Has Taxable Income Overtaken Financial Reporting Income?

Download Background Paper No. 11

Background Paper No. 11

Executive Summary This paper investigates how the Tax Reform Act of 1986 (TRA86) may have altered the relationship between taxable income and financial reporting income over the last two decades. The paper examines whether a significant increase in the ratio of taxable income to financial reporting income in the post-TRA86 period occurred and tests whether the ratio of taxable income to financial reporting income is an increasing function of the firm’s alternative minimum tax (AMT) exposure.

Two measures of taxable income are developed from a sample of U .S. manufacturing firms over the 1981-92 period. The table above shows that the ratio of taxable income to financial reporting income increased for both measures of taxable income in the post-TRA86 period. Remarkably, taxable income exceeded financial reporting income in 1988, and both ratios of taxable income to financial reporting income show an increasing trend until 1992.

Contrary to expectations, the AMT position of the firm does not appear to explain the increase in the ratio of taxable income to reporting income. One implication of the reported results is that the benefit of lower statutory tax rates under TRA86 appears to have been partly offset by an expansion of the tax base. Indeed, available aggregate data show significant increases in the post-1986 period in corporate tax receipts and effective tax rates.