Interactions of Tax and Nontax Costs

1
Interactions of Tax and Nontax Costs

• Uncertainty
• Symmetric uncertainty
• Strategic uncertainty (information asymmetry)
• Hidden action (moral hazard)
• Hidden information (adverse selection)
• Financial Reporting Conflicts

2
Symmetric Uncertainty

• All contracting parties are equally informed but
  uncertain about future cash flows
• Estimate probabilities of alternative outcomes,
  and calculate expected values
• When tax rates are progressive, symmetric
  uncertainty can lead to decrease in risk-taking,
  even for risk-neutral investors!

3
Example Interaction of Taxes and Symmetric
Uncertainty

• Progressive tax rate structure as follows
• If taxable income is 50,000 or less the tax rate
  is 25
• Taxable income in excess of 50,000 is taxed at
  45
• Two 100,000 investment alternatives (held for 1
  year)
• Riskless investment yields 50,000 profit
• Risky investment yields 25,000 with 50
  probability and 80,000 with 50 probability

4
Example continued

• Calculate the before-tax rate of return on each
  investment alternative
• Without taxes, which investment would a risk
  neutral investor prefer?
• Calculate the after-tax rate of return on each
  investment
• Given the progressive tax rate structure, which
  investment would a risk neutral investor prefer?

5
Conclusions

• Progressive tax rate structures can distort
  investment decisions
• Progressive tax rate structures can lead
  investors to choose less risky projects
• Questions
• Can we differentiate the impact of taxes on risky
  investment from risk aversion?
• How can the tax law mitigate these investment
  distortions?

6
Hidden Action (Moral Hazard)

• One contracting party has control over an
  unobservable action choice that affects future
  cash flows
• How do hidden action settings interact (conflict)
  with tax planning?
• Risk of default increases costs of borrowing,
  reducing effectiveness of tax arbitrage
  strategies
• Labor contracts

7
Labor Contracts with Progressive Tax Rates

• Suppose that the employer and the employee face
  different tax rates. In particular, employee
  faces constant tax rate and employer faces
  progressive rates
• With symmetric uncertainty, no moral hazard, and
  risk neutrality, optimal contract would pay a
  bonus when profits are positive and nothing when
  profits are negative
• With symmetric uncertainty, no moral hazard, and
  employee risk aversion, tradeoff must be made
  between tax minimization and risk sharing

8
Labor Contracts with Progressive Tax Rates
continued

• With moral hazard and risk aversion, tradeoff
  must be made between motivating desired action by
  employee (via bonus arrangements) and sheltering
  employee from risk (via fixed salary)
• If tax rates are changing over time, tax
  strategies may either conflict with or support
  strategies to mitigate moral hazard and risk
  aversion

9
Labor Contracts and Tax Tradeoffs

• Consider a multi-period labor contract, where the
  employees hidden action will be revealed in the
  future
• Tax rates for the employee, the employer, or both
  could change over time
• Also assume that the employee is risk averse and
  the employer is risk neutral
• In each of the following settings, what are the
  employees and the employers preferences if the
  compensation choices are either
• Fixed salary currently or
• Deferred bonus in the future if the revealed
  action is profitable

10
Labor Contracts and Tax Tradeoffs continued

• Recall that employee faces constant tax rate,
  while employer faces progressive rates
• What if employers highest rate is
• Increasing over time?
• Decreasing over time?
• What if employees constant tax rate is
• Increasing over time?
• Decreasing over time?

11
Conclusions

• Progressive tax rate structures can distort
  optimal labor contracts
• Progressive tax rate structures can lead
  employers to offer labor contracts that impose
  risk on risk-averse employees, and do not align
  incentives so as to mitigate moral hazard
• Questions
• Can we differentiate the impact of taxes from
  moral hazard?
• How can the tax law mitigate these contracting
  distortions?

12
Hidden-Information (Adverse Selection)

• One contracting party is better informed about
  uncertain future cash flows
• Classic hidden information setting asset sales
• Tax consequences of asset sales could, in some
  cases, mitigate the hidden information problem
• Sellers of high value assets could obtain
  sufficient tax benefits from the sale to offset
  bargain sales price
• Buyers who obtain favorable tax benefits from
  purchase might be willing to pay more

13
Conflicts between Financial Reporting and Tax
Planning

• Conflicting incentives
• Managers generally wish to report higher (and
  less volatile) net income for book purposes
• Earnings management
• How does reported income impact firm value and
  manager compensation?
• Managers generally wish to report lower taxable
  income for tax purposes
• Minimize current tax costs

14
Conflicts between Financial Reporting and Tax
Planning continued

• Is it ever possible to do both? Why?
• How do the objectives of the tax system and the
  objectives of GAAP differ? When do these
  differences permit managers to achieve both tax
  minimization and higher book income?
• Which tax planning strategies (converting income
  from one type to another, shifting income from
  one time period to another, shifting income from
  one pocket to another) might permit this?

15
Conflicts between Financial Reporting and Tax
Planning continued

• When conflicts do exist, how should tradeoffs be
  made?
• If perfectly informed, what would the
  shareholders prefer?
• What are the incentives of the managers making
  the decisions?
• Are managers willing to forego tax savings in
  order to increase reported book income? Why?
  How much tax savings is sacrificed?
• How do the choices made impact before-tax rates
  of return? After-tax rates of return?

16
Tradeoffs between Financial Reporting and Tax
Planning - Example

• In periods of rising prices, adoption of the LIFO
  inventory method for tax purposes results in
  higher cost of goods sold and lower taxable
  income. However, LIFO can only be used for tax
  purposes if also used for financial reporting
  purposes. Thus, lower taxable income can only be
  achieved by also reporting lower book income.
• With perfect information, shareholders would
  probably prefer LIFO for the tax savings
• Research indicates that managers forego LIFO tax
  savings to avoid reduced book earnings