On the one hand, your company did extremely well last year. You reported large profits to your shareholders. On the other hand, last year was very difficult for your company. Your tax returns showed losses. Such a scenario is more and more common, according to HBS assistant professor Mihir A. Desai, who is studying the gap between book income — what companies report to shareholders — and tax income — what companies report to the IRS. In a paper titled “The Divergence between Book and Tax Income” published in the forthcoming volume 17 of the National Bureau of Economic Research’s Tax Policy and the Economy, Desai examines the relationship between book and tax income for U.S. corporations over the last two decades.

In the past, the discrepancy between book and tax income was associated with different treatments of depreciation, in the reporting of income from foreign sources, and, in particular, the changing nature of employee compensation. By taking these items into account, one could reconcile tax returns with accounting statements. In the last decade, however, a huge, unexplained difference between the two methods has emerged.

“During the 1990s, book and tax income have diverged markedly for reasons not associated with identifiable factors,” says Desai. “In 1998, more than half of the difference between tax and book income — approximately $154.4 billion or 33.7 percent of tax income — could not be accounted for by these historically relevant measures of discrepancy.”

“The evidence suggests that the large unexplained gaps between tax and book income that have arisen during the late 1990s are at least partly associated with increased sheltering activity,” writes Desai, who adds that it has become necessary to reevaluate the manner in which corporate earnings are taxed and the degree to which book and tax income are allowed to diverge. Desai concludes by pointing out that “the underlying developments driving these phenomena — including increased globalization and financial innovations — are unlikely to decline in importance in the near future.”

Desai and several coauthors examine the discrepancy further in two related working papers: one that looks at the link between stock options and sheltering activity and another that discusses the implications of tax enforcement on shareholders.

For more information, visit www.hbs.edu/research.

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