Corporations have traditionally considered taxes a painful but necessary cost of doing business. But this view has changed, says Harvard Business School professor Mihir A. Desai. With the advent of sophisticated tax shelters, global tax-reduction opportunities, and high-priced finance experts focused on the issue, corporations are turning the tax function into a profit center, says Desai, an expert on international corporate and public finance.

In this e-mail interview, he discusses new ways businesses are looking to shrink their tax obligations, how the commonly accepted dual-book system may ultimately harm shareholders, and the role boards of directors play in making sure their companies stay within the rules.

Ann Cullen: How has the way corporations view taxation changed?

Mihir A. Desai: There is growing evidence that the tax function within corporations has shifted from being a compliance function to being a profit center. The ratio of corporate taxes to GDP declined through the late 1990s even during an economic expansion. There has been a growing disconnect between the income reports to capital markets and tax authorities (a byproduct of the dual-book system where firms characterize profits to tax authorities and capital markets separately).

There is also much anecdotal evidence on the profusion of tax shelters and compensation incentives for managing effective tax rates. Managers appear to have become more attuned to the possibilities of creating profits by minimizing tax obligations.

Q: You mentioned the dual-book system. Why are firms allowed to report their profits in two different ways to capital markets and tax authorities?

A: It is a curious system. Imagine if you were allowed to report income to the IRS in one way and on your mortgage application in another way. You might, in a moment of weakness, depict your situation in a particularly favorable light to your prospective lender and make yourself look worse off to the IRS. Indeed, you might end up with two completely different pictures of your economic situation that would serve your best interests.

With the growing globalization of firms and the growth of these discretionary opportunities, the dual-book system is clouding the true picture of how firms are actually performing.

Of course, you don't have this opportunity, and for good reason. Your lender can rest assured that the 1040 they review in deciding whether you deserve a mortgage would not overstate your earnings, given your desire to minimize taxes. Similarly, tax authorities can rely on the use of tax forms for other purposes to limit the degree of income understatement, given your need for capital. In that sense, the uniformity with which you are forced to characterize your economic situation provides a natural limit on opportunistic behavior that serves the interests of prospective lenders and tax authorities. This uniformity may even benefit you if it makes both reports more credible and eliminates doubts about your income.

While individuals do not have this opportunity, corporations do. Historically, accounting treatments deviated to allow for differential accounting of expenses. In the process, policymakers get a policy tool without distorting the way in which income is reported to capital markets. For example, depreciation schedules for investment can be different for tax and accounting purposes, creating a tool for fiscal stimulus.

I think this rationale has outlived its usefulness for several reasons. For starters, these different definitions of such expenses no longer account for much of the difference between book and tax income, and yet this disparity has been growing. Other factors such as the peculiar accounting treatment of stock option compensation and differential treatment of overseas income, subsidiary income, and pension obligations account for some of this disparity, and a large portion remains unaccounted for but is consistent with tax sheltering. Moreover, investment lives have shortened considerably, removing much of the power of accelerated schedules.

With the growing globalization of firms and the growth of these discretionary opportunities, the dual-book system is clouding the true picture of how firms are actually performing. As such, enforcing uniformity could reduce uncertainty over the level of true profits thereby furthering the interests of unsure investors, tax authorities, and firms.

Q: What is driving this change in the way managers view corporate taxes?

A: I think several factors are at work. First, financial engineering increasingly allows for cheap recharacterizations of income for tax and book purposes, making tax obligations easily disappear.

Second, the growing global reach of companies and falling costs of global transactions means that profits can be reallocated to lower-tax jurisdictions with a fair amount of ease.

Finally, changing patterns of incentive compensation have sharpened incentives to squeeze profits out of parts of the organization that were heretofore not profit centers.

Q: Is this necessarily a bad thing? Isn't this good news for shareholders? In other words, don't lower corporate taxes just mean more profits for shareholders?

A: You're absolutely right to think that this could be viewed as a good thing. Indeed, there are a variety of reasons to think of the corporate tax as distortionary, and reductions of that burden could be welcome. Moreover, if shareholders are the recipients of all this value, then this would just be a transfer from tax authorities to shareholders. Unfortunately, the evidence is more mixed on the degree to which shareholders benefit from these activities. Countering the tempting logic that tax avoidance is good for shareholders is the fact that tax avoidance opportunities require obfuscation and, consequently, open the door to managerial opportunism. Indeed, several high-profile cases of managerial opportunism including Enron, Tyco, and Dynegy had their genesis in tax-planning activities. These activities, and the secrecy they demanded, became the cover for activities that were not in shareholders' best interests.

Oversight of tax planning, much like accounting, can no longer be relegated to specialists within corporations.

There are other more systematic pieces of evidence that suggest that the link between reduced taxes and shareholder benefits is tenuous. Specifically, my coauthors and I have examined a crackdown in tax enforcement in Russia that was accompanied by an increase in share prices of those companies subject to the crackdown. In a setting where there's plenty of scope for managerial diversion, having the state enforce its claim can be a wonderful thing for shareholders. Similarly, tax avoidance in the United States is only valued fully for firms that are considered well-governed firms. Some apparently tax-motivated transactions such as corporate inversions are often not greeted with a positive price reaction.

In short, the view that tax avoidance is simply a net transfer of value from the state to shareholders is complicated by the agency problem between shareholders and managers.

Q: How should CEOs and boards of directors respond to this changing environment?

A: Because of increased activity by tax planners within corporations and the heightened attention to tax shelters by regulators, boards have to become attuned to what tax risks are being borne by shareholders.

Tax planning can be a legitimate, value-enhancing activity and, indeed, can be a competitive necessity. But tax planning can also cross the line into activity that is costly to shareholders. Creating the right incentives within organizations and ensuring transparency for these activities is critical. Oversight of tax planning, much like accounting, can no longer be relegated to specialists within corporations, given the risks that it entails.

Q: If both shareholders and tax authorities are potentially worse off from all this activity, what should be done about this more generally?

While firms are forced to do some minimal reconciliation of their tax reports and capital market reports, these reconciliations provide very limited detail (in tax forms) or are completely opaque to even the most nuanced analysts—take a look at the tax footnotes of any major corporation. As such, a minimal solution would be the clarification and elaboration of these differences in public documents.

More generally, a wholesale revisiting of the rationale for departing from conformity in the reporting of book and tax income seems long overdue. Given that financial report accounting has evolved over the years while tax accounting remains quite primitive, conformity on financial reporting definitions would seem to make sense. This change could prevent a variety of tax shelters, as managers seldom undertake tax shelters when they reduce book profits. This possibility does raise some concerns that capital market profit reporting will be driven by tax considerations. This concern has to be weighed against the gains in reduced compliance costs (firms would no longer have to file hundreds or thousands of returns) that are currently sizable, reductions in tax sheltering, and reduced opportunities for managerial manipulation created by book-tax differences. Simple calculations also indicate that book-tax conformity could reduce tax rates considerably, as a 15 percent tax on book-pretax profits (just for public companies) would provide the same amount of corporate tax revenues being collected today.

Most radically, these trends provide another reason to revisit the rationale for a corporate tax more generally. The corporate tax is hard to like, as it facilitates an additional layer of taxation on savings. If, in addition, the evasion of these taxes is widespread and this evasion is linked to managerial malfeasance, it is even harder to rationalize such a tax.