Book-Tax Conformity: Implications for Multinational Firms

This paper examines the implications for multinational firms of recent proposals to conform tax and financial reporting (i.e., book-tax conformity). Proponents of book-tax conformity argue that the current dual system in the U.S. allows firms to simultaneously manage their taxable income down while managing their book income upward. By requiring book-tax conformity, they contend that firms will be forced to trade-off reporting high earnings numbers to shareholders and reporting low earnings to the taxing authority, resulting in improved financial reporting and less tax avoidance. Reduced compliance costs and easier auditing have also been cited as potential benefits of book-tax conformity. Aspects of book-tax conformity that have not been examined, however, include its international implications, particularly regarding the foreign operations of U.S. multinationals. We describe several possible approaches to implementing book-tax conformity for firms that have both domestic and foreign operations. We discuss issues likely to arise with each approach and conjecture at the behavioral responses to each. Using firm-level financial data from Compustat, we simulate the effects of book-tax conformity on publicly traded U.S. firms. Specifically, we simulate the effects of book-tax conformity on the mean and variance of tax payments / collections and book earnings. Scott Dyreng provided valuable research assistance on this project. We appreciate funding from the International Tax Policy Forum and the NBER Conference on Financial Reporting and Taxes. Michelle Hanlon appreciates funding from the Ernst & Young Faculty Fellowship at the Ross School of Business at the University of Michigan and the Bank One Corporation Foundation. Ed Maydew appreciates funding from the David E. Hoffman Chair and the Harry W. Cherry Accounting Faculty Development Fund.