Greatest Tax Research Hits of 2018

In the social media era, “expertise” appears to be losing its clout with respect to public policy.  Academics who have dedicated careers to the study and understanding of hugely complicated policy topics are undoubtedly frustrated to see 280 characters of attitude and opinion having more influence than pages of evidence, analysis and conclusions from their carefully designed research.  (Although, to be sure, some of this growing policy impotence is a self-inflicted wound of insularity.  Witness the National Tax Association annual meeting.  Once a vibrant mix of tax practitioners, lawmakers, and academics advancing the intersection of tax research, policy, and practice, today you can’t get served at the cash bar without being able to articulate and defend a regression approach.)

Nevertheless, the world of academia soldiers on offering insights into the complicated cause and effect relationships in public policy.  As is our custom, our year-end edition of Fiscal Focus takes a look back at a handful of the interesting 2018 National Bureau of Economic Research Working Papers we came across in the areas of tax policy.

What Hath the TCJA Wrought?

Unsurprisingly, Congress’ passage of the Tax Cuts and Jobs Act (TCJA) has created an irresistible laboratory for investigation.  In the creatively-titled (for academia at least) “Tax Reform Made Me Do It!”[1], a member of the U.S. high priesthood of tax scholarship, Joel Slemrod from the University of Michigan, along with colleagues from MIT and the University of North Carolina examined the relationship between the actions corporations took and the statements made in response to federal tax reform.  Just as interestingly, the researchers took a closer look at the characteristics of those companies that publicly expressed a cause and effect relationship between passage of the TCJA and their behaviors.

The researchers examined four different outcomes reporting during the first quarter (Q1) of 2018: bonuses and other actions that benefitted workers, announcements of new investments, share repurchases, and dividend announcements.  According to the working paper:

• Researchers found only 4% of the public firms in their sample announced in Q1 that some of their tax savings would be directed toward workers.  Of these 163 public firms that explicitly linked the passage of the TCJA to some sort of worker benefit, the most common award (72%) announced was a one-time worker bonus.  (Note that in some cases, a firm announced more than one enhanced benefit.)  To provide some quantitative perspective on this result, researchers were able to compare total worker bonuses with total staff expense for 43 of these companies and concluded that the $441.5 million in TCJA-prompted worker bonuses equaled 0.5% of annual staff expense for these firms.
• With respect to investment announcements, 22% attributed some form of investment due to tax reform.  Many companies provided additional detail about what the investment would entail: 62% of this group identified investment in technology improvement and 45% of this group mentioned new capital expenditure.
• With respect to share repurchase plans, only 5% of the 179 announcements of new share repurchase plans made in Q1 explicitly tied the repurchase to the passage of the TCJA.  There was evidence that share repurchases through already existing plans experienced an uptick but were not out of line with historical trends.
• With respect to dividend increases, 41 of the 344 firms that increased dividends in Q1 of 2018 publicly announced the increase was attributable to passage of the TCJA.  However, researchers detected no obvious trend increase in either the number of firms, the dollar value of dividends provided, or the establishment of special dividends.

Were these announcements and actions politically or economically motivated?  Researchers found evidence of both at play.  Companies that had the highest pre-TCJA tax rates and expected their tax rate to decrease the most were more likely to provide worker related benefits and assert more investment.  However, corporations with PACs emphasizing Republican candidates over Democrats were also more likely to announce TCJA-tied worker benefits.  Researchers concluded political motivations may have played a role in these announcements but firms with the most to gain from reform were most likely to announce actions in response to reform.

Issues Motivating Corporate Tax Reform

Aside from the effects of TCJA itself, several policy issues embedded in the recent tax reform debate also received a fair amount of research attention.  Chief among them is the desire to stop profit shifting to tax havens by multinational companies.  Such pursuits are premised on the argument that profit shifting only affects tax revenues but has no meaningful impact on real economic outcomes.  But in “Unintended Consequences of Eliminating Tax Havens”[2] a Duke University researcher revisits an historical example of a U.S. policy change to limit profit shifting and finds economic fallout – negative impacts on both domestic investment and employment.

For decades, the federal government exempted U.S. multinationals from income taxes if the income originated in affiliated corporations located in Puerto Rico or other U.S. possessions.  In 1976, the exemption was replaced with a tax credit but concerns persisted that the provision was a conduit for profit shifting.  “Section 936” as it was called was repealed as part of the Small Business and Job Protection Act of 1996.  In the year prior to the repeal, 682 domestic “Section 936 firms” with Puerto Rican affiliates employed nearly 11 million workers in the continental United States.[3]

The study uses firm-level data to examine what happened to these now-exposed “tax haven using firms” with respect to investment and employment and compares them to “non-exposed” firms (i.e., U.S. firms not utilizing Section 936 and therefore not exposed to its repeal) using a wide variety of controls, robustness tests and related checks.  Prior to the repeal both exposed and non-exposed firms featured very similar investment and employment trends.  However, following repeal “Section 936” firms reduced global investment by 23%, increased the share of investment abroad by 17.5% and reduced U.S employment by 9.1% relative to non-exposed firms.  These responses had a significant effect on the U.S. economy as impacted firms lowered domestic investment by 38% and reduced payroll by 1 million jobs.  Moreover, the firm level effects were geographically concentrated in the U.S. and had long term impacts.  The study found fully 15 years after the repeal of Section 936 local U.S. labor markets that were more exposed to the repeal saw slower growth in employment, wages and home values and had become more reliant on government transfers.

The study concludes firms do respond to limits on profit shifting as they do in response to tax increases: by lowering global investment and reducing economic growth.  As a result, an accurate cost benefit analysis of policies that aim to limit profit shifting, “should include the unintended consequences of these policies and account for employment and investment losses in the United States.”  But perhaps most importantly, the author argues these findings have relevance for current efforts and proposals to combat profit shifting such as are in the TCJA.  Such unilateral polices “can backfire” the study concludes, and argues multilateral approaches are better able to address these concerns while limiting the unintended consequences.

Another topic driving interest in tax reform is innovation – do taxes affect the amount, quality, and location of research and development (R&D) work by both individuals and firms?  That is the question behind “Taxation and Innovation in the 20^th Century”[4], which systematically examines the effects of individual and corporate income taxation on U.S. inventors and firms over decades.

The scope of this investigation was rather remarkable – researchers created a dataset by compiling 80 years of detailed information on the R&D activities of both private and publicly traded firms, and 100 years of federal and state individual and corporate income tax data.  Their principal sample period alone, which covered the years 1940 through 2000, contained 1.95 million U.S. inventors and 2.78 million patents.  The researchers investigated both state-level effects and the effects of taxes on individuals and firms and concluded taxes matter across all the different dimensions of innovation.

• State Level Effects – Researchers found both individual and corporate income taxes have significant effects at the state level on patents, patent citations (an indicator of the quality of the patents), inventors in the state, and the share of patents produced by firms as opposed to individuals.  For example, a one percentage point higher top corporate marginal rate leads to around 6.3% fewer patents, 5.9% fewer citations, and 5.1% fewer inventors.  Approximately 50% of the corporate tax’s impact on patents, citations, and inventors can be assigned to a reduction in innovative activity and 50% to movement of this activity across state lines.  Researchers also found a lag in the effect of tax changes on innovation at the state level with the strongest effects appearing 1-3 years after the tax increase or decrease.
• Individual level Effects – While both individual and “corporate” inventors (individuals working for corporations) demonstrated sensitivity to income taxation, corporate inventors were found to be much more sensitive to taxes on both individual and corporate income than their non-corporate counterparts.  Taxes had an impact on inventors’ location choices – average tax rates were found to be a strong negative predictor of location decisions.  However, two factors weaken these tax effects: 1) the tendency for inventors to remain in their home state rather than move, and 2) “agglomeration forces” (the existence of professional networks and amenities offering continuing education and learning).
• Firm Effects – Corporate tax rates had a significant effect on the number of patents, their quality (as captured in citations), and the number of research workers.  Individual income tax rates also influenced firm level outcomes but less so than the corporate tax rate.  Interestingly, it was the marginal tax rate at the median income level rather than at the 90^th percentile of income that reflected tax impacts.  The top corporate tax rate was found to have a significantly negative effect on the decision to locate an R&D lab in a given state.

As the authors conclude, “the quantity, quality and location of innovation are all affected by the tax system and the effects are quantitatively important.”  Yet, at least with respect to corporate income taxation we can’t help wonder if these relationships might be evolving in light of single sales factor apportionment, which renders the location of plant and people irrelevant to state corporate income tax burdens.

But as the debate over federal tax reform illustrated, equity issues are no less a fixture of today’s tax policy discussion.  While corporate tax cuts may foster innovation and economic growth, new research suggests that comes with a trade-off that concerns many policymakers.  In “Corporate Tax Cuts Increase Income Inequality”[5] researchers found state corporate income tax reductions increased capital investment in the state but were also responsible for growth in income inequality.  Researchers found that between 1990 and 2010 a 0.5 percentage point reduction in state corporate taxes explained 12.4% of the total increase in the share of income accruing to the top 1% of earners.  Notably, the size of the effect is much greater than that which would be implied if the cut created no behavioral responses – i.e., no effect on the location of firms, workers, wages, or investment.  Growth in income inequality was also a function of 1) gains from increased investment in the state that are concentrated on top earners, and 2) taxpayers at the top of the distribution shifting income from salary and wages to capital income to reduce taxes.

One final corporate tax study captured our attention this year.  Policymakers have long observed that many households do not take advantage of program benefits to which they are entitled and taxpayers often do not take full advantage of tax benefits that are available to them.  This is typically chalked up to a simple lack of awareness, but complexity can be a contributing factor.  In “The Costs Of Corporate Complexity”[6] investigators found these same situations also exist in business.  In a sample of 1.2 million observations of corporate tax returns, researchers found only 37% of eligible firms claimed their refund for tax losses.  Moreover, a cost benefit analysis did not explain the low take up.  For small businesses, their knowledge of the refund’s availability and how to file for it, along with the sophistication of the tax preparers they use, explains the underutilization.  For larger firms, the researcher posits that complex interactions with other tax code provisions including the alternative minimum tax and interference with ongoing audits explain decreases in credit takeup.

The Compliance Question

For all the countless empirical investigations devoted to tax issues over the decades, surprisingly few have centered on tax compliance and enforcement.  That is apparently changing as a literature review[7] documents an “explosion” of activity from around the world examining the other two pillars of the tax system – tax remittance and enforcement.  This new wave of investigation is examining the magnitude and nature of tax evasion and evaluates the effectiveness of various policy measures in addressing compliance concerns.  Real money is at stake; according to the latest IRS estimates in the literature review, the federal tax gap estimate is $406 billion, representing 16.3% of the estimated actual (i.e., remitted plus unremitted) tax liability.

Here are a few facts and interesting findings culled from the various studies worthy of consideration:

• Unsurprisingly, the extent of information reported to the IRS has a major impact on compliance rates.  Where there is little if any third-party reported information (like self-employment income), the noncompliance rate is 63%.  Where there is substantial third-party reporting, non-compliance drops to only 7%.  For wages and salary income, noncompliance is 1%.
• Appeals to personal responsibility, conscience, duty, and the public good with respect to tax remittance don’t demonstrate any significant effect on increased compliance.
• Compliance responses to enforcement initiatives like audit threats can vary by income.  One proposed explanation: higher income and self-employed filers (and their accountants) view an audit threat as part negotiation and see taxable reported income as the opening bid that does not necessarily result in finding and penalizing all noncompliance.
• Communication content matters.  Letters to taxpayers that contain general statistical information about the probability of being audited and penalty rates increased tax compliance by 6.3% or about one-fourth its current level.  Adding a paragraph that evading taxes increased the probability of being audited increased tax compliance by about 7.4%.
• The staying power of such communication with respect to compliance efforts is less clear.  Interventions improve compliance in the short term but taxpayers may become desensitized to these efforts.
• There is some evidence that “public shaming” (e.g. public notifications of tax crimes or tax debt) can be effective compliance motivation for some types of taxpayers.
• Political alignment with the party of the presidential administration has a positive impact on compliance.
• Compliance issues exist at both ends of the income spectrum.  The ratio of misreported income to true income increases with income peaking at adjusted growth income in the 99.0 to 99.5 percentile.  However, the ratio of underreported tax to true tax is highest for the lowest income taxpayers.
• Recent studies based on information leaks from foreign financial intermediaries suggest the superwealthy evade as well as avoid taxes.  One study estimated the top 0.01% evade about 30% of the income and wealth taxes they owe.
• In a few places around the world compliance rewards (like being entered into a lottery for tax holidays) improved compliance rates.

While these studies suggest a wide variety of potential avenues to pursue, the author closes with an important acknowledgement: knowing the effect on compliance “is by no means sufficient information for guiding policy decisions.”  Policymakers also need to know about the social costs of these policies including intrusions on privacy and the rights of taxpayers.  It’s easy for the latter to get lost in the “pay their fair share” debates but acknowledgment of rights and responsible taxpayer protections is a no less critical part of a sound, effective tax system.