WSB Faculty Reveals Truths About Taxes

The Truth About Taxes: WSB Faculty shed new light on how taxes affect individuals and companies

Benjamin Franklin said, “Nothing is certain but death and taxes.” Although there’s still some truth to that axiom, recent research from Wisconsin School of Business faculty shows that taxes and tax policies can affect individuals and companies in surprising ways, and the way that companies pay their taxes—and the amount they pay—can be quite subjective.

‘Will you file a joint return with me?’

It’s not the most romantic marriage proposal, but according to Randall Wright, Ray Zemon Professor of Liquid Assets in the finance department at the Wisconsin School of Business, it happens. Wright and his co-authors discovered that love isn’t the only reason for getting married or sharing a household. Sometimes it’s the financially logical thing to do.

Being single is cash intensive. Services such as cooking, cleaning, and childcare must be provided by the market if there aren’t household members available. This means that single people are disproportionately affected by consumption taxes, income taxes, and inflation. When these costs are high, people are inclined to set up households through marriage or some other shared living arrangement.

Lifestyles of the rich and...independent contractors?

Just as the reasons to form a household are not always as obvious or as simple as love, a household’s purchasing decisions may be motivated by more than their observed income levels.

Sarada, assistant professor of management and human resources, found that while self-employed people on average report earnings 26.2 percent lower than wage earners, they consume 4.5 percent more and save significantly more.

What’s happening here? First, self-employed people have more opportunities to underreport their earnings, and often do. Beyond underreporting to avoid paying taxes, the earnings of the self-employed are also often misclassified, especially when they choose to compensate themselves in different forms, according to Sarada.

For example, a self-employed person may forego salary or a portion of a salary. They may put cash into the business; take firm shares as compensation, which are taxed only on value appreciation and at a much lower rate than regular income; or receive dividends, annuities, royalties, or rents, which are not necessarily reported as earnings from employment.

The moral of the story is that self-employed people are not doing as badly as the traditional measure of reported income would indicate— in fact, they may be living a richer lifestyle than individuals who report higher taxable income.

Self-employed people on average
report earings
26.2%
lower
than wage earners

Self-employed people on average
consume
4.5%
more
and save significantly more

The power to reduce taxes

Most people want to avoid paying more taxes than necessary—at home and at work—but some firms are better at that than others.

Dan Lynch, assistant professor of accounting and information systems, and his co-authors found that firms with product market power—the ability to influence the price, quality, and nature of the product in the marketplace to a greater extent than competitors—have more opportunities and incentives to reduce their taxes.

Powerful companies engage in riskier endeavors, such as tax avoidance, more often than less powerful firms because they can, basically. Their market power helps them maintain higher, smoother, and more consistent profitability, which makes them better able to forecast and realize the benefits of tax avoidance.

Then, once some of these companies have successfully reduced their taxes, their competitors mimic their strategies to compete on this important metric. Finally, it appears investors require additional returns for the risks associated with the tax planning of these powerful firms.

Can creativity be hindered by Lego instructions? Get answers from WSB faculty to intriguing questions like this.

Not all tax deductions are created equal

While some firms pay more tax than others because they employ different tax strategies, other firms pay more simply because they use different types of assets to generate returns. For example, capital- and inventory-intensive firms can eventually pay a disproportionately high amount of tax depending on the economy’s inflationary cycle.

Fabio Gaertner, assistant professor of accounting and information systems, and his co-authors found that tax deductions on depreciation of property, plant, and equipment (PP&E) are not enough to compensate for the real cost companies incur in producing goods and services in times of inflation.

In fact, during periods of inflation, as selling prices for products and services increase, deductions for depreciation remain flat, which means that firms’ taxable income as a percentage of sales increases, causing these firms to pay more taxes.

For example, a soft drink manufacturer that invests in a bottling facility gets to take tax deductions for depreciation based on the cost of the facility when it was built, but these deductions remain the same over time while production costs and sales prices increase with inflation. Even though other portions of the tax code attempt to mitigate this effect, these mechanisms don’t fully offset the added tax effects of inflation.

Not only that, deductions for the cost of producing goods can be based on historical accounting rather than on inflation-indexed or current asset value. The authors show that “last in, first out” (LIFO) accounting helps firms mitigate the tax effects of inflation. As a result, disallowing LIFO accounting, a proposal which is gaining more and more traction recently, would put firms relying on inventory at a significant disadvantage.

So even though Benjamin Franklin was right—it’s a certainty that you will have to pay your taxes—the amount that you pay and the effect it will have on your life are not necessarily certain.

Class Notes

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