Practice and policy insights from academic tax research

Editor: Annette Nellen, Esq., CPA, CGMA

In the continued spirit of bridging the gap between tax academics and tax practitioners, for the third year in a row, this column features examples of published academic tax research (see Meade, “Campus to Clients: Academic Research for Your Practice Consideration,” 52 The Tax Adviser 526 (August 2021), and Meade, “Campus to Clients: Practitioners Can Benefit From Academic Tax Research,” 51 The Tax Adviser 532 (August 2020)). The papers were selected by the External Relations Committee of the American Taxation Association (ATA) with the aim of sharing research that is relevant and of interest to practitioners. The ATA is the leading organization of tax academics, and the External Relations Committee aims to connect with tax professionals.

The five articles selected for this column highlight the wide breadth of topics and methodologies found in academic tax literature. Topics within academic tax literature that may be of interest to practitioners include tax policy, corporate and individual taxpayer behavior, effects of tax on stakeholders, tax accounting issues, and tax data analysis. Researchers provide valuable guidance on tax policy by providing insight on potential policy changes as well as feedback on existing policy.

Many academic tax papers examine corporate behavior using publicly available data such as annual reports, stock prices, rankings, and other sources of information. Studies of individual taxpayers are also common, with researchers conducting experiments or developing creative uses of public data. Federal, state, and international tax issues are often examined, as well as the impact of nontax developments on tax policy and behavior.

As with most academic research, these five articles were subject to a rigorous development and review process as outlined in the earlier columns. Researchers generally get input from peers on their “working paper” by presenting their thesis, approach, and initial findings at campus forums and conferences such as those sponsored by the American Accounting Association (AAA). Most articles undergo thorough blind peer review. Reviewers often call for some revisions, such as for clarification or deeper analysis, for the paper to be accepted for publication. The academic publishing world is often harsh, as many papers are rejected under these rigorous standards for research approach, content, novelty, and timeliness.

Of the articles summarized here, one was in a tax-specific journal, while the others come from broader accounting journals, including one focused on accounting history.

‘The Effects of Income Tax Timing on Retirement Investment Decisions’

Withdrawals from a tax-deferred (i.e., traditional) individual retirement account (IRA) or 401(k) are taxable, making the account’s after-tax value less than the nominal value appearing on a quarterly or annual account statement. This future tax liability’s salience is weak for most individuals, which may cause them to overestimate their after-tax retirement savings. Roth IRA accounts are not affected in this way because withdrawals from them generally are tax-free.

In their article published in the March 2021 issue of The Accounting Review (Vol. 96, Issue 2), Shane Stinson, Marcus Doxey, and Timothy Rupert hypothesize that individuals’ inclination to overestimate a tax-deferred account’s after-tax value may cause them to believe that it will be easier to meet their future cash flow needs than is the case. Such an individual therefore may see less of a need to generate a higher return than does an individual holding a Roth account with the same after-tax value, so investments held in tax-deferred accounts may be lower-risk, and thus lower-return, than investments held in Roth accounts.

The authors conducted an experiment to test this hypothesis. Participants allocated an account’s balance between two investments, where one of them had lower risk and a lower expected return than the other. Some participants had a tax-deferred account, while others had a Roth account. The two types of accounts had similar after-tax values. After controlling for participants’ risk preferences, the authors found that, compared with Roth account holders, tax-deferred account holders had higher estimates of their future after-tax balances, allocated more of their account to the lower-risk, lower-return investment, and perceived less difficulty in meeting their after-tax goal for retirement savings. These results are consistent with the authors’ hypothesis.

Additional parts of the experiment tested whether various interventions mitigate individuals’ inclination to take on less risk with a tax-deferred account. The authors found that tax-deferred account holders allocated more of their savings to higher-risk, higher-return investments when their retirement savings goal was stated in pretax dollars, when they had to estimate their final tax liability, and when they were given feedback about their progress toward saving for retirement. The authors also found that the effect was stronger when multiple interventions were applied simultaneously. Tax advisers and financial planning professionals are well positioned to provide such interventions, and the results of the authors’ experiment suggest that the interventions will have beneficial effects.

‘The Possible Weakening of Financial Accounting From Tax Reforms’

The objective of financial accounting is to provide information about a firm’s economic performance to shareholders and other external stakeholders. The objective of the federal income tax is to raise revenue and to provide various economic incentives to taxpayers. Because these objectives differ, a firm’s book income, which is determined under financial accounting rules, sometimes is greater than its taxable income, which is determined under tax law. This outcome can seem inappropriate to many taxpayers. Several proposals have been made in recent years to more closely link taxable income to book income, and the recently enacted Inflation Reduction Act of 2022, P.L. 117-169, includes a 15% minimum tax for large corporations that is based on adjusted financial statement income.

In her Presidential Scholar address to the AAA, which was published in the September 2021 issue of The Accounting Review (Vol. 96, Issue 5), Michelle Hanlon discusses several issues that are pertinent to such proposals. She notes that there could be full linkage, where book income is used as taxable income. There instead could be partial linkage, such as the business untaxed reported profits (BURP) adjustment that applied in the latter 1980s. Hanlon notes that the implementation of partial or full linkage is more complicated than many people realize because of such issues as net operating losses and controlled foreign corporations.

Hanlon reviews research on the financial reporting effects of linking book income and taxable income, such as during the BURP adjustment’s brief life and international differences in book-tax linkages. The evidence generally indicates that firms are more likely to alter their financial reporting to attain tax objectives when book-tax linkages are stronger, and this leads to a book income that is less informative for capital market participants. While these research results are not surprising to accountants, they seem to be underappreciated by the economists and lawyers who advise policymakers. Hanlon notes that there is not much research on these financial reporting effects and advocates for more of it.

Hanlon concludes that linking taxable income more closely to book income would be unwise because it likely would impair the quality of financial reporting. The capital market costs of such impaired quality are not easy to discern but are nonetheless real. In addition, increased book-tax linkages could tempt Congress to play a stronger role in financial reporting standard setting because of the tax effects. Whether or not one agrees with Hanlon’s conclusions, her discussion of the pertinent issues does an excellent job of better educating the reader about them.

‘Transparency and Tax Evasion: Evidence From the Foreign Account Tax Compliance Act (FATCA)’

The Foreign Account Tax Compliance Act (FATCA) was enacted in 2010 (as part of the Hiring Incentives to Restore Employment Act, P.L. 111-147) to limit U.S. individuals’ ability to evade U.S. tax through the use of offshore accounts. The act requires automatic information transfers to the IRS about foreign account and cross-border payments by foreign financial institutions (FFIs). Prior to FATCA, FFIs were subject to self-reporting requirements under the qualified intermediary program established in 2001. The IRS estimated that $458 billion of annual offshore income was unreported in the years leading up to the passage of FATCA (IRS, “The Tax Gap — Tax Gap Estimates for Tax Years 2008–2010”).

In their 2020 article in The Journal of Accounting Research (Vol. 58, Issue 1), Lisa DeSimone, Rebecca Lester, and Kevin Markle examine how U.S. individuals responded to the passage of FATCA. The shift from self-reporting under the prior rules to automatic third-party reporting increased the perceived and actual risk of detection, which should reduce the level of tax evasion. However, the costs of evasion could remain below the tax savings from the use of offshore accounts, resulting in continued evasion through such accounts.

The actual amount of hidden offshore assets held by U.S. investors is unobservable. To measure the effects of FATCA, the study uses “round-tripping” behavior, in which assets hidden in foreign accounts are invested back in the United States. Specifically, foreign portfolio investment by individual investors into the United States from tax havens, relative to other countries, measures the inbound investment part of the “round trip.” The amount of inbound equity investment to the United States from tax havens declined by $7.8 billion to $15.3 billion in the years following FATCA, consistent with U.S. investors’ moving financial assets out of tax havens following the rule change.

To avoid FATCA, U.S. citizens may renounce their citizenship. The authors observed a large increase in expatriations following FATCA. Investments in alternative investments that are not subject to FATCA appear to have increased following FATCA, specifically, European collective investment vehicles, real estate, and art. Taken together, these results show U.S. individuals’ behavior regarding investment location and allocation decisions changed in response to FATCA.

The study highlights an intended consequence of FATCA, specifically, the reduction of the use of offshore accounts in tax havens to avoid U.S. tax. While this is considered progress, the use of offshore accounts for tax evasion remains. As with many tax rules, unintended consequences have also been observed, in that U.S. citizens avoid the FATCA requirements in a variety of ways, including renouncing their citizenship and investing in assets not subject to FATCA. These are important considerations for policymakers moving forward with third-party reporting regimes.

‘SALTy Citizens: Which State and Local Taxes Contribute to State-to-State Migration?’

Although there are many reasons for people to relocate across state lines, it is an open question whether, how much, and which type of taxes affect individuals’ decisions on which state to reside in. In their 2021 article in The Journal of the American Taxation Association (Vol. 43, Issue 1), Amy M. Hageman, Sean W.G. Robb, and Jason M. Schwebke study the impact of taxes on location decisions by specifically investigating which state and local taxes are most associated with state-to-state movement of individuals.

Several studies have considered the relationship between taxes and state migration, with mixed results and limited sample composition. For example, one study (Young and Varner, “Millionaire Migration and State Taxation of Top Incomes: Evidence From a Natural Experiment,” 64 National Tax Journal 255 (2011)) found little evidence that taxes have any effect on the change in migration patterns for millionaires within New Jersey. However, another study (Cebula, “Migration and the Tiebout-Tullock Hypothesis Revisited,” 68 American Journal of Economics and Sociology 541 (2009)) concludes that people tend to be attracted to lower state income and property tax burdens.

The authors examine the tax-effect question by hypothesizing that there will be a greater decrease in population in states that have a higher overall burden of death/gift, sales, and property taxes. They test their hypotheses by using regression models that separately compare the net migration at the state level against each of the tax burdens. They find that states with higher taxes tend to be associated with greater out-migration. They also find, when combining all the tax burdens into one model, that property and some types of sales (selective sales) taxes are the most significant. When examining the economic impact on migration from these two taxes, they find that a one-standard-deviation increase in net migration is associated with a $12.99 and $126.73 per capita decrease in selective and property taxes, respectively, collected.

State and local policymakers would find this paper of interest as they consider the degree and type of taxation levied on residents. It is important to have the revenues to fund services and projects but at the same time recognize that an increase in taxes is associated with a decrease in overall tax participants. This paper provides some quantitative analysis that can help determine the right mix of taxes and services. Further, businesses can use this information when they consider where to locate operations to best attract talent and employees.

‘Six Decades of US Tax Reform: Why Has the Average Couple’s Tax Burden Increased?’

The IRS and many other federal and state offices and agencies collect a lot of data, typically reported as raw data, such as how many returns are filed by individuals within various income ranges. What is not always seen is a lot of analysis of this data in ways that provide insights into historical trends and possible improvements to the laws to which the data relates.

In a 2021 article published in the Accounting Historians Journal (Vol. 48, No. 2), James M. Plečnik and Shan Wang report on their findings from research and tax calculations performed for 1955 through 2018. The researchers reviewed the tax laws applicable to a hypothetical median-income married couple with no dependents and income beyond eligibility for the earned income tax credit. This research involved finding the standard deduction, personal exemption, married-filing-jointly tax rate structure, and any special temporary relief provided to individuals, all for over 60 years. They also researched payroll tax information for the years under review. U.S. Census Bureau data was used to determine the median income for the couple, which ranged from $4,421 in 1955 to $80,663 in 2018.

With this income and payroll tax information (for both employee and employer, after tax), the researchers measured for all years the effective income tax rate (EITR) and the effective tax rate (ETR). The ETR includes both income and payroll taxes borne by the median-income couple. The authors found that the EITRs have decreased but ETRs have increased. They also observe that federal tax collections relative to GDP have been mostly constant over the past decades. They conclude that with payroll taxes included in the ETR analysis, there is a higher overall tax burden for the middle-class demographic studied.

The findings are a good reminder that employees bear federal taxes beyond what is reported on their Form 1040, U.S. Individual Income Tax Return, and how a distorted picture results for taxpayers and policymakers when the somewhat hidden payroll taxes are omitted from reports on tax incidence and ETRs. The article also includes interesting lists of the major individual tax changes enacted during each presidency from that of Dwight Eisenhower to Donald Trump’s.

Practice relevance

The five articles summarized here are a small portion of the tax research produced by tax faculty annually. When practitioners visit campuses or otherwise interact with faculty, we encourage them to ask faculty about their research. Academics will benefit from additional insights into how that research relates to practice, and we believe practitioners will gain insights that can help in their planning and advocacy work.

Contributors

David Hulse, Ph.D., is an emeritus professor at the University of Kentucky in Lexington, Ky.; Kerry Inger, CPA, Ph.D., is an associate professor at Auburn University in Auburn, Ala.; Annette Nellen, Esq., CPA, CGMA, is a professor in the Department of Accounting and Finance at San José State University in San José, Calif., and is a past chair of the AICPA Tax Executive Committee; and Mitchell Oler, CPA, Ph.D., is a department chair and associate professor at the University of Wyoming in Laramie, Wyo. For more information about this column, contact thetaxadviser@aicpa.org.