Taxation and Corporate Governance

What is the justification for the U.S. corporate tax? Scholars have provided various potential explanations for this question. Yet, no explanation has gained consensus among scholars and, indeed, this article claims that none of the current explanations is convincing. The main contribution of this article is introducing the corporate governance effects of the corporate tax to this arena. The article claims that taking into account the corporate governance effects of the corporate tax increases the allure of each one of the potential justifications for the corporate tax.

The article starts by describing (and expanding) the literature regarding the potential corporate governance effects of the corporate tax. First, because diversion of corporate value towards managers (or controlling shareholders) reduces corporate tax liabilities, the Internal Revenue Service has an incentive to prevent and detect such diversions. The Internal Revenue Service is de facto the largest minority shareholder in almost all corporations. In corporate governance terms, there is an alignment of interests between the non-controlling shareholders and the IRS. The mechanisms aimed at enforcing the corporate tax make it also more difficult for controlling shareholders to divert corporate value to their own advantage. In other words, because managerial diversion hurts both tax authorities and noncontrolling shareholders, the two parties have a common goal: reducing managerial diversion. The article further notes that the corporate tax can have a comparative advantage in protecting investors and maintaining efficient markets relative to the SEC and financial auditors. For example, in auditing a corporate tax return, the IRS can (and in fact does) turn not only to the corporate’s own returns for past years, but also to returns filed by related corporations, partnerships, and individuals, including returns filed by customers, suppliers, employees, shareholders and payors of various type of income subject to income gathering.

Second, the corporate tax can potentially mitigate the problem of inflation of reported earnings in a simple and quite straightforward way: by taxing the reported income of the corporation. This effect is well known in the financial literature as the “book-tax trade-off,” since firms can be forced to make a “trade-off” between the benefits of inflating book earnings and the direct tax costs of increasing taxable income.

Third, to the extent that corporate tax returns (or information from such tax returns) are available to investors, the corporate tax can shed new light on financial reports and improve their quality. The notion is that publicity of corporate tax information can enable market participants (e.g., minority stockholders, credit agencies and creditors) to compare the financial reports information with the contents of the tax returns. Even if corporate tax returns are not publicly available, information regarding the tax liabilities is reflected in the financials. In addition, and more importantly, market participants regularly request the tax returns prior to making investment decision or have contractual rights to receive such tax returns.

The article then argues that the corporate governance effects can shed a new light on the existing potential justifications for the corporate tax:

• Efficient Tax Collection Mechanism. The most common justification for the corporate tax is its ability to efficiently tax the shareholders of such corporations. However, it is argued that shareholders can be taxed in other more efficient means. Specifically, the main alternative “contender” to the existing corporate tax is a tax system where (i) non-publicly traded corporations are subject to passthrough taxation (e.g., similar to how partnerships are currently taxes) and (ii) the holders of publicly traded corporations are subject to a “mark to market” taxation. Indeed, non-publicly traded entities are generally already allowed to be taxed as pass-through entities and are effectively incentivized to choose to be taxed as pass-through entities. In contrast, publicly traded corporations generally are not allowed to be taxed as passthrough entities. Taking into account the corporate governance effects of the corporate tax, this justification is becoming much more alluring. The corporate tax is an efficient vehicle to collect taxes, because tax authorities do not only collect taxes for the government, but also provide governance services to the investors. In this perspective, the governance functions of corporate tax can be viewed as positive “externalities” of the tax. While other methods of taxation of corporate entities (e.g. mark to market) do not provide governance services, corporate tax does so.
• Fee For Services. Under the “fee for services” justification, the tax is a fee which must be paid to the government in exchange for services rendered, and particularly the right to incorporate and the limited liability protection. However, this justification was rejected, since non-incorporated entities also have characteristics that were traditionally associated with corporations (e.g., limited liability) and are not subject to corporate tax. This justification is also not consistent with the provision of the benefit of incorporation by the states, while the corporate tax is paid to the federal government. Armed with the new understanding of corporate tax’ role, the article re-visits this justification. We believe that the corporate tax could be viewed as a “fee” paid by publicly traded corporations for the governance services provided by tax authorities. This justification could be plausible only if the aggregate increase in investor’s wealth (mainly, reduction in agency costs) is higher than the total amount of corporate tax collected.
• Executives Regulation Justification. Under the “Regulation Justification,” corporate tax is desirable as a mean to restrict and regulate corporate power. The tax restricts the corporate power because it reduces corporate income, and consequently reduces the amount of cash and hence power available for the corporation (“The limiting function”). This explanation, rather than being focused on increasing investor’s wealth or increasing the society’s economic welfare, is focused on the interest of a liberal democratic state in restricting managerial abuses of excessive powers. Absent the corporate governance effects of the corporate tax, this explanation should be rejected for two reasons. First, this justification cannot explain why corporate tax is based on the income of the corporation, rather than on retained earnings. Second, this justification may be accepted only if corporate tax can regulate firms in a unique manner that cannot be achieved by other forms of regulation. Taking into account the corporate governance effects of the corporate tax, the article re-visits this justification. Specifically, the previously stated counter-arguments that were raised against the original regulatory justification do not apply. This new justification is consistent with the fact that corporate tax is based on the income of the corporation, since – as noted earlier – imposing tax on the corporate income is necessary in order to enable the governance functions of the corporate tax. In addition, in many important circumstances the corporate tax has a comparative advantage relative to the SEC and financial auditors in improving corporate governance. This justification could be valid even if the corporate tax (in comparison to any alternative tax system) reduces both investors’ wealth and the overall economic welfare, as its main purpose is to restrict managerial abuses of excessive powers (provided that there are no alternative more efficient mechanisms to achieve such restrictions).

Indeed, one of the biggest developments in corporate taxation over the past decade is the increased alignment of book-tax treatments. For example, (i) the Tax Cuts and Jobs Act enacted a general rule for the taxable year of inclusion of gross income that requires most corporation to recognize income at the earliest of when the all events test is met or when any item of income is taken into account as revenue in the taxpayer’s applicable financial statement, (ii) recently, Congress has directed insurance companies to follow their financial statements prepared in accordance with GAAP in many circumstances, (iii) the Inflation Reduction Act of 2022, amended the tax code to impose a new corporate alternative minimum tax (CAMT) based on the “adjusted financial statement income” of the most valuable corporations, and (iv) the IRS has recently promulgated “bad debt” regulations permitting regulated financial companies to use a method of accounting under which amounts charged off from the allowance for credit losses under GAAP would be conclusively presumed to be worthless for Federal income tax purposes. Some of these changes have been subject to fierce criticism, including conceptual claims regarding the role and the purpose of the corporate tax. Hopefully, our article provides a response to those criticizing these changes and supports further developments that enhance the corporate governance role of the corporate tax.