Interactions of Tax and Nontax Costs n Uncertainty u Symmetric uncertainty u Strategic uncertainty (information asymmetry) F Hidden action (moral hazard) F Hidden information (adverse selection) n Financial Reporting Conflicts

Symmetric Uncertainty n All contracting parties are equally informed but uncertain about future cash flows u Estimate probabilities of alternative outcomes, and calculate expected values n When tax rates are progressive, symmetric uncertainty can lead to decrease in risk- taking, even for risk-neutral investors!

Example – Interaction of Taxes and Symmetric Uncertainty n Progressive tax rate structure as follows: u If taxable income is $50,000 or less the tax rate is 25% u Taxable income in excess of $50,000 is taxed at 45% n Two $100,000 investment alternatives (held for 1 year): u Riskless investment yields $50,000 profit u Risky investment yields $25,000 with 50% probability and $80,000 with 50% probability

Example continued n Calculate the before-tax rate of return on each investment alternative u Without taxes, which investment would a risk neutral investor prefer? n Calculate the after-tax rate of return on each investment u Given the progressive tax rate structure, which investment would a risk neutral investor prefer?

Conclusions n Progressive tax rate structures can distort investment decisions n Progressive tax rate structures can lead investors to choose less risky projects n Questions: u Can we differentiate the impact of taxes on risky investment from risk aversion? u How can the tax law mitigate these investment distortions?

Hidden Action (Moral Hazard) n One contracting party has control over an unobservable action choice that affects future cash flows n How do hidden action settings interact (conflict) with tax planning? u Risk of default increases costs of borrowing, reducing effectiveness of tax arbitrage strategies u Labor contracts

Labor Contracts with Progressive Tax Rates n Suppose that the employer and the employee face different tax rates. In particular, employee faces constant tax rate and employer faces progressive rates u With symmetric uncertainty, no moral hazard, and risk neutrality, optimal contract would pay a bonus when profits are positive and nothing when profits are negative u With symmetric uncertainty, no moral hazard, and employee risk aversion, tradeoff must be made between tax minimization and risk sharing

Labor Contracts with Progressive Tax Rates continued n With moral hazard and risk aversion, tradeoff must be made between motivating desired action by employee (via bonus arrangements) and sheltering employee from risk (via fixed salary) u If tax rates are changing over time, tax strategies may either conflict with or support strategies to mitigate moral hazard and risk aversion

Labor Contracts and Tax Tradeoffs n Consider a multi-period labor contract, where the employee’s hidden action will be revealed in the future n Tax rates for the employee, the employer, or both could change over time n Also assume that the employee is risk averse and the employer is risk neutral n In each of the following settings, what are the employee’s and the employer’s preferences if the compensation choices are either u Fixed salary currently or u Deferred bonus in the future if the revealed action is profitable

Labor Contracts and Tax Tradeoffs continued n Recall that employee faces constant tax rate, while employer faces progressive rates u What if employer’s highest rate is F Increasing over time? F Decreasing over time? u What if employee’s constant tax rate is F Increasing over time? F Decreasing over time?

Conclusions n Progressive tax rate structures can distort optimal labor contracts n Progressive tax rate structures can lead employers to offer labor contracts that impose risk on risk-averse employees, and do not align incentives so as to mitigate moral hazard n Questions: u Can we differentiate the impact of taxes from moral hazard? u How can the tax law mitigate these contracting distortions?

Hidden-Information (Adverse Selection) n One contracting party is better informed about uncertain future cash flows n Classic hidden information setting: asset sales u Tax consequences of asset sales could, in some cases, mitigate the hidden information problem F Sellers of high value assets could obtain sufficient tax benefits from the sale to offset bargain sales price F Buyers who obtain favorable tax benefits from purchase might be willing to pay more

Conflicts between Financial Reporting and Tax Planning n Conflicting incentives: u Managers generally wish to report higher (and less volatile) net income for book purposes F Earnings management F How does reported income impact firm value and manager compensation? u Managers generally wish to report lower taxable income for tax purposes F Minimize current tax costs

Conflicts between Financial Reporting and Tax Planning continued u Is it ever possible to do both? Why? F How do the objectives of the tax system and the objectives of GAAP differ? When do these differences permit managers to achieve both tax minimization and higher book income? F Which tax planning strategies (converting income from one type to another, shifting income from one time period to another, shifting income from one pocket to another) might permit this?

Conflicts between Financial Reporting and Tax Planning continued n When conflicts do exist, how should tradeoffs be made? u If perfectly informed, what would the shareholders prefer? u What are the incentives of the managers making the decisions? F Are managers willing to forego tax savings in order to increase reported book income? Why? How much tax savings is sacrificed? u How do the choices made impact before-tax rates of return? After-tax rates of return?

Tradeoffs between Financial Reporting and Tax Planning - Example n In periods of rising prices, adoption of the LIFO inventory method for tax purposes results in higher cost of goods sold and lower taxable income. However, LIFO can only be used for tax purposes if also used for financial reporting purposes. Thus, lower taxable income can only be achieved by also reporting lower book income. u With perfect information, shareholders would probably prefer LIFO for the tax savings u Research indicates that managers forego LIFO tax savings to avoid reduced book earnings