Bad foundation mires U.S. income tax system

dougblogA fundamental problem undermines the U.S. income tax system.

It’s like a house with a bad foundation. Neither a new roof or a paint job – nor changing the timing of income and deductions or extending a few credits – can fix the crumbling foundation on which our income tax system sits.

The foundation for our corporate income tax system is financial accounting. From its inception, the code defaulted to general accrual accounting practices and today – despite numerous book-tax differences – we use the same general approaches to measuring income for both taxes and financial reporting.

These instruments for measuring income in financial accounting – developed long before there was an income tax – were designed for a bricks-and-mortar economy. They still work remarkably well for those companies.

But the problem is that increasingly our economy is based on human capital – not physical capital – and financial accounting is struggling to measure activities arising from human capital.

Unlike the days of old, when the most important assets were property, plant and equipment, today the most important assets of many companies are labor force, know-how and brand – items that are largely missing from the balance sheet.

Because it is difficult to determine the portion of expenditures on human capital development, marketing and R&D that should be capitalized, financial accountants default to conservatism, immediately expense these costs and then hope for the best. The result is that reports created by financial accounting have become less useful over time as our economy shifts from tangibles-based to intangibles-based.

This foundational erosion is well understood in financial accounting circles. Although these fundamental accounting problems apply equally to taxable transactions, the tax community has paid less attention to them.

Since tax systems rely on financial accounting to guide them about the timing of income and deductions – and since accountants can’t measure people, marketing and R&D very well – tax systems also struggle to recognize income and deductions in an intangibles-based economy. And the tax problem is magnified because we need to know not just when to recognize but where – which jurisdiction.

When Pittsburgh had big plants, when the steel had been created and where the sale occurred were fairly clear. You couldn’t argue that the taxable profits had arisen in Ireland or the Cayman Islands.

But when value-add comes from a global talent pool working in cyberspace, determining whether a taxable event has occurred – and if so, where and when – is difficult. Since the financial accounting of the bricks-and-mortar world is increasingly inadequate at handling such transactions, the measurement of income and deductions appears increasingly arbitrary.

The result is that the foundation of income taxation – accounting – is crumbling in an intangibles-based world, and no amount of tinkering with the structure above ground will make things right underground.

What we need is radical reform of our system of taxing business profits, not just minor modifications. It’s time to move away from taxing corporate income and increase our destination taxes, such as dividends and capital gains.