Book-Tax Conformity for Corporate Income: An Introduction to the Issues

Executive Summary This paper discusses the issues surrounding the proposals to conform financial accounting income and taxable income. The two incomes diverged in the late 1990s, with financial accounting income becoming increasingly greater than taxable income through the year 2000. While the cause of this divergence is not known for certain, many suspect that it is the result of earnings management for financial accounting and/or the tax sheltering of corporate income. Our paper outlines the potential costs and benefits of one of the proposed "fixes" to the divergence: the conforming of the two incomes into one measure. We review relevant research that sheds light on the issues surrounding conformity both in the United States as well as evidence from other countries that have more closely aligned book and taxable incomes. The extant empirical literature reveals that it is unlikely that conforming the incomes wifi reduce the amount of tax sheltering by corporations and that having only one measure of income will result in a loss of information to the capital markets. 1. Introduction This paper discusses the issues surrounding the proposal to conform financial accounting (book) income and taxable income. We review recent literature that sheds light on this proposal in order to inform the policy debate regarding what to do about the current divergence between financial accounting and taxable incomes. The expanding divergence between book and taxable incomes has attracted much attention and analysis in recent years (e. 2002). The real concern with diverging book and tax incomes is not 102 Hanlon & Shevlin that they are different per Se, but that the difference may be caused by some misleading or even fraudulent activity on the part of firms in reporting book income, taxable income, or both.1 While there is little debate that the incomes are diverging, the cause of the divergence and whether and how to fix it are very much open questions. One proposal to fix the system is to conform the financial accounting (book) and taxable income numbers. For example, Yin (2001), in response to the Treasury's white paper entitled "The Problem with Corporate Tax Shelters," claims that one way to solve the "problem" is to tax public corporations on their income reported for financial reporting purposes, as adjusted by tax rules authorizing specific deviations from that base (p. 26). Further, Desai (2004) argues that the dual reporting of corporate income has led to a degradation …