Tax Law and Accounting

Tax Law

Taw Law and Accounting

In the United States, 43 states currently impose a personal income tax. New Hampshire and Tennessee tax only "intangible" income, which is composed of interest and dividends. The remaining 41 states have "broad-based" income taxes, with most sources of income subject to tax. In 1932, Washington voters approved an initiative establishing a personal income tax. However, the State Supreme Court ruled this initiative unconstitutional. Since then, the voters have defeated six constitutional amendments trying to enact a personal income tax. The last proposal in 1973 was defeated 77% to 23%. Subsequent efforts at enacting a personal income tax have died in the Legislature.

State income taxes are generally tied in varying degrees to the federal IRS personal income tax statutes. This creates a number of administrative efficiencies for the states. It also makes it simpler for the taxpayer to comply. While most income is subject to tax under a broad-based structure, some sources of income may be considered nontaxable such as certain types of pension income and interest from bonds issued by other government entities. Allowable deductions and personal exemptions may also reduce taxable income for filers and their dependents. Exemptions subtract a fixed amount per household member. Deductions may also subtract a fixed amount per return or per return by filing status (single, joint, etc.). States may also allow itemized deductions similar to those allowed under the IRS personal income tax code. Once taxable income is determined, the entire amount may be subject to tax at a single "flat" rate or it may be subject to tax through a "graduated rate" structure, with the marginal tax rate increasing as taxable income increases. Graduated rates create a "progressive" tax structure, with higher income returns paying a proportionately higher percentage of their income than lower income filers. Personal income tax may be partially "exported" to the federal government as state income tax paid is allowed as an itemized deduction. This lowers the amount of federal tax paid by state taxpayers. Having a tax tied to the IRS code can create administrative efficiencies and enhance enforcement efforts. The prospects for voter approval of a state income tax are not promising in light of the history of prior attempts.

Corporate net income tax is currently levied in 46 states. All of these states either adopt or heavily refer to the federal IRS corporate income tax code. The application of corporate income tax by states is greatly complicated by multi-state firms and by the complexities of corporate organization. By federal law, an out-of-state firm generally must have both a permanent physical presence and employees within a state to be subject to tax. Attribution of profits may be done through "separate accounting" at the establishment level within a state. It may also be done through "apportionment" based on payroll, property and sales. Apportionment methods are not uniform, some states double-weight sales or use sales as the single factor. Further complications are caused by the complexities of corporate organizations, withholding companies and parent-subsidiary relationships. Some states tend to treat corporations within a holding company as separate entities. Others have pursued a "unitary" approach, viewing the overall corporation as the taxable entity.

There are several advantages of a corporate income tax including:

Perception of fairness in taxing profits rather than total sales or activity.

Possibility of interstate cooperation on issues affecting the great majority of states.

The disadvantages of a corporate income tax includes:

Corporate income tax is an extremely volatile tax, with revenue levels subject to great fluctuations and generally much lower during economic downturns.

Generally, state corporate income taxes are declining as a long-term source of revenue.

The tax is subject to great accounting complexity and potential manipulation with respect to taxable net income.

There is no direct relation between profitability and dependence on government services.

Companies effectively keep two sets of books under two sets of accounting rules: tax accounting and Generally Accepted Accounting Principles (GAAP) (Marcus, 1993). The tax rules are used to calculate profitability solely for the purposes of paying taxes, while GAAP accounting is used for everything else, especially reported profits from public companies. Companies have an incentive to bend the rules one way (minimize profits) for tax purposes, and the other way (maximize profits) for public reports. By making the tax accounting rules the same as GAAP, and requiring that companies pay taxes on the actual profits they report to shareholders, two things may be accomplished:

Companies which "push the envelope" on their accounting in order to boost profits for Wall Street will have to pay more taxes as a result, reducing the incentive for abusive accounting; and Companies will have less incentive to use loopholes or accounting tricks to reduce the taxes they pay, since that will also cut their reported profits (Dupell, 1997).