Tax Avoidance Through Corporate Accounting: Insights for Corporate Tax Bases

Abstract

We investigate the degree to which corporations can manipulate their accounting of expenses to avoid taxes, and estimate the corresponding effects for corporate tax bases. We exploit a unique corporate tax reform in Texas that replaced a 4.5% profits tax with a much broader 1% tax on gross revenue, but where firms could still deduct either cost of goods sold (COGS) or total worker compensation, but not both. Using data from federal corporate income tax returns, we find large avoidance responses in the form of reclassifying newly non-deductible expenses into COGS (with an elasticity of −5 ± 1), which reduced the tax base by roughly 4%. However, we find little reclassification into compensation. Our findings shed light on the magnitudes and highly context-specific nature of accounting reclassification responses, both of which are important for policymakers and tax authorities considering proposals to broaden corporate tax bases by incorporating accounting measures.

Keywords: Tax avoidance, Reclassification, Corporate Taxation

JEL Classification: H25, H26, M41