Investigating the book-tax income gap : factors which affect the gap and details regarding its most significant component

Abstract

(cont.) In total, my thesis suggests that recent changes in the book-tax income gap may be exogenous and transitory, due to changes to the calculation of book income, general business conditions or other factors which generate temporary differences, rather than due to the deceptive and permanent influence of tax sheltering.

My thesis consists of two separate essays, the second of which is joint work. Both essays analyze the book-tax income gap and offer explanations regarding its recent rise and fall. Many view the book-tax income gap as a measure of tax sheltering. Economists and legislators almost exclusively interpret changes in the book-tax income gap as due to changes in tax sheltering behavior. This paper studies alternative factors which influence the book-tax income gap. I find that changes to the calculation of book income, general business conditions and earnings management explain approximately 60% of the variation in the book-tax income gap. This result suggests that the book-tax income gap is a noisier measure of tax sheltering than previously thought. My results establish that, while tax sheltering may influence the book-tax income gap, significant alternative influences also exist. Although book-tax differences can result from either "permanent" or "temporary" differences, there has been little systematic analysis of the relative importance of these two components. The second essay explores the relative importance of permanent and temporary differences by compiling data on deferred tax assets, which are the cumulative effect of past temporary differences. We find that temporary differences are frequently as important, or more important, than permanent differences in contributing to the difference between book and taxable income. In our sample, temporary differences which increase the book-tax income gap are more prevalent and larger than temporary differences which decrease it. Our data demonstrates that the growth of the book-tax income gap is due both to firms permanently reducing their tax burden and to firms temporarily deferring their tax burdens.