JATA - Fall 1998

Volume 20, No. 2

The Choice of Incentive Stock Options vs. Nonqualified Options: A Marginal Tax Rate Perspective

Jeffrey R. Austin, Jennifer J. Gaver, and Kenneth M. Gaver


Nonqualified options minimize the joint tax liability of executives and their firms when the corporate tax rate is high and executives have a short holding period for stock obtained from option exercise. Otherwise, ISOs are tax advantageous. We test the proposition that joint tax minimization explains the choice between ISOs and nonqualified stock options by examining a sample of 337 option grants by 187 firms during the early nineteen-eighties. We find that ISOs (or a mixture of IOSs and nonqualified options) are the overwhelming choice of our sample firms, despite their corporate tax disadvantage. These results are consistent with joint tax minimization only if executives have long holding periods for stock acquired through option exercise, and holding period is not adequately controlled for by our empirical proxies. An alternative explanation is that option choice is made to minimize the executive’s tax burden, without regard for the corporate tax implications.

Earnings Management in Response to Political Scrutiny of Effective Tax Rates

W. Dana Northcut and Cynthia C. Vines


This study investigates whether political scrutiny of corporate effective tax rates (defined as current federal tax expense divided by pretax book income) influences accounting policy choices. In an attempt to increase corporate taxes with the Tax Reform Act of 1986 (TRA 1986), political groups used effective tax rates to argue that many corporations paid little or no federal tax taxes. We propose that the political attention to effective tax rates influences firms with low effective tax rates to choose income-decreasing accruals with low book-tax conformity in order to increase reported effective tax rates. Higher effective rates suggest "equity" to tax policy makers and reduce the likelihood of higher future taxes. Accruals with low book-tax conformity increase deferred taxes and thus, our proxy for the change in low book-tax discretionary accruals is the change in deferred tax expense. We expect that firms with low average effective tax rates during 1981-1984 (prior to legislative deliberation) will decrease income and deferred tax expenses with low book-tax accruals in the financial reporting year prior to TRA 1986. Therefore, we predict a positive association between 1981-1984 average effective tax rates and changes in deferred tax expenses for 1985. Consistent with our prediction, we find a positive association for a sample of firms publicly identified by the Citizens for Tax Justice (1985) as "corporate freeloaders." This result suggests that political scrutiny of effective tax rates provide incentives that influence discretionary accounting choices.

Identifying Tax-Induced Earnings Management Around TRA 86 as a Function of Prior Tax-Aggressive Behavior

Thomas J. Lopez, Philip R. Regier, and Tanya Lee


This study extends previous research examining how conflicts between tax and financial reporting are resolved. A variable reflecting a firm's propensity to engage in tax-minimizing behavior is developed to augment previous models used to explain shifts in discretionary current accruals resulting from the tax rate reductions contained in The Tax Reform Act of 1986. The paper provides evidence consistent with the following predictions: (1) tax-aggressive firms are more likely to make negative discretionary current accrual shifts in the year prior to the tax rate reduction than other firms; (2) tax-aggressive firms make greater negative discretionary current accrual shifts in the year prior to the tax rate reduction than other firms; and (3) the magnitude of the shift in negative discretionary current accruals is a function of the tax rate change faced by the firm.

New Evidence on Participation in Individual Retirement Accounts (IRAs)

Peter J. Frischmann, Sanjay Gupta, and Gary J. Weber


Using longitudinal data from individual tax returns spanning different tax regimes and fixed-effects regression models that control for unobserved heterogeneity in savings tastes, we find that use of paid tax return preparers and presence of a balance due to the IRS increase the probability of IRA participation. These results provide first-time evidence that preparers’ role in the tax system extends beyond compliance issues to taxpayers’ personal decisions such as savings, and reconfirm prior research results that framing bias widely impacts taxpayer decisions. We also find that segregating persistent and infrequent participants potentially explains conflicts in prior research regarding the impact of marginal tax rates on IRA participation, suggesting the importance of incorporating persistence in savings behavior in future research.

The Use of Marginal Tax Rates in Decision Making MAKING: The Impact of Tax Rate Visibility

Tim Rupert and Arnold Wright


Taxpayers need to know their marginal tax rate to make optimal decisions, for instance, in choosing between work and leisure or between taxable and tax-exempt bonds. However, previous studies (e.g., Rupert and Fischer 1995; Fujii and Hawley 1988) have shown that many individual taxpayers either do not accurately recall or are unaware of their marginal tax rates. This study examines the impact of the visibility of the marginal tax rate (MTR) on taxpayer decision making. In addition, the effect of visibility on the rate of learning is examined. It is hypothesized that greater visibility will lead to better decision performance and more rapid learning as a result of task properties feedback. To investigate these issues, subjects in a computerized experiment were presented with a series of eleven periods in which they were given an investment choice between a taxable and nontaxable savings account. Visibility of the rate structure was treated as a between-subjects variable with four conditions, ranging from no indication of the MTR (low visibility) to explicit identification of the MTR as provided by the tax rate schedule (high visibility). Results indicate that increased visibility of the rate structure significantly enhanced decision performance. Further, learning was most rapid for the high visibility conditions. Implications of the results for policy makers, practitioners and researchers are discussed.

Extending Scholes/Wolfson For Post-1997 Pension Investments: Application to the Roth IRA Contribution and Rollover Decisions

Jim A. Seida and Jerrold J. Stern


The Scholes/Wolfson [SW] (1992) savings vehicle formulas are a powerful tool to analyze investment alternatives. However, application of their pension formula to cases where the after-tax investment exceeds statutory limitations on investment size results in overstated after-tax future values. This overstatement occurs because the SW pension equation does not explicitly model tax law restrictions that limit deductible pension investments. We use the SW savings vehicle formulas as investment components and provide a pension formula that explicitly models tax law restrictions. Our pension strategy consists of two distinct components: the pension account and a supplemental account. The supplemental account captures any after-tax investment that exceeds statutory limitations associated with deductible pension plans.

We use our investment component perspective to analyze the annual Roth versus deductible IRA decision. We then extend the SW investment formula approach to analyze the Roth IRA rollover decision. For both decisions, algebraic expressions are derived that are useful in determining the after-tax future value maximizing decision in most cases.

The Acquisition and Transfer of Tax Skills

Richard Gore and Bernard Wong-on-Wing


Consistent with the recommendations of the Accounting Education Change Commission (1990, 1992), one emphasis of the new paradigm proposed by Jones and Duncan (1995) is the need to teach tax "skills" versus tax "facts". Human information processing theories of cognition, in particular ACT-R, provide a framework to understand the acquisition and transfer of knowledge. These theories posit that knowledge is comprised of two elements: declarative knowledge (facts) and procedural knowledge (skills). Accordingly, if students are going to acquire tax skills versus tax facts, they will need to acquire procedural knowledge. This paper discusses the characteristics of procedural knowledge and proposes a method of teaching the introductory tax course to promote the acquisition of procedural knowledge. Briefly stated, the proposed method suggests that (1) instruction should be organized around specific tax skills, (2) a task analysis should be completed for each skill, (3) instruction should be example based, and (4) students should be given practice on holistic real world problems. This paper identifies a missing link between the acquisition of declarative knowledge and the ability to apply that knowledge to a task in a specific situation. Our experience indicates that the method leads to the acquisition of identifiable tax skills.