .57
n .s. n.s. (0.001)
0 .617 0 .417 1 .936 0 .516 .419 0 -0.374 -1 .062 2 .136 2 .083 0 .789 1 .870 2 .505
2.59 6 .74 2 .48 .60 1 2 .01 -4 .57 1 .96 5 .84 4 .06
(0.005) (0.001) (0.007) (0.055) c (0.001) (0,050) (0.001) (0 .001) n .s.
-0 .09 -3 .31 -2.16
(0.001) (0 .0t5)
0.742 730
Note: Variable definitions are in Appendix I . 'p-values are one-sided if a directional hypothesis is predicted, and are two-sided if no direction is predicted. s, Estimated coefficient is not in the predicted direction and is significant at the p=0 .01 (p=0 .05) level . n .s . Estimated coefficient is not significant at the p=0.10 level .
reduces ITR by 0 .885 . This suggests that, after TRA86, changes in personal tax rates have had more of an effect on the spread of short-term bond yields than changes in the corporate tax rate . For each of the three other maturity groups with time-to-maturities greater than five years, coefficients on both the personal tax rate (/3) and the corporate tax rate ()3,) are significantly positive . For the 6-10 year maturity
294
ELIZABETH PLUMMER
group, the /3 i and /3Z values are 0 .506 and 0 .534, respectively, and tests indicate the estimated coefficient values are not significantly different from one another. For the 11-20 year maturity group, the estimated values for /3 i and $2 are 0 .900 and 0 .739, respectively, and /3, is marginally greater than /3 z (p < 0.06) . For the longest-term bonds (21-30 years), /3, and /3, are 0 .563 and 0 .617, and are not significantly different from one another. These results suggest that, prior to TRA86, both personal and corporate tax rate changes affected longer-term bond yields and, in general, their effects were not significantly different from one another . For each of these longer-term maturity groups, tests indicate that /3'1 is significantly greater than zero (all p-values < 0 .001) . This suggests that, after TRA86, personal tax rate changes had an increased effect on the spread of these longer-term bond yields . In addition, for each of these maturity groups, tests indicate that the sum of /3 i + 0', is significantly greater than /32 . This is similar to the shortest-term bond group (0-5 years) and suggests that, after TRA86, changes in the personal tax rate have had more of an effect on ITR than changes in the corporate tax rate . In summary, the results are consistent with the hypotheses and suggest that, on average : (1) prior to TRA86, the marginal investors in the shortest-term bonds (0-5 years) were corporations, while the marginal investors in longerterm bonds were both individuals and corporations, and (2) subsequent to TRA86, the marginal investors in both short-term and long-term bonds are individuals . The shift toward individuals being the marginal investors in bonds of all maturities is consistent with Poterba's (1989) hypothesis and with the aggregate statistics showing a relative decrease in bank ownership of tax-exempt securities . Because TRA86 significantly decreased the incentives for banks to purchase municipal bonds, banks will play a relatively smaller role in the municipal bond market, and individuals will play a relatively larger role . As a result, personal tax rates became more important in establishing bond yields . The estimated coefficients on the issue-specific variables vary in magnitude and significance across the maturity groups, but are generally consistent with predictions . For all groups, the estimated coefficients on Call, Sink, and Yrmat are either significant in the predicted direction or insignificant . As expected, IssuESZ is significantly negative for two maturity groups (p <0 .001), but is significantly positive for the other two maturity groups (p < 0 .05) . Across all four time-to-maturity groups, the estimated coefficient on MEDIUMRTG is either significantly negative or insignificantly different from zero . The industry indicator variables are generally insignificant or marginally significant for the three groups with maturities of 20 years or less . For the 21-30 year maturity group, the two industry indicator variables are significantly
The Effect of Tax Rate Changes on the Yield Spread
295
positive . The coefficients on the risk variables (Rlstc 0V Pj and RiSK MV ,c d are either significantly negative, as expected, or insignificant . Lastly, as predicted, Mum _ALL ' is negative in all four of the maturity groups and significantly negative in three of the groups . Differences Across Risk Levels : Low- vs . Medium-risk Bonds
In the sample, bonds are divided into low- and medium-risk bond groups . Results suggest that ITR is not constant across the two risk groups . The full sample results in Table 6 suggest that ITR is lower for medium-risk bonds than for low-risk bonds (i .e . MEDtuMRTC is significantly negative) . The ITR differences between the two risk groups suggest that the marginal investor in low-risk bonds differs from the marginal investor in medium-risk bonds . As a result, the effect of tax rate changes on the yield spread may differ for low- and medium-risk bonds . In this section, evidence first is provided on the differences in the marginal investor in low- and medium-risk bonds, then, tests for differential effects of personal and corporate tax rate changes on the yield spreads of low- and medium-risk bonds are run . To provide descriptive evidence on differences in the marginal investor for low- and medium-risk bonds, Panel A of Table 8 presents the median ITRs across tax regimes for the two risk groups . For all years combined, the median ITR is 30 .84% for low-risk bonds and 28 .39% for medium-risk bonds . Within all tax regime periods, the median ITR for the low-risk bonds is greater than that for the medium-risk bonds (all differences are significant at p < 0 .001 by the Jonckheere test) . This pattern is consistent with the marginal investor in low-risk bonds having a higher marginal tax rate than the marginal investor in medium-risk bonds . Because the time-to-maturity results in Table 7 suggest that the ITR differences between the two risk groups are more pronounced for bonds with less than 10 years to maturity, the sample is divided into short-term bonds (those with 0-10 years to maturity) and long-term bonds (those with 11-30 years to maturity) . Panel B of Table 8 presents the median ITRs across tax regimes for low- and medium-risk short-term bonds, while Panel C presents the median ITRs for low- and medium-risk long-term bonds . For short-term bonds, the descriptive evidence in Panel B is consistent with the full sample evidence in Panel A . For all years combined and within each tax regime period, Panel B shows that the median ITR for the low-risk, short-term bonds is greater than that for the medium-risk, short-term bonds (all differences are significant at p < 0 .001 by the Jonckheere test) . In contrast, the descriptive evidence for long-term bonds is not consistent with the full sample or short-term bond
296
ELIZABETH PLUMMER
Table 8.
Median implicit tax rate by tax regime, risk level, and time-to-maturity .a
Panel A : Full Sample" Risk Group Low-risk bonds Medium-risk bonds
Pre-ERTA (1979-1980)
ERTA (1981-1985)
TRA86
All Years
(1986-1989)
(1979-1989)
44 .16 (147) 40 .16 (171)
30.76 (493) 28 .43 (552)
28 .38 (723) 26.68 (684)
30 .84 (1,363) 28 .39 (1,407)
TRA86 (1986-1989)
All Years (1979-1989)
34 .67 (340) 30.65
31 .53 (534) 28.16
33 .26 (960)
(379)
(419)
30 .34 (868)
TRA86 (198(-1989)
All Years (1979-1989)
Panel B : Short-term bonds (0-10 year maturities)b Pre-ERTA ERTA Risk Group (1979-1980) (1981-1985) Low-risk bonds
46 .05
Medium-risk bonds
(86) 43 .47 (70)
Panel C : Long-term bonds (11-30 year maturities)` Pre-ERTA ERTA Risk Group (1979-1980) (1981-1985) Low-risk bonds
38 .01
24.75
23 .25
25 .96
Medium-risk bonds
(61) 37 .66 (101)
(153)_ 24 .25 (173)
(189) 22.35 (265)
(403) 23 .44 (539)
Notes : ° The first number is the median implicit tax rate, while the second number in parentheses is the sample size N. Low risk bonds are those rated "prime" and "good", and medium-risk bonds are those rated "medium ." b Differences across tax regimes and across ratings groups are significant at p < 0 .001 by the Jonckheere test of ordered alternatives (Hollander & Wolfe, 1973) . `Differences across tax regimes are significant at p < 0 .001 by the jonckheere test of ordered alternatives (Hollander & Wolfe, 1973), but differences across ratings groups are not significantly different from one another .
evidence . For all years combined and for each tax regime period, Panel that the median
ITR
C
shows
for the low-risk and medium-risk long-term bonds are not
significantly different from one another. The descriptive evidence in Panels and
C
suggest that the short-term bonds drive the
full
B
sample results . For
short-term bonds, evidence suggests that there are different marginal investors in low- and medium-risk bonds . For long-term bonds, there the marginal investor differs across the two risk groups
30
is
no evidence that
The Effect of Tax Rate Changes on the Yield Spread
297
The pattern of median ITR values across risk groups in Table 8 is consistent with differing marginal investors for low- and medium-risk bonds . This suggests that changes in the personal and corporate tax rates may have differing effects on the yield spreads for low- and medium-risk bonds . To test for possible differences, equation (4) is modified by including an indicator variable (D M, j ) equal to one if the bond is rated medium, and equal to zero otherwise . Specifically, the estimate of the model is : t m ~~=(3i) +(%a D xe +a()D Md +a o 'D Rh*D MCd +/3 1 tpt +a l l)
i
t
+ /9,t,t + a,D M J * tc1 + $ 'D sh * trt + al D N6 * D MCd *tp( + )3,CALL + /34SINK, +
P S ISSUESZ,
+ )% YRMAT,
+ /3 H UTILITY, + $,FINANCE, +/3 IU RISKC „sr( +)3 1 RiSKM , scI +$ i ,MUNi -ALL,+error,
(5)
The coefficients /3 i and /3 z provide estimates of the effects on ITR of changes in tP and t', respectively, for low-risk bonds . For medium-risk bonds, the sum /3 i + a i provides an estimate of the effect on ITR of changes in tp, while the sum /3, +a, provides an estimate of the effect on ITR of changes in t . Equation (5) also tests whether the effects of changes in the personal tax rate differ after enactment of TRA86. For low-risk bonds, the sum /3, + /3', provides an estimate of the effect on ITR of post-TRA86 changes in t Fl Similarly, for medium-risk bonds, the sum ()3 i + /3' i ) + (a 1 + a' 1 ) provides an estimate of the effect on ITR of post-TRA86 changes in tp Because the evidence in Table 8 suggests that results differ for short-term and long-term bonds, equation (5) is estimated separately for the two time-tomaturity groups . Results are presented in Table 9, Panels A and B, respectively . For ease of exposition, rather than present the coefficient estimates for equation (5) individually, Table 9 presents the combined coefficients that measure the total effect of changes in t and t on ITR for the low- and mediumrisk bond groups ." Results for the short-term bonds are presented in Panel A . For the low-risk bonds, the estimated effect on ITR of a one-percentage point decrease in the personal tax rate (tr ) is 0 .513, and of a one-percentage point decrease in the corporate tax rate (to ) is 0 .495 . Tests indicate that these effects are not significantly different from one another . In contrast, for the medium-risk bonds, the estimated effect on ITR of a change in t p is 0 .431, and is significantly less than the 0 .658 estimated effect of a change in tc (p < 0 .001) . These results
298
ELIZABETH PLUMMER
suggest that, prior to TRA86, changes in corporate tax rates were more important than changes in personal tax rates for determining the yield spread on mediumrisk, short-term bonds . For the low-risk bonds, both personal and corporate tax rate changes affected bond yield spreads and their effects were not significantly different from one another . The last row of Panel A presents the estimated effect on ITR of changes in the personal tax rate after enactment of TRA86 . Results suggest that the effect of changes in t on ITR increased after TRA86 . A decrease of one percentage o point in the personal tax rate reduces the implicit tax rate on low-risk (mediumrisk) bonds by 0 .787 (0 .756) percentage points . Each of these effects is greater than the corresponding effect on ITR of a change in the corporate tax rate (estimated effects of 0 .495 and 0 .658, respectively) . This evidence suggests that, after TRA86, changes in personal tax rates have had more of an effect on the spread of short-term bond yields than changes in the corporate tax rate . Results suggest the increased importance of t p holds for all short-term bonds, regardless of their risk level . Results for the long-term bonds are presented in Panel B of Table 9 . For low-risk (medium-risk) bonds, the estimated effect on ITR of a change in the personal tax rate is 0 .725 (0 .693) . The estimated effect of a change in the corporate tax rate is 0 .648 (0 .618) . Tests indicate that the personal and corporate tax rate effects are not significantly different from one another at conventional levels . This evidence suggests that, prior to TRA86, both personal and corporate tax rate changes affected long-term bond yields and their effects were generally not significantly different from one another . This finding holds irrespective of risk level . Evidence also suggests that, after TRA86, personal tax rate changes had an increased effect on the spread of these long-term bond yields . Estimates in the last row of Panel B indicate that a one-percentage point decrease in t o decreases ITR by 0 .929 (0 .899) percentage points for low-risk (medium-risk) bonds . This is similar to the short-term bond results in Panel A and suggests that, after TRA86, changes in tP have had more of an effect on ITR for long-term bonds than changes in ~ have had . In summary, the results in Tables 8 and 9 suggest that, on average : (1) prior to TRA86, the marginal investors in medium-risk, short-term bonds were corporations, while the marginal investors in low-risk, short-term bonds were both individuals and corporations ; (2) prior to TRA86, the marginal investors in long-term bonds were both individuals and corporations, regardless of risk level ; and (3) subsequent to TRA86, the marginal investors in both short-term and long-term bonds are individuals, regardless of risk level .
The Effect of Tax Rate Changes on the Yield Spread
Table 9 .
299
Combined coefficient estimates by risk groups (low/medium) and time-to maturity groups (short/long) .'
+ $,t„ + a,Dmat ' t" + 0 1 + $,CALL, + /34 ,SINK I
'% * t pt
+ a, Its, *
+ /351SSUGSZ, +
DM«,*t
,
(36YRMA r
+ /3B UT H.n'v, +)3„PINANCF_, +R,,,RISKG,„ r ,+/3„RISK Mvy(,
+/3MUNiALL,+errorl,
Panel A : Short-term bonds (0-10 year maturities) Variable t n,
Low-Risk Bonds
Medium-Risk Bonds
0 .513 (0 .001)
0.431 (0,001)
0 .495 (0 .001)
0 .658 (0 .001)
0 .787 (0 .001)
0.756 (0 .001)
Panel B : Long-term bonds (11-30 year maturities) Variable
Low-Risk Bonds
Medium-Risk Bonds
0.725 (0 .001)
0 .693 (0 .001)
0 .648 (0 .001)
0.618 (0 .001)
0 .929 (0 .001)
0 .899 (0 .001)
Note: Variable definitions are in Appendix l .
'The first number is the estimated total effect (measured as the sum of the relevant coefficients), while the number in parenthese is the p-value that tests whether the total effect is greater than zero . Specifically, the values are as follows : Variable
Low-Risk Bonds R, R,
D
/3
+a,"
Medium-Risk Bonds 01 + . , )3, +a,
(R,+R,')+(a,+aI')
300
ELIZABETH PLUMMER
5. CONCLUSIONS This study examines the effects of personal and corporate tax rate reductions on the differential between corporate and municipal bond yields, and provides evidence of tax clientele differences across bonds of different maturities and different risk levels . Implicit tax theory suggests that the personal and corporate tax rate reductions of ERTA and TRA86 should reduce the spread between pre-tax corporate and municipal bond yields . The sample consists of 2,770 newly issued taxable corporate bonds over the period 1979-1989 . Each corporate bond issue is matched with a similar municipal bond issue . Descriptive results indicate that ITR is greater for short-term municipal bonds than for long-term municipal bonds, and that ITR decreased over the sample period for bonds of all maturity lengths . In order to examine the effects of the personal and corporate tax rate reductions on the yield spread, ITR (a measure of the yield spread) is modeled as a function of the personal and corporate tax rates, corporate bond issuespecific variables, and other explanatory variables . For the full sample, reductions in both the personal tax rate and the corporate tax rate decrease ITR . For the shortest-term bonds prior to TRA86, changes in the corporate tax rate had more of an effect on ITR than changes in the personal tax rate. For each of the other three longer-term maturity groups prior to TRA86, both personal and corporate tax rate changes affect ITR and their effects are not significantly different from one another . After TRA86, for all four maturity groups, changes in the personal tax rate have a greater effect on ITR than changes in the corporate tax rate . These results suggest that, prior to TRA86, the marginal investors in short-term bonds were corporations, while the marginal investors in longer-term bonds were both individuals and corporations . Following TRA86, the marginal investors in both short-term and long-term bonds are individuals . This shift is consistent with the changes made by TRA86 that decreased the incentives for banks to invest in municipal bonds . Results also suggest that the effects of tax rate changes differ across low- and medium-risk bonds . Examining the effects of tax rate changes on corporate and municipal bond yields is useful to policymakers and to managers of both corporations and municipalities . Although beyond the scope of the current study, a meaningful extension would be to examine the effects of state tax rates on the implicit tax borne by municipal bonds . In addition, one could examine the effect of changes in the issuing corporation's marginal tax rate on the bond yields of its new debt issues . Both Newberry and Novack (1999) and Harwood and Manzon (2000) find that firms with high marginal tax rates use more long-term debt than do firms with low marginal tax rates because high marginal tax rate firms have a
The Effect of Tax Rate Changes on the Yield Spread
301
higher expected value of future interest expense tax shields . An issuing corporation's marginal tax rate also is likely to affect the pre-tax bond yield the corporation is willing to pay because the interest expense is tax deductible .
NOTES I . Nester (1986, 1987) describes the steps used by the Treasury Department's Office of Tax Analysis in estimating the effect a proposed tax law change will have on tax revenues . 2 . As defined in Scholes and Wolfson (1992), the marginal investor is that investor for whom the after-tax returns are the same for differentially taxed alternative investments of equal risk . 3 . Of the 13 event months in Poterba (1989), only 3 months reflect tax policy debates that focused exclusively on changes in corporate tax rates . The other 10 months reflect months in which Congress discussed either changes in the personal tax rate alone (6 months) or changes in both the personal and corporate tax rates (4 months) . This limits the study's ability to measure the effects of corporate tax rate changes on bond yields, and may therefore underestimate the effects of corporate tax rate changes on bond yields . 4 . Corporations having a taxable year that straddled July 1, 1987 were subject to blended rates so as to reflect the reduced rates for the part of the year that fell after June 30, 1987 . 5 . In addition to federal taxes, state taxes could influence ITR . Corporate bond interest income will be subject to state taxation (if any) by the bondholder's state of residency, while municipal bond interest income may or may not be subject to state taxes . (The state taxation of municipal bond interest income will depend on the issuing municipality and the bondholder's state of residency .) In addition, the different bondholders of any single bond issue are likely to be residents of several different states . The effect of state taxes on ITRs is likely to be a second-order effect relative to federal tax effects, and will add measurement error to ITR . However, the effects of state taxation on municipal and corporate bond yields remains an interesting avenue for future research . 6 . This information is taken from the Federal Reserve Bulletins, Flow of Funds accounts . 7 . This database is published by the Fixed Income Research Program at the University of Houston, and excludes convertible bonds . 8 . For example, IRC Section 171 provides that the premium on taxable bonds may, at the election of the taxpayer, be amortized and used to offset interest income from the bond . For owners of municipal bonds, the amortization amount is not allowed as a deduction, but does reduce the adjusted basis of the bond [IRC Section 1016 (a)(5)] . 9 . These municipal bonds are restricted to general obligation bonds, and do not include revenue bonds or private activity bonds . General obligation bonds are backed by the "full faith and credit" of the issuing government . This bond data appear to be the best publicly available source, and has been used in prior studies (e .g. Poterba, 1986 ; Hochman et al ., 1993) . 10 . All bonds in the sample are investment grade and are thus eligible for purchase by commercial banks . The Comptroller of the Currency's commercial bank regulations prohibit commercial banks from investing in non-investment grade bonds .
302
ELIZABETH PLUMMER
11 . For example, a 7-year corporate bond issued on March 15, 1980, with an An rating, would be matched with the Salomon Brothers' good grade, 5-year municipal bond dated April 1, 1980 . The corporate bond yield on the FIDB is the yieldto-maturity as of the last day of the issue month, In this case, March 31, 1980 . 12 . When testing for implicit taxes, it is difficult to control for risk differences between differentially-taxed securities . Matching securities on credit rating has been used in almost all studies of implicit taxes (e.g . Poterba 1986, 1989 ; Ang et al ., 1985 ; Hochman et al ., 1993 ; Engel et al ., 1999). Although several measures were taken to help control for risk differences, it still is possible that the matched municipal and corporate bonds are not of equivalent risk . To increase confidence that risk differences are not influencing the results, the sample was restricted to bonds that did not have a ratings change over the 18-month period subsequent to their issuance . This attempts to isolate those bonds for which the rating at issuance was most likely the "correct" one (i .e. most timely) . With this restricted sample, all analyses in the article were repeated . Results regarding the inferences of tax rate changes on ITR are essentially identical . 13 . The tax rates t,,, t , and t, are entered as percentages . For example, if the personal tax rate is 50%, t is coed as 50 . 14 . The interaction term D ft6 *t , is not included because the model would not be full rank. The interaction term D R6 *t, would be a linear combination of : -46*Intercept + t, +46*D R6 , and there would not be a unique solution available . If the effective corporate tax rate is used as a measure of t rather than the statutory rate (see Table 2), then the intercept term D 86 *t, can be included in equation (4) . Inferences from this revised equation (4) are the same as those from equation (4) not including the interaction term . 15 . The effective personal and corporate tax rates are available from the U .S . Treasury Department's Statistics of Income: Corporate Income Tax Returns and Statistics of Income : Personal Income Tax Returns. The effective personal tax rate is set equal to the effective rate for individuals in the highest income bracket, and is calculated as their total income taxes paid divided by their total taxable income . The effective corporate tax rate is set equal to the effective rate for corporations in the highest corporate business receipts bracket, and is calculated as their total income taxes paid divided by their total taxable income . These calculations are consistent with those in Hochman et al . (1993) . 16 . This study examines the effect of the bondholder's tax rate on relative bond yields . However, the issuing firm's tax rate also is likely to affect the bond yield because interest expense is deductible by the corporation for tax purposes . The tax deductibility of the interest expense decreases the corporation's effective cost of borrowing . (The after-tax and pre-tax costs to municipal issuers are equivalent because municipal issuers do not receive tax benefits from interest expense deductions .) As corporate tax rates change across time, corporate bond yields are likely to be affected because interest expense is deductible for tax purposes . This will result in a correlation between corporate bond yields and corporate tax rate changes irrespective of the marginal investor in the bond . To test the sensitivity of the results to this possibility, all bonds for which the issuing corporation's marginal tax rate is greater than 38% are omitted . This causes the issuing corporations' marginal tax rates to be more similar across the sample period, thereby reducing the likelihood that the results are due to the effect of corporate tax rate eductions on issuing firms' tax rates . (38% is used as the cutoff because that is approximately 10% higher than the maximum corporate tax rate of 34% after the corporate tax rate reduction. The issuing corporation's tax rate is estimated using
The Effect of Tax Rate Changes on the Yield Spread
303
Shevlin's (1990) estimation procedure .) All analyses in the article are repeated with this subsample . Although the coefficient values are slightly different, the inferences regarding the relative importance of corporate and personal tax rate changes on ITRs for bonds of different maturities and risk levels remain unchanged from those reported in the paper . 17 . In models explaining bond yields, Ederington et al . (1987), Ziebart and Reiter (1992), and Sengupta (1998) include variables related to a bond's call option, and Ziebart and Reiter (1992) also include an indicator variable to denote the bond has a sinking fund provision . Both Ziebart and Reiter (1992) and Sengupta (1998) include the log of issue size in their models. 18 . Ziebart and Reiter (1992) include years-to-maturity in their model, and Sengupta (1998) includes the log of years-to-maturity . All analyses in the article are replicated using log of years-to-maturity and inferences are unchanged . 19 . Both Ederington et al . (1987) and Ziebart and Reiter (1992) include variables denoting bond rating in their models . 20 . Prior studies do not make a distinction between industries when examining implicit tax rates or bond yields . Although there are no predictions regarding differences across industries, an indicator variable to allow for this possibility is included . As discussed in the results section, the industry indicator variables are either insignificant or significantly positive . To explore the possibility that the effects on ITR of changes in tax rates vary across industry, the analyses in Tables 6, 7, and 9 are repeated separately for each industry . Inferences regarding the variables of interest (t . and tc) are unchanged from those reported in the article . 21 . The data used to generate this variable are available on a half-yearly (1979-1986) and quarterly (1987-1989) basis only . The value of this variable is thus set equal to the respective half-yearly or quarterly figure . 22 . MUNI_AI .t, controls for the effect of the relative supply and demand for municipal bonds on the yield spread. In addition, the relative supply and demand for corporate bonds could affect the yield spread . Therefore, all analyses including CORP ALI . a s an additional explanatory variable are replicated, where CORP-ALL is defined as the supply of new corporate debt divided by the supply of new aggregate U .S . market debt . All inferences on the variables of interest it p and Q are essentially identical . 23 . The Pearson correlation coefficients between the corporate bond yield (y,,) and Call and Sink are 0 .34 and 0 .20, and the Spearman correlation coefficients are 0 .36 and 0 .21, respectively (all significant at p < 0.001) . 24 . ERTA reduced the personal tax rate in 1982, whereas TRA86 reduced both the personal and corporate tax rates in 1987 and 1988 . Because investors knew the tax law changes approximately one year before their effective dates, the pre-ERTA period ends with 1980, and the pre-TRA86 period ends with 1985 . 25 . The Jonckheere test is a nonparametric, distribution-free statistical test that tests for differences across sample populations . The null hypothesis is that all samples are from the same population . The alternative hypothesis is that the samples are from different populations where the values are increasing (or decreasing) across populations in a predicted direction . 26 . The finance literature shows that when a firm issues debt, it signals firm strength to investors . Therefore, firm values will rise with increases in debt since the market increases its estimate of firm value (Ross, 1977) . If a debt issue increases a firm's equity value, it is conceivable that a firm could issue the debt at a higher yield relative to what it could in the absence of this signaling effect . Although this would tend to overstate
304
ELIZABETH PLUMMER
the measure of ITR (equation (2)), it does not necessarily follow that this overstatement of ITR would introduce a systematic bias in the relation of ITR with t and t. (i .e . the /3 i and Yr coefficients in equation (4)) . Nonetheless, to test for the sensitivity of the results to this possible signaling effect, all firms that also issued equity in the year of the debt issue, or in the year following, are deleted . This provides a sample of firms that are less likely to directly benefit from increased equity values attributable to a signaling effect. All analyses are repeated using this subsample, and the results are essentially identical to those reported in the paper. It also should be noted that any increase in yield due to a signaling effect could be lessened or negated if the debt issue increases the market's perception of firm value, thereby reducing the firm's perceived risk and the yield required on its debt . 27 . Equation (4) is also estimated for the full sample and all time-to-maturity groups based on setting i s and t. equal to the maximum statutory tax rates for the year the bond is issued . Inferences are qualitatively similar, although the t-statistics generally are smaller but still highly significant . Consistent with Hochman et al . (1993), Eq . (4) also is estimated using the maximum effective personal and corporate tax rates from Table 2 . The inferences are similar to those reported in the article . 28 . The sum of /3, + /3', is not significantly different from 1 .00 at conventional levels . Recall that Dsb *t,, cannot be included as an explanatory variable in Eq . (4) because the model would not be estimable . To test for differences in the effect of changes in t C across time, the model is estimated for various subsets of post-1984 years . Equation (4) also is estimated including an interaction term D sfi *t,, where t is the maximum effective corporate tax rate . In all instances, the inferences are similar to those reported in the article . 29 . To test for differences across industries, the analyses in Tables 6, 7, and 9 are repeated separately for each industry . There is no evidence of differences across industries for the coefficients on i and t . 30 . Dividing the low- and medium-risk bonds into short- and long-term bond groups also helps address concerns that the differences in ITRs across bonds of differing maturities (in Table 5) are attributable to measurement error in ITR for the short-term bond group . Newberry and Novack (1999) find that riskier corporations use shorter-term debt . Therefore, if a riskier corporate bond is matched with a less risky municipal bond, the ITR would be artificially high . If this mis-matching is more prevalent for short-term bonds, then the pattern in Table 5 could be due to measurement error in ITR . The same criteria are used to match both short-term and long-term bonds, so it is not clear why matching on bond rating should introduce this measurement error only into the shortterm bond group. Nonetheless, the results in Table 8, Panel B, suggest that the ITR for medium-risk bonds is lower than the ITR for low-risk bonds . If measurement error due to mis-matching is a problem, then Panel B suggests it is a relatively larger problem for the low-risk bonds. This seems counter to what one would expect if the problem was a mis-matching due to risky corporate debt (i .e . one would expect the problem to be more evident in the riskier, medium-rated debt) . In addition, if there was measurement error in the low-risk, short-term bonds, this would most likely bias against finding similar results to the long-term bonds (where measurement error due to mis-matching is not expected) . However, results in Table 9 suggest that the marginal investors for low-risk, short-term bonds are the same as the marginal investors for long-term bonds . See footnote 12 for a discussion of additional measures taken to increase confidence that risk differences due to mis-matching are not influencing the results .
The Effect of Tax Rate Changes on the Yield Spread
305
31 . All analyses in Table 9 are replicated using the four different time-to-maturity groups as defined earlier . The inferences are qualitatively similar to those presented in this section . For ease of exposition, the analysis is presented using the sample partitioned into two time-to-maturity groups as opposed to four .
ACKNOWLEDGMENTS I wish to thank Linda Bamber, two anonymous reviewers, and the editor for their helpful comments . Financial support from the Price Waterhouse Tax Foundation is gratefully acknowledged .
REFERENCES Ang, J ., Peterson, D ., & Peterson, P . (1985). Marginal tax rates : Evidence from nontaxable corporate bonds : A note . The Journal of Finance, 40, 327-332 . Beek, D . (1982) . Rethinking tax-exempt financing for state and local governments . Federal Reserve Bank of New York Quarterly Review, 7, 30-41 . Buser, S ., & Hess, P . (1986) . Empirical determinants of the relative yields on taxable and taxexempt securities . Journal of Financial Economics, 17, 335-355 . Constantinides, G ., & Ingersoll, J . (1984) . Optimal bond trading with personal taxes . lournal of Financial Economics, 13, 299-336 . Ederington, L., Yawitz, J., & Roberts, B . (1987) . The informational content of bond ratings . The Journal of Financial Research, 10, 211-226 . Engel, E., Erickson, M ., & Maydew, E . (1999) . Debt-equity hybrid securities . Journal ofAccounting Research, 37, 249-274 . Feenberg, D ., & Poterba, J . (1991) . Which households own municipal bonds? Evidence from tax returns . National Tax Journal, (December), 93-103 . Fortune, P . (1988) . Municipal bond yields : Whose tax rates matter? National Tax Journal, (June), 219-233 . Guenther, D . (1994) . The relation between tax rates and pre-tax returns : Direct evidence from the 1981 and 1986 tax rate reductions . Journal of Accounting and Economics, 18, 379-393 . Harwood, E ., & Manzon, G ., Jr. (2000) . Tax clienteles and debt maturity. The Journal of the American Taxation Association, 22, 22-39 . Heaton, H . (1986) . The relative yields on taxable and tax-exempt debt . Journal of Money, Credit, and Banking, 18, 482-494 . Hochman, S ., Palmon, 0 ., & Tang, A . (1993) . Tax-induced intra-year patterns in bond yields . The Journal of Finance, 48, 331-344 . Hollander, M ., & Wolfe, D. (1973) . Non-parametric statistical methods . New York : John Wiley and Sons . Nester, H . (1986) . Revenue estimates-macrostatic, microdynamic . In : Proceedings of the 79th Annual Conference on Taxation . Columbus: National Tax Association-Tax Institute of America . Nester, H . (1987) . A guide to interpreting the dynamic elements of revenue estimates . In : Compendium of Tax Research-1987 . Washington, D .C . : GPO . Newberry, K ., & Novack, G. (1999) . The effect of taxes on corporate debt maturity decisions : An analysis of public and private bond offerings . The Journal of the American Taxation Association, 21, 1-16.
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Peek, J ., & Wilcox, J . (1986). Tax rates and interest rates on tax-exempt securities . New England Economic Review, 29-41 . Poterba, J . (1986) . Explaining the yield spread between taxable and tax-exempt bonds : The role of expected tax policy. In : H . S . Rosen (Ed.), Studies in State and Local Public Finance . Poterba, J . (1989) . Tax reform and the market for tax-exempt debt . Regional Science and Urban Economics, 19, 537-562. Ross, S . (1977) . The determination of financial structure : The incentive-signaling approach . Bell Journal of Economics, 8, 23-40. Scholes, M ., & Wolfson, M . (1992) . Taxes and business strategy : A planning approach . Englewood Cliffs, NJ : Prentice-Hall . Sengupta, P . (1998) . Corporate disclosure quality and the cost of debt. The Accounting Review, 73, 459-474 . Shevlin, T . (1990) . Estimating corporate marginal tax rates with asymmetric tax treatment of gains and losses . The Journal of the American Taxation Association, 11, 51-67. Trczinka, C . (1982) . The pricing of tax-exempt bonds and the Miller hypothesis . The Journal of Finance, 38, 907-923 . White, H . (1980). A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity . Econometrica, 48, 817-838 . Ziebart, D ., & Reiter, S . (1992) . Bond ratings, bond yields, and financial information . Contemporary Accounting Research, 252-282 .
APPENDIX 1 : VARIABLE DEFINITIONS
y ;,
• implicit tax rate (ITR) on municipal bond issue i, measured at time t, equal to (y„ y ajt) / y it ; • yield-to-maturity of corporate bond issue i, issued at time
y nit
= yield-to-maturity of the nontaxable municipal bond issue
trt
D86 CALL, SINAI ISSUES ; YRMAT,
matched to corporate bond issue i, measured at time t ; = the maximum statutory personal tax rate at time t plus 12 months ; • the maximum statutory corporate tax rate at time t plus 12 months ; = dummy variable equal to I if the year is 1986 or later, and equal to zero otherwise ; = 1 if bond issue i is callable, 0 otherwise ; = 1 if bond issue i has a sinking fund, 0 otherwise ; = log of issue size of bond issue i, in thousands of dollars ; = years to maturity of bond issue i, defined as number of days from date of issuance date until maturity date, divided by 365 ;
The Effect of Tax Rate Changes on the Yield Spread
if bond issue i is rated "medium" (A to Baa), and 0 otherwise ; I if firm issuing bond issue i is in the utility industry, 0 otherwise ; I if firm issuing bond issue i is in the financial industry, 0 otherwise ; yield spread between newly-issued, one-year good-grade (GI) and prime-grade (P1) municipal debt, divided by PI [i .e . (GI-Pl)/Pl], measured at time t ; yield spread between newly-issued, one-year medium-grade (M1) and good-grade (GI) municipal debt, divided by GI [i .e. (MI-Gl)/Gl], measured at time t ; and the supply of new municipal debt divided by the supply of new aggregate U .S . market debt, measured at time t .
MEDIUMRTG ., = 1
UTILITY
=
FINANCE
=
RISKCvspi
=
RISKM„GC I
=
MUNI ALL,
=
307
