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IN PRACTICE / TAX

Highlights of tax research

Studies examine the benefits of tax incentives and the effects different compensation structures have on tax directors’ tax planning.

By Cynthia E. Bolt-Lee, CPA, and Elizabeth Plummer, CPA, Ph.D.
July 2013

Highlights of tax researchWith tax reform in the news, it is helpful to understand the origins of some popular and long-lived tax incentives, such as the favorable tax treatment of people over 65 and tax incentives that encourage people to save. As the economy takes fitful steps to recover, insight into the efficacy of property tax incentives offered by states and municipalities to attract businesses to their jurisdictions is also timely. A final study examines the relationship between a tax director’s compensation structure and the level of tax planning handled in that position. This article examines recent research on these topics in prominent accounting and tax research journals.

INCOME TAX BREAKS FOR SENIORS: A LEGISLATIVE HISTORY

Tax breaks for seniors have been around since the 1940s. As the Baby Boomers enter retirement age, this popular tax policy will continue to have a widespread and material effect on federal and state budget deficits. “The Genesis of Senior Income Tax Breaks,” published in the December 2012 National Tax Journal, investigates the origin of state and federal tax laws to determine how tax breaks for retirement-age individuals ended up where they are today.

Authors Karen Conway and Jonathan Rork analyze two main income tax breaks: (1) tax exemptions, deductions, or credits based on a taxpayer’s age and (2) exemptions or exclusions for pension and retirement income. Results of the study reveal that these two categories of tax breaks began in very different ways and that, interestingly, neither occurred as a result of political pressure or election strategy.

In 1948, Congress began providing age-related exemptions for individuals 65 or over, arguing that seniors who experienced low income were also unable to find work to help with the increasing cost of living. In an effort to gain President Harry Truman’s approval for the age-related exemption, the general personal exemption and the exemption for the blind, both of which existed at the time of the proposal, were increased as well. The opposing minority view held that the high cost of living equally affected younger, low-income individuals and that tax breaks for people over 65 would be inequitable. However, the increase in the general exemption from $500 to $600 was popular among voters and paved the way for the passage of the law. As an additional incentive for passage, those in favor of the $600 old-age exemption argued that failure to increase Social Security benefits to meet post-World War II cost-of-living increases created a hardship for the elderly.

Passage of the federal age-based exemption caused a ripple effect in states’ tax laws, with Vermont becoming the first state to offer the exemption. By 1980, more than 90% of the states had some type of tax break based on advanced taxpayer age.

The taxability of retirement income was an issue addressed separately from the age-based exemption. When Social Security was enacted in 1935, federal law did not address its taxability, but by 1941, the federal government officially acknowledged the exclusion of Social Security benefits from taxable income in an office ruling. This ruling, from the Bureau of Internal Revenue (the IRS’s predecessor), appears to have “accidentally” created the exclusion of Social Security benefits. As the federal tax break became official, many states followed, but not without concern about the loss of revenue.

While the federal government has always taxed non-Social Security retirement income, the states chose a different path. The first state tax break for pension income occurred, once again, in Vermont in 1931, and, once again, appeared to have occurred by oversight. However, the Vermont pension exemption was short-lived and was soon replaced by an old-age exemption in 1947.

A few states followed, mostly by failing to include non-Social Security pension income in their tax base when laws were originally written. By the early 1970s, pension exclusions from state taxable income became more widespread. These tax breaks appear to have been a response to Social Security amendments signed by President Richard Nixon in 1972, which transferred most of the responsibility for elderly health care and retirement needs to the federal government from the states. Not needing to spend revenue on the elderly made the older population more attractive to the states, which enacted tax breaks to entice them to move.

As more states exempted pension income, competition between states appeared to be a strong factor in the increasing number of states adopting the exemption. Neither the size of each state’s population nor the size of its elderly population appeared to have an effect on whether a state adopted the exemption. Instead, the states appeared to be overtly as well as covertly competing for the elderly to live in their states, justifying the tax breaks because the elderly did not use public services.

Research reveals that at higher income levels, the elderly typically pay almost 50% less in state income taxes than other taxpayers. As the population continues to age, that disparity will have a growing effect on state budgets. Knowing how these tax laws originated provides useful information as the debate continues about the effectiveness and efficiency of these exemptions and other tax breaks. This research, funded by the National Institutes of Health, fills the gaps in understanding the evolution of senior income tax breaks.

HOW TAX CHANGES AFFECT TAX-PREFERRED SAVINGS

Do taxpayers respond to changes in tax laws that affect retirement plans by participating more frequently or increasing the size of contributions to their tax-preferred savings accounts? No doubt tax policies play a large role in the volume of contributions to these retirement plans, but to what extent?

Assets in defined contribution plans (e.g., 401(k)s) in the late 2000s totaled almost $8.5 trillion, more than three times larger than the amount held in defined benefit plans (e.g., employer-funded pension plans). This study, “The Effect of Recent Tax Changes on Tax-Preferred Saving Behavior,” (National Tax Journal, June 2012) examines the changes that occur to defined contribution plans—in participation rates as well as contribution size—when tax policies change. The research additionally measures the reduction in tax revenue from increased taxpayer contributions. Those findings help determine the effectiveness of changes in tax law on increasing retirement savings as well as the effect on tax revenue.

For this research, authors Bradley Heim and Ithai Lurie examined data from the IRS’s Statistics of Income (SOI) Program for the years 1999–2005. The SOI program provides taxpayer data obtained from information reports and tax returns. The data include items such as contributions to IRAs and 401(k)s and taxpayer income and adjusted gross income (AGI).
The authors analyzed data from more than 190,000 tax returns to determine taxpayers’ responses to changes in the after-tax cost of contributing to a tax-preferred plan. More than 92,000 contributions were in the returns analyzed.

During the period studied, two major changes in tax policy affected tax-preferred savings accounts. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), P.L. 107-16, created the saver’s credit, a nonrefundable credit for retirement account contributions. EGTRRA also increased the earned income tax credit for those making pretax contributions to their employer-based retirement plans. The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), P.L. 108-27, reduced marginal tax rates, making tax-preferred savings plans less attractive than during periods with higher marginal tax rates, but alternatively providing taxpayers with higher after-tax income. Prior research has shown that higher after-tax income results in greater savings overall, which would potentially make a tax-preferred savings account more attractive. Tax law changes before EGTRRA and JGTRRA also affected the period examined.

The authors’ analysis reveals that these changes had a statistically significant effect on the number of taxpayers contributing to tax-preferred retirement accounts. More people contributed to retirement accounts, with lower-income taxpayers (income less than $50,000) more likely to begin contributing than higher-income taxpayers (income greater than $100,000). This effect appears to have been caused by a reduction in marginal tax rates (which increases after-tax income) and a decrease in the cost of contributing (due to the reduction in tax as a result of making contributions). The dollar amount of these contributions, however, did not increase.

The authors suggest that changes in tax policy may motivate a taxpayer to open a retirement account, but once the account is opened with the minimum amount required for employer matching funds, the taxpayer does not tend to increase the contribution. Given the less-than-significant impact on savings revealed in the study, policymakers should reconsider using tax incentives to influence taxpayers’ savings behavior.

PROPERTY TAX INCENTIVES: PROBLEMS AND SUGGESTED REFORMS

State and local governments spend $5 billion to $10 billion a year on property tax incentives to entice businesses to locate in their jurisdictions and to promote economic development. Although incentives can take different forms, common ones include property tax abatement programs, tax increment financing, enterprise zones, and incentives granted to specific companies. But how well do these incentives work? What are the problems? What can be done to improve their effectiveness? In their article, “Property Tax Incentive Pitfalls,” published in the December 2012 issue of the National Tax Journal, authors Daphne Kenyon, Adam Langley, and Bethany Paquin use case studies on property tax incentives to highlight the incentives’ problems and to suggest reforms.

The authors found that the biggest problem is providing property tax incentives to a company that would have located in the jurisdiction anyway, which means the government has reduced its tax revenues for no reason. The authors argue that property tax incentives are more likely to affect a company’s location decision if property taxes are a significant component of a company’s total costs and if the company serves a national or international market. The larger the company’s market, the less likely the company is tied to a specific geographic area. Governments can make more effective use of property tax incentives if they focus them on companies that meet this description.

Another common error in property tax incentives occurs when the costs of the incentive exceed the benefits to the jurisdiction. Although attracting a company may result in desirable outcomes such as increased employment and population growth, how much will public service costs increase? Will the government be required to expand or improve the existing infrastructure, and at what cost? And while the new business may enhance the city’s character and property values, are there significant environmental or congestion costs as well?

Assuming a property tax incentive creates new jobs, what proportion of the jobs will go to current residents versus commuters or new residents, and how much will the jobs pay? Attracting minimum wage jobs is less likely to provide a net benefit to the community. The government must also consider what effect the new business will have on existing businesses. Will the new company purchase goods and services from current businesses, or will it take customers away from them? Policymakers must undertake this type of comprehensive analysis to determine whether granting the incentive makes good sense for the community as a whole.

Rather than providing a tax reduction for a specific business, governments can also lower property tax rates and make their communities more attractive to businesses in general. The authors review studies on tax reductions that suggest that property tax differences within a metropolitan area do have a significant effect on where businesses choose to locate, with a 1% reduction in a jurisdiction’s property taxes leading to a 1.59% to 1.95% increase in economic activity.

Evidence suggests that the economic benefits are temporary because neighboring jurisdictions often respond by lowering their tax rates, so in the end all jurisdictions have lower tax rates and no one gains a competitive advantage. For incentives to be effective, state and local policymakers must ensure that tax incentives are designed with a specific purpose (e.g., to attract a certain business or to aid an economically disadvantaged area).

The authors discuss how evaluating the effectiveness of property tax incentives is difficult because state and local governments provide little information about them, and when they do, little of the information is specific, such as which companies benefit and by how much. Evidence is rarely available on the actual response to the incentive, such as changes in employment or economic activity. Making government officials more accountable can help increase the effective use of property tax incentives. States such as Oregon and Minnesota have taken steps toward increasing transparency and evaluation.

The authors call on state and local governments to increase the information available on tax incentive programs, and to provide systematic and independent reviews of their effectiveness. Although there is ample evidence of the problems with property tax incentives, the authors remain optimistic about improving their use.
 
TAX DIRECTORS' INCENTIVES FOR TAX PLANNING

Company tax directors are normally most directly responsible for advising management on how to structure transactions to reduce tax costs, as well as for making their companies’ tax planning and tax strategy decisions. Their responsibilities range from lowering the company’s cash tax burden to reducing the income tax expense reported on financial statements. Despite tax directors’ importance, little is known about how tax directors are compensated because their compensation is generally not publicly available. Are tax directors’ compensation packages structured so that they have incentives to make advantageous tax planning decisions?

In their paper, “Incentives for Tax Planning” in the Journal of Accounting and Economics (February–April 2012), authors Chris Armstrong, Jennifer Blouin, and David Larcker examine the annual compensation for tax directors employed by 423 companies from 2002 through 2006. Their study examines proprietary data provided to them by a large human resources consulting firm that administers an annual survey and collects detailed compensation information for several executive positions, including tax directors. The data include the annual salary, bonus, restricted stock and option grants, and long-term incentive plans for each tax director. The authors’ sample consists of very large companies, with a median market value of $9.2 billion and median taxable income of approximately $460 million. These companies therefore have significant tax liabilities, making them more likely to hire tax directors to pursue tax planning opportunities.

The tax directors in the sample are highly paid, with mean and median total compensation of $788,000 and $559,000, respectively. On average, tax directors’ compensation consists of 41% fixed components such as salary, 45% equity components (e.g., stock options), and 14% bonus, meaning that, on average, 59% of the tax directors’ compensation is performance-based. This suggests that tax directors’ responsibilities extend beyond tax compliance to tax planning and strategy.

The authors use several types of statistical analyses to examine the relation between tax directors’ incentive compensation and the level of a company’s tax planning, using information contained in a company’s financial statements. They choose to focus on two tax rate measures: the company’s book tax rate (or effective tax rate) and the company’s cash tax rate (the amount of cash a company pays for taxes during the year, divided by net income before taxes).

The authors find that tax director’s compensation increases as the company’s book tax rate decreases, suggesting that tax directors are provided with incentives to reduce the tax expense reported in a company’s financial statements. In contrast, the authors find no evidence that tax director’s incentive compensation varies with the company’s cash tax rate.

Overall, the results suggest that tax directors have incentives to reduce the tax expense reported in the financial statements, but do not have incentives to affect the other measures of tax planning. This suggests that a company’s book tax rate is a clearer signal of a tax director’s efforts and results, making it a more desirable variable to include in a tax director’s compensation contract.

Cynthia E. Bolt-Lee (boltc@citadel.edu) is an associate professor of accounting and taxation at The Citadel School of Business Administration in Charleston, S.C. Elizabeth Plummer (c.e.plummer@tcu.edu) is an associate professor of accounting at the Neeley School of Business at Texas Christian University in Fort Worth, Texas.

To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, senior editor, at sschreiber@aicpa.org or 919-402-4828.


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