Pitfalls in the Computation of 

"Effective Tax Rates" Paid by Corporations 

Seymour Fiekowsky

U. S. Treasury Department 

OTA Paper 23 July 1977 

Office of Tax Analysis

U. S. Treasury Department, Room 1104 

Washington, D. C. 20220 

Issued: July 1977 
TABLE OF CONTENTS 

Page 

1. Statement of the Problem ........... 1 

2. Penetrating the Fog of Financial Statements ... 6 

3. Differences between Financial and Tax Accounting 

Procedures ................... 8 

a. Rules for Consolidation: Foreign Income 

Aspects. .................. 8 

b. Accounting for Capital Consumption . . . . 13 

c. Effects of Using the Tax Account for Clearing 

Purposes .................. 17 

(1) Intercorporate Dividends ....... 17 

(2) Clearance of "Tax Refunds" through the 

Current Year Tax Accounts. ...... 20 

(3) Clearance of subsidies in the Form of Tax 

Credits through the Current Year Tax 

Account ................ 22 

4. Summary: Presenting a Meaningful Estimate of 

"Effective Tax Rate" of a 

Particular Corporation ........ 25 
-1-

1. Statement of the Problem. 

Published income statements of corporations, including 

those filed with the Securities and Exchange Commission, 

invariably include an item labelled "Federal Income Tax." 

This encourages the unwary reader to compute the ratio of 

this number to the preceding number, "Income Before Taxes," 

and conclude that it describes the "effective" rate of tax 

paid by the corporation in question. In almost every case, 

however, the ratio thus computed tells little or nothing 

about the taxability of the corporation's income. The 

reawns for this statement follow, but to help the reader 

through the discussion, the following income statement format 

is presented first: 

The ABC Corporation

Consolidated Income Statement for Year Ended 

December 31, 1976 

Sales, net of returns and allowances . . . . $10,000 

less: 

Allowance for depreciation . . . . 

Dividends earned (non-consolidated 

Cost of goods sold . . . . 69;OiO

200 9,200 

Income from operations . . . . . . V 

Plus: Net interest (interest received

less interest paid) .$ 10 

corporations). . . . 90 100 

Income before tax: . . . . . . . . less: Provision for foreign income tax . $ 200 

Provision for U. S. income tax . . . 90

Deferred U. S. tax . . . . . 10 300 

Net income for year . . . . . . -
-2-

The automatic reflex of journalists and others unskilled 

in the interpretation of financial statements is to pick out 

the $90 for U. S. tax, divide by $900 of income before tax, 

and proclaim in headlines that, "The ABC Corporation in 1976 

paid an effective tax rate of 10 percent, and this is less 

than the rate paid by their assembly line workers!" 

Headlines like this cause irate citizens to write to the 

Treasury wanting to know how the ABC Corporation has managed 

to avoid paying its fair share of income taxes which is 

supposed to be 48 percent, not 10 percent. 

In response, the Treasury tells them that in 

interpretating "effective tax rates" it is important: 

(1) to account for both domestic and foreign tax and 

income items. 

In the foregoing statement, $200 is reported as 

provision for foreign income taxes. This suggests that some 

part of the $900 of before-tax income has been earned abroad. 

Since by long-standing international conventions the United 

States (and other developed countries) do not "double-tax" 

incomes of their residents which are earned abroad and taxed 

there, if foreign income is to be included in the denominator 

of the "effective tax rate" calculation, foreign taxes should 

be included in the numerator. If this were done, a more 
-3-

appropriate inference of the ABC Corporation tax rate is 

$290/$900 = 32.2 percent. This is closer to the "truth" but, 

for reasons yet to be explained, still incorrect.l/-

(2) to remember that the accountinq rules for 

determininq income for financial reporting purposes 

are not the same as those used for tax accounting 

purposes. 

Income tax items are the product of tax accounting 

rules. At the most basic level, rules for determining which 

corporate entities may be consolidated -- aggregated for 

purposes of tax assessment -- differ from those used for 

financial reporting, and this causes radical differences 

between "income before tax" reported to stockholders and 

"income before tax" subject to tax. In general, the 

difference in rules invariably causes financially reported 

income before tax to be larger than taxable income. While 

this discrepency has no direct effect on the taxability of 

corporation income, it invariably leads to an understatement 

of "effective tax rates" gleaned from financial statements. 

(3) to make allowances for capital consumption;

depreciation and depletion used for financial 

reportinq and income tax accounting differ. 

Since the net income of corporations is that 

attributable to assets employed in the business, the 

allowance for depreciation and depletion is a critical 
-4-

determinant of income before tax. Frequently, the rules 

adopted for measuring capital consumption for financial 

reporting result in a currently lower deduction from gross 

income than that produced by permissible tax rules. But 

since either set of rules involves estimates of a cost not 

established by market transactions, there is no objective 

basis for choosing which is more nearly "correct" and, 

therefore, whether reported income is a "truer" 

representation of "income" than taxable income. In terms of 

the foregoing example, it is not clear that $900 is the 

proper denominator to use when evaluating taxes paid. 

(4) to remember that at both the corporate or Treasury

levels current year tax accounts are ambiguous 

measures of tax borne by the income of that year. 

If, during a current year, the corporation experiences a 

negative income but had paid positive taxes in three prior 

years on taxable income at least equal to its current year 

loss, it can get a refund. In this case, the corporation's 

tax account for the loss year will display the refund as a 

negative tax, which increases its after-tax net income. On 

the other hand, if the corporation cannot so carryback its 

current year loss to qualify for a refund, it may carry the 

loss forward to future years. Then, in a future year, when 

it does have positive taxable income, it may take as a 

deduction whatever amount of prior losses it is carrying 
-5-

forward up to the current year's otherwise taxable income. 

In the extreme, this refund with respect to prior year losses 

may reduce the current year tax liability to zero. This use 

of the tax account as a clearinghouse for intertemporal 

adjustments never fails to confuse those who compute 

"effective tax rates." 

Similarly, the tax account is used as a clearing 

mechanism for a number of subsidy programs -- the investment 

credit, the WIN credit, rapid amortization, etc. In exchange 

for the performance of some service, the corporation or other 

taxpayer is permitted a remission of tax, either by some 

additional deduction from gross income or by a direct credit 

against tax otherwise due. If these subsidies were paid in 

cash rather than cleared through the tax account, the income 

of the corporation would be increased by the subsidy. If 

this were a normal subsidy, then the tax liability would be 

increased correspondingly and the effective tax rate would be 

unchanged. But if the subsidy were to be declared tax exempt 

then the effective tax rate of the corporation would be 

reduced. However when Congress chooses finance subsidy 

through the tax system it does so by reducing the amount of 

the tax currently payable and usually does not require the 

value of the subsidy to be reflected in taxable income. The 

effect of providing a subsidy in this manner is to sharply 
-6-

reduce the numerator, taxes paid, while holding the 

denominator, taxable income constant. The significance of 

such a "low effective tax rate" produced by a numerator which 

does not measure tax liability and a denominator which does 

not measure taxable income is open to serious question. 

The following sections explain in specific detail how 

accounting for these four points results in an estimate of 

"effective tax rate" ranging from 42 to 47 percent, depending 

on one's choice of "income subject to tax." 

2. Penetrating the Fog of Financial Statements. 

The initial income statement format presented above 

provides the reader no clue as to the foreign and domestic 

portions of the ABC Corporation income. Indeed, aside from 

income tax accounting rules, there is no standard set of 

procedures by which a multinational corporation can divide 

its activities into separate geographical parts.2/ - This

being so, we must imagine we have access to the ABC 

Corporation books of account to derive the following 

reorganization of its income statement: 
-- 

-- 

-7-

The ABC Corporation

Consolidated Income Statement for the Year ended - December 31, 1976 

Domestic Foreign Total 

Sales ........... $5,000 $10 ,O00 

less: Cost of goods sold 4 ,500 9,000 

Operating income ... Plus: Interest ...... Dividends ..... 400 

10 

90 

4 0 0 7 

10 

90 

Income before tax ..... 500 400 900 

less: Provision for taxes 90 200 290 

Tax deferred ... 10 10 

Net income for year .... $ 400 $7 

Depreciation ... 100 100 200 

With this reformatting, we may now take account of Point 

#1 above; we can distinguish between domestic and foreign 

income and associated taxes. We see that half the operating 

income and 5/9 of total income before tax originates within 

the United States, the remainder abroad. With respect to 

domestic income the apparent "effective tax rate" is 

$90/$500, or 18 percent; and with respect to the foreign 

income, the rate is $200/$400, or 50 percent. From the U. S. 

point of view, these approximations of foreign income and tax 

are consistent; the foreign income is measured by such rules 

as the reporting corporation employs, and the foreign taxes 

it has paid or accrued with respect to that income are 

obviously related to that income.?/ But the domestic income 

and tax items are not consistant with each other, nor is the 

U.S. tax item consistant with the foreign tax item. These 

consistancy problems are due to the difference between tax 
-8-

and financial accounting procedures noted in Point #2 above, 

a matter to which we now turn. 

3. Differences between Financial and Tax Accounting

Procedures. 

a. Rules for Consolidation: Foreign Income Aspects. 

For financial reporting purposes, a corporation may 

consolidate all corporate entities in which it holds 50 

percent or more of the voting stock, and the corporate 

entities so consolidated may be chartered in the United 

States or abroad. For tax purposes, however, a corporation 

may consolidate only those corporate entities in which it 

holds 80 percent or more ownership and which are not 

chartered in a foreign country. The difference this makes, 

along with other differences in rules, may be illustrated by 

comparing the foregoing income statement with the following 

statement reflecting the tax accounts for the same year for 

the ABC Corporation: 
10 -- 

-- 

-- 

-9-

The ABC Corporation

Consolidated Tax Rules Income Statement for the Year Ended 

Dec. 31, 1976 

Domestic Foreign Total 

Sales . . . . . . $5,000 $1,O00 $6,000 

"Operating" income . 120 20 140 

Plus: Interest . . . . . _ - 10 

Dividends . . . . 9u 300* 390 

less: Dividend rec'd 

deduction . . . . (76.50) 380 (76.50) 

less: Cost of goods sold 4,500 900 5,400 Depreciation . . -380 7-m 

Current year taxable income 403.50 783.50 

less: Net operating loss 

carryforward 103.50 103a 50 1976 Taxable income . .. .. 300.00 380 -68-0,oO 

*Includes dividend plus foreign tax of $150 attributed 

thereto. 
-10-

Information items: 

U. S. tax rate = 48% 

Tax rate abroad = 50% 

Foreign taxes paid; .50 x $380 = $190 

Investment (domestic) qualified fi3r credit = $320 

Tentative investment credit = $32 

Plus: Investment credit carryforward = $22 

Tax calculation: World-wide income. . $680.00 

U. S. tax @ 48 percent 326.40 

Less: Foreign tax credit 

(.48 x $380) . 182.40 

(excess credit carryforward = $7.60) 

Equals U.S. tax before 

investment credit . . 144.00(=.48 x $300) 

Less: investment credit. 54.00 

Net tax due 

U. S. Treasury . .$ 90.00 

The effect of difference in consolidation rules shows up 

vividly in the foreign income column: Whereas in its 

financial statement the ABC Corporation reported operating 

income of $400 derived from foreign sales of $5,000, in its 

tax accounts only $80 of income is reported as derived from 

$1,000 of sales. That is, of the $5,000, of foreign sales 
-11-

consolidated in the ABC Corporation financial statement, only 

$1,000 of the sales were by U.S. corporate entities 

controlled by ABC Corporation and hence reportable in U.S. 

tax returns. The remaining $4,000 of foreign sales were by 

foreign corporations not controlled by ABC Corporation; and 

the $320 of operating income attributable to these $4,000 of 

foreign sales is -not reportable in the U. S. tax return for 

ABC Corporation in 1976. Instead, only the income from these 

controlled foreign corporations (commonly called 

"subsidiaries" by tax practitioners) which ABC "repatriated" 

--received as dividends -- is reportable as potentially 

taxable U. S. income; and since, in accordance with 

long-standing international conventions observed by the 

Internal Revenue Code, income from foreign sources is not to 

be subjected to two separate taxes (levied on the same income 

base), the dividends from foreign sources are grossed-up for 

income taxes paid to the foreign governments so that U. S. 

tax liability and creditable foreign taxes may be later 

computed. 

As a consequence of the ABC Corporation repatriation of 

$300 (a cash dividend of $150 plus imputed tax of $150 paid 

to foreign governments) plus the $80 of foreign operating 

income of consolidated U. S. corporations (commonly referred 

to as "branches" by tax practitioners), a total of $380 is 
-12-

all that appears in the ABC Corporation foreign income tax 

accounts. Thus, in the year in question $20 of foreign 

income, not having been repatriated, is unreported in the 

U.S. tax accounts of the ABC Corporation. Of course, since 

the foreign tax rate in this case is a shade higher than the 

U.S. tax rate, which means that no U S. tax will ever be 

collected with respect to this foreign income, the 

discrepancy between the financially reported income and the 

tax accounts will not result in any misstatement of the 

"effective rate" of foreign tax: in its financial statement, 

$200 is 50 percent of $400; in its tax accounts, $190 ($40 of 

tax with respect to "branches" plus $150 with respect to 

"subsidiaries'" dividends) is also 50spercent of $380, the 

taxable (U. S.) foreign income. However, since foreign 

income reported in financial statements is invariably higher 

than that reported in tax returns, "effective tax rate" 

calculations derived from financial statements will 

overweight the foreign relative to domestic income items in 

the denominator and, therefore, increase the contrast between 

"U. S. tax as a percentage of world-wide income" and "U. S. 

plus foreign income tax as a percentage of world-wide 

income".4/ 
-13-

b. Accounting for Capital Consumption. 

In any income statement, the allowance for depreciation 

or depletion is a critical determinant of "income" -- the 

amount which is available to pay tax and be distributed to 

stockholders or retained for expansion. In the ABC 

Corporation statement above (p. 6), of the $500 excess of 

domestic sales revenue over the "cost-of-goods sold" 

(material and labor costs, etc.), $100 is deducted for 

capital consumption. This is 1/5 of the ''gross margin" and 

1/3 of the "net' or after-tax margin on operations. 

Notwithstanding its critical importance in income 

measurement, appallingly little attention is paid to its 

estimation. Virtually any procedure which allocates the cost 

of a depreciable asset over a "reasonable" expected life will 

be accepted by accountants if it is "consistently" applied, 

i.e., if year-to-year changes in the procedure are not made 

in a capricious manner. Moreover, since acceptable 

procedures are always tied to the historical cost of assets, 

if there has been inflation, the current year estimate of the 

cost of capital "consumed" or expired during the year will be 

a melange of allocations of cost expressed in dollars'of 

prior years, each dollar of which will be worth progressively 

less compared with current dollars the farther in the past 

their origin.5/-
-14-

These same considerations apply to the allowance for 

depreciation used to derive taxable income. Then, inasmuch 

as the two allowances may differ, the question is raised: 

Which allowance is more nearly correct? Which produces a 

measure of income suitable for use in the computation of a 

corporation's "effective tax rate?" Those who would compute 

"effective tax rates" from corporations' financial statements 

implicitly assume the underlying accounting procedure yields 

the more nearly correct result. Yet, there is no empirical 

evidence to support this choice. Indeed, the notorious 

tendency of corporate managements to wish to report large 

"earnings per share", in view of the fact they are under no 

obligation to distribute reported earnings, suggests that 

when the financial report estimate of depreciation is smaller 

than the tax allowance figure the latter number may be nearer 

to the truth.6/-

In the example we are pursuing, absent knowledge of the 

tax allowance for depreciation, how does one know the tax 

allowance differs so that he may correct the reported 

allowance and, accordingly, reduce reported income before 

tax? He looks to see whether an item labelled "deferred 

taxes" is reported. If he finds such an item, as in the case 

of the ABC Corporation income statement where $10 of deferred 
-15-

tax is reported, the inference that tax depreciation 

allowances exceed the financial estimate is warranted. The 

origin of this item is revealed by comparing the allowances 

for depreciation with respect to domestic operations in both 

the reformatted ABC Corporation income statement and the tax 

rules income statement, above. Whereas the ABC Corporation 

reported $100 in its financial statement, computing its 

taxable income by rules available in the tax laws, it 

deducted $120 for depreciation expense that same year. As a 

consequence, the corporation's taxable income from domestic 

operations was $380 while it reported $400 to stockholders. 

At a tax rate of 48 percent, this difference of $20 

results in a tax liability which is $9.60. Since the ABC 

Corporation's accountants are bound by their certification of 

$100 as depreciation for the year, according to prevailing 

accounting principles they must "reconcile" this difference. 

If the $100 allowance is correct, and since no more can 

be ultimately be written-off for depreciation under any set 

of rules than the original cost of the property, deducting 

$120 this year for tax purposes means that, in some future 

year, $20 less will be deductible and future tax will be 

$9.60 higher. Thus, "reconciliation" of the excess of tax 

over financial accounting depreciation takes the form of 
-16-

recognizing the $9.60--which was rounded to $10 for 

expositional purposes in the foregoing income statements --

as "deferred taxes": It, along with the $90 of actual taxes 

paid the Treasury, is deducted from before-tax income to 

derive the residual presumably available to distribute to 

stockholders or retain in the business. By this procedure, 

the accountant declares that $100 has been the "tax expense" 

for the year: $90 due within the statutory payment period 

(and credited to "accrued taxes payable"): $10 due in the 

indeterminate future (and credited to "deferred income tax", 

an account presented in balance sheets between long-term 

liabilities and net worth). 

Many critics of this accounting procedure, particularly 

those who regularly engage in the computation of "effective 

tax rates" delight in correctly pointing out that, so long as 

the enterprise at least maintains its stock of depreciable 

assets, it will never arrive at the time when the "deferral" 

ends. But, this is a frivolous criticism of the accountants' 

procedure for maintaining financial consistency. The fact 

that, for tax purposes, the undepreciated cost ("adjusted 

basis") of assets is different from that reported in the 

financial books of account is a matter bearing on the 

financial status of an enterprise; should the corporation run 

on hard times, its tax bill will be higher; and should the 
-17-

enterprise have to be liquidated, the lower tax "basis" also 

has operational significance to the corporation's 

stockholders. 

Rather, the real issue is whether the observer believes 

the financial or tax allowance for depreciation is nearer the 

truth. If he believes the financial allowance is better, and 

if he believes the corporation is in no imminent danger of 

decline, then he should regard the actual tax paid, $90 in 

this instance, with respect to the reported financial 

before-tax income as a final discharge of the corporation's 

tax obligation. On the other hand, if he believes the tax 

allowance for depreciation is superior, he should divide the 

reported deferred tax by .48 to derive the difference between 

the two measures of depreciation, and subtract this amount 

from the reported before-tax income, again taking $90 as the 

tax for the period. 

c. Effects of Using the Tax Account for Clearing

Purposes. 

(1) Intercorporate Dividends. 

If several corporations are consolidated for purposes of 

financial reporting or for tax accounting, the payment of 

dividends from one to another of the consolidated group has 
-18-

no effect on the aggregate income of the group; the payment 

of a dividend by a subsidiary to a parent merely relocates 

the funds but has no effect on the combined income of the 

two. In a tax system with a separate corporation income tax 

such as that of the United States, the possibility exists 

that there may be intercorporate ownership of stock but that 

the degree of ownership should fall short of the 80 percent 

control required in order that the separate corporations 

might be consolidated, for tax purposes. 

In the present example, it is apparent from the $90 of 

dividends reported by the ABC Corporation that it has minor 

interests in other corporations. These other corporations 

have filed tax returns and paid taxes. If these other 

corporations could have been consolidated with ABC 

Corporation, the payment of tax with respect to their 

earnings would have terminated corporation tax liability for 

all. But since ABC Corporation cannot consolidate its share 

of the income of the others, the question is raised how the 

shareholders of the ABC Corporation can be spared incurring 

an additional tax on the flow of already-taxed income that 

comes to ABC Corporation. In the United States, this 

question is answered by allowing the ABC Corporation to 

deduct 85 percent of the dividends it has received from 

domestic corporations in the computation of its own taxable 
-19-

income. Presumably, this penalty of "double-taxing" 

unconsolidated intercorporate dividends to the extent of 15 

percent of the normal corporate rate is intended to 

discourage use of particular corporate entities as 

independent vehicles for managing portfolios rather than 

distributing as dividends funds not needed for investment in 

physical assets employed in carrying out the corporate 

purposes of those entities. 

The effect of this deduction, of course, is to cause the 

taxable income of the ABC Corporation to be $76.50 less than 

its reported before-tax income. Correspondingly the 

unsophisticated observer who examines only the ABC 

Corporation income statement is likely to conclude that, 

because each dollar of dividend income reported pays tax at 

only 7.2 percent (.15 x .48), the ABC Corporation "pays" a 

distressingly low "effective tax rate", for the reported 

dividend income accounts for 18 percent of the total reported 

before tax income. Paradoxically, the imposition of a 

"penalty" tax on corporations' dividend income produces the 

appearance of "tax avoidance! 

In a system of separate corporation income taxation, the 

logical procedure for determining the "effective tax" on the 

income of a particular corporation requires that its 
-20-

"dividend income" from domestic corporations be removed from 

its reported income before tax, and that the tax attributable 

to that income be removed from its reported tax paid. The 

residual income and tax thus obtained will refer specifically 

to the income produced by the particular corporation during 

the year in question: it will be net of the share of other 

corporations' income claimed by the given corporation as 

shareholder, which has been taxed elsewhere. 

(2) Clearance of "Tax Refunds" Through The Current Year 

Tax Accounts. 

The corporation income tax is strictly a levy on the 

income attributable to equity claims -- interest payments to 

creditors are "deductible", both in financial and tax 

accounting procedures. The essential characteristic of the 

equity share of income is that it is residual: the claims of 

employees, government, and creditors precede the claims of 

the equity owners. As a consequence, corporate "income 

before tax" and taxable income are highly volatile quantities 

which may even be negative during a given accounting period. 

Over a long period of time, the positive and negative 

periodic incomes must average to a positive return, else no 

equity investment would be forthcoming. 
-21-

This being so, if an income tax system is not to unduly 

depress after-tax returns and thus discourage risk taking, 

when risk taking refers to the acceptance of a variable 

stream of returns some of which may be negative,it must make 

provision for offsetting negative periodic incomes against 

other years' positive incomes. This is practically 

accomplished by permitting a corporation (or other taxpayer 

with equity income) to "carryback" a given year's negative 

taxable income -- known as "net operating loss" -- against 3 

prior years' positive taxable income and thus to claim a 

refund: or, in the event the positive income in the 3 prior 

years is insufficient to cover the current year negative, the 

balance may be carried forward 5 additional years. In the 

latter case, the carryforward of unrequited and unexpired 

prior years' losses negatives will constitute a deduction 

from current year taxable income. 

If a current year negative income is carried-back and 

the corporation receives a refund, its income statement will 

duly show the subtraction of the refund (shown as a negative 

tax payment) from before tax income.7/ - But, if an unrequited

prior year negative income is carried forward, it will merely 

depress the current year U.S. tax liability. As the ABC 

Corporation tax rules income statement above shows, in 1976 

that corporation carried-forward $103.50 of unrequited prior 
-22-

year losses, reducing its taxable domestic income of $403.50, 

after taking account of the dividends received deduction, to 

but $300 in 1976. In effect, the ABC Corporation is 

permitted to pay $49.68 (.48 x $103,50) less in tax for 1976 

in order to make that amount of refund with respect to its 

negative taxable income in prior years which had not been 

requited theretofore. 

To the unwary observer, however, these uses of the 

current year tax liability to adjust for events occurring in 

other years -- refunds from prior years in the event of a 

carryback; refunds this year in the event of a carryforward 

from prior years -- naturally appear to reduce the taxability 

of the corporation in the current year. Unless the observer 

who would divide this year's reported tax by this year's 

reported income can adjust the numerator for these refunds, 

his result will be meaningless. In the case of the ABC 

Corporation, he should -add $48.60 to the 1976 reported U.S. 

tax of $90 before dividing by an appropriate 1976 domestic 

income measure. 

(3) Clearance of Subsidies in The Form of Tax Credits 

through the Current Year Tax Account. 

If Congress appropriates funds to subsidize a business 

activity, the normal treatment of the payment by the 
-23-

recipient is to "bring it into income." If the payment is an 

above-market price for commodities, the seller appropriately 

reports the entire payment (in both his financial and tax 

books-of-account) as gross income (sales). If the payment is 

for improving his land, either by draining it or letting it 

lie fallow, the land-owner might record the receipt as gross 

income in the year received, or, preferably, prorate the 

payment as income over the period it is expected the 

improvement will persist. On the Federal budget side of 

these subsidy transactions, the expenditures are duly 

recorded as outlays: and for tax accounting purposes receipts 

of these outlays become an addition to taxable income. 

But consider what happens when Congress, instead of 

appropriating funds for subsidy payments, authorizes entities 

which receive the subsidy to simply pay a corresponding 

amount less in tax. First, and most obviously, the 

enterprise is absolved from including the value of the 

benefit in his gross income for tax purposes: and he will not 

be required by his accountant to display the subsidy in his 

before tax income.t/ Secondly, the Budget shows the subsidy 

not as an expenditure, but as a "reduction in tax revenues." 

The effect of this convention, the sole purpose of which is 

to give the tax-writing committees of Congress jurisdiction 

over the subsidy in place of the cognizant standing 
-24-

appropriations committees, is to completely muddle the 

concepts of income and effective tax rates. 

Refer to the tax rules income statement of the ABC 

Corporation, for example. We see there that during 1976, the 

Corporation had acquired $320 of property qualified for the 

10 percent investment credit. But, instead of the $32 

subsidy being paid in cash, the tax laws provide that $32 

less may be paid in tax otherwise due that year.?/ In 

addition, due to prior years' lack of tax liability (remember 

its carryforward of $103.50 in unrequited prior year negative 

taxable income), the ABC Corporation is able to reduce its 

1976 payment by $22 more to satisfy the amount of its as yet 

unrequited subsidy claim for qualified investment in prior 

years. 

Harking back to our earlier remark about the treatment 

of cash subsidies, it is clear that, if we wish to discuss 

the taxability of the ABC Corporation income for 1976, we 

need to do two things: We must restore the $32 of credit to 

the $90 of tax due that year; and we must add $32 to the 

before-tax (or taxable) income figure.lO/ - That, in fact, the

subsidy is not taxed merely means that this portion of the 

ABC Corporation income bears a zero tax rate; including it in 

income, but restoring it to tax due, serves to reduce the 
-25-

effective tax rate, but by far less than simply excluding the 

subsidy from tax due and not including it in income. With 

regard to the $22 of prior year investment credits "cashed" 

this year, this, too should be restored to the numerator in 

the effective tax rate calculation, but it should not be 

added to the 1976 income denominator since it merely reflects 

extinguishing a prior year's obligation of the Treasury, not 

a current year income transaction. 

4. Summary: Presenting a Meaningful Estimate of the 

"Effective Tax Rate" of a Particular 

Corporation. 

If the pitfalls of "effective tax rate'' estimation are 

to be avoided, the general rules set forth above advise that 

the estimator should be careful to match the numerator --

income tax liability for the year -- with the denominator --

income before tax. Unfortunately, no set of assembled income 

accounts, whether maintained by rules prescribed for 

financial reporting, or for tax return accounting, permits 

this to be done. Although the proper tax numerator can be 

derived from a corporation's tax books-of-accounts, its 

annual tax return is insufficiently complete for this task, 

since it does not include the requisite carryback and 

carryforward data. Nor can published financial statements 

provide the information required for the computation, since 

the principles of consolidation used for deriving the tax 
-26-

element of the calculation are not consistent with those used 

for the income element in the denominator. 

But we may recapitulate what needs to be done by 

reference to the example we have used throughout this paper. 

We begin with the obviously misguided "effective tax rate" 

derived directly from the ABC Corporation income statement, 

which was noted at the outset, and proceed by stages to the 

end, a reasonable statement of the taxability of the ABC 

Corporation income for 1976: 

U.S. tax paid income before tax: $90/$900 . . . . . . 10% 

(effective rate) 

(1) Match domestic and foreign income and tax items: 

Domestic: $90/$500 = 18% 

Foreign: Either financial consolidation: 

$200/$400 = 50% yielding a weighted 

average of . . . . . 32.2 

or, tax consolidation 

$190/$380 = 50%, yielding a weighted 

average of . . . . . . . . . . . 31.8 

(2) Choose domestic income measure: 

$500, if book depreciation seems right 

or, $480, if tax depreciation seems right 

(3) Correct domestic income and tax for inter-corporate

dividends: 

$500 - $90 = $410) 

(Domestic income, net of dividends 

or $480 - $90 = $390)

$90 - $6.48 = $83.52, tax, net of penalty tax 

(4) Correct tax for refund with respect to prior year

losses: 

$83.52 + $49.68 = $133.20 tax gross of net operating

loss refund 
-27-

(5) Correct domestic income and tax for current year

investment credit: 

Income: 

$410 + $32 = $442) 

) Domestic income including subsidy 

or, $390 + $32 = $422)

Tax: $133.20 + $32 = $165.20 tax, before subsidy 

payment 

(6) Correct tax for refund of prior year credit: 

$165.20 + $22 = $187.20 

We are left with two sets of domestic income figures: 

$442, if the financial statement estimate of depreciation is 

taken as the norm: $422, if tax depreciation is the norm; 

and, for domestic tax we have $187.20. We also have two sets 

of foreign income figures: $400 if the financial statement 

consolidation rules are followed; $380 if tax consolidation 

rules are followed; and, corresponding to the $400 foreign 

income is a $200 tax paid abroad; to the $380 income a tax Of 

$190. 

This provides us the following meaningful estimates of 

effective tax rate paid by the ABC Corporation with taxes in 

the numerators matched to the incomes in the denominators: 

Domestic income only:

$187.20/$442 = 42.3% 

$187.20/$422 = 44.4% 

World-wide income: 

Financial statement rules, foreign and domestic: 

($187.20 + $200)/($442 + $400) = 46.0% 

Tax rules, foreign and domestic: 

($187.20 + $190)/($422 + $380) = 47.3% 
-29-

FOOTNOTES 

-1/ Sometimes financial statements distributed to 

stockholders will not separately show the provision for 

foreign income taxes. Instead, the foreign tax is subtracted 

from "income before tax," which then becomes "income before 

U. S. tax." In this event, the "effective tax rate" would be 

$90/$700 = 12.85 percent. But this still mismatches 

numerator and denominator, for the denominator still includes 

rlnet" foreign income, and this is not subject to U. S. tax. 

-2/ The principal problems are those concerning 

intra-corporate transactions. It is easy to consolidate all 

the activities of a far-flung enterprise without concern 

about whether the prices at which goods and services are 

transferred from one sub-entity to another properly allocate 

costs and earnings between the parts, for the only concern is 

with the total enterprise' revenues and costs. But if 

separate accounts are to be independently maintained for 

individual units, a uniform set of rules for establishing 

inter-unit transfer prices must be established. This is 

uniformly done in every well-managed multi-unit firm, but the 

sets of rules adopted serve highly varied management 

objectives unconstrained by the need to periodically inform 

outsiders about the financial condition of the separate 
-30-

units. This is also done under the tax laws, of course, in 

order to achieve a definite assignment of income and tax 

liabilities as between foreign and domestic operations. The 

rules are, of course, controversial; but in no important 

respect would the tax rules be those that might be used for 

financial reporting by multi-unit, multi-national 

corporations. 

-3/ The tax rate abroad is assumed to be 50 percent. 

-4/ A related phenomenon occurs with respect to consolidated 

U.S. income, although it is not illustrated in the example in 

the text. Since consolidation criteria are lower for 

financial reporting purposes, the likelihood occurs that more 

domestic controlled corporation "operating income" will 

appear in financial statements than in tax returns; and for 

the same reason, less "dividends" in financial statements as 

compared with tax returns. In published financial 

statements, therefore, more income of consolidated companies 

and their associated taxes will appear, and this will tend to 

boost the apparent effective tax rate. On the other hand, if 

the reporting company uses the "equity" method for pooling 

its interests in other corporations, it will report only its 

share of "net income", that is, income net of taxes paid by 

the subsidiaries; in this case, the effect will be to depress 
-31-

the apparent effective tax rate of the reporting company. 

-5/ If prices have increased by 50 percent over a decade of 

depreciation representing an allocation of cost expressed in 

dollars of 10 years before needs to be "inflated" to $1.50 if 

it is to be compared with sales and other income statement 

items expressed in current years dollars. If only $1 of 

current year gross income is set aside to maintain the stock 

of depreciable assets -- to offset the value of depreciable 

assets consumed, or expired during the year -- the stock will 

not be maintained. This is equivalent to saying that 

ignoring the impact of inflation has caused an overstatement 

of "operating income" due to an understatement of 

depreciation, in current year dollar magnitudes. 

-6/ The reader is cautioned that this generalization applies 

only to machinery and equipment and, to a lesser degree, to 

industrial plant. It has no application to such real estate 

assets as rental housing, office buildings and commercial 

structures for which tax allowances for depreciation are 

egregiously exaggerated. 

-7/ Recalling that before tax income is a combination of both 

domestic and foreign income, instances have occurred when 

reported before-tax income is positive -- reflecting income 
-32-

abroad -- while a U. S. tax refund is shown. Since the 

foreign income has been taxed and would not generate 

additional U. S. tax, the foreign tax credit wipes-out U.S. 

tax liability: then, it the corporation has earned tax 

credits for eligible investment, these would be carried-back 

to prior years and, thus, generate a tax refund. See section 

(31, following. 

-8/ In the ABC Corporation financial statement, the 

investment credit for the year (including that from prior 

years discussed later in the text) is "flowed-through" to net 

(after tax) income by simply reducing tax expense for the 

year. Even companies which "normalize" the credit, i.e., 

prorate the credit benefit over the life of the subsidized 

assets, "bring the credit into income" "below the before tax" 

line. They would never do this if the subsidy were paid in 

cash, even if the payments earned in a year were paid in 

installments over a future period. 

-9/ One of the constraints on availability of the investment 

credit subsidy which has been imposed to keep the credit a 

"reduction in tax", and thus to sustain the illusion that it 

is solely a tax matter, is the limitation which prevents the 

amount of the credit in any one year from extinguishing more 

than the first $25,000 of tax liability plus 50 percent of 
-33-

the excess. Amounts of credit in excess of this annual 

limitation can be carried-back (3 years) or -forward (7 

years) I 

-10/ A more precise accounting procedure would be to 

"bring-inV1to income in 1976 all the prorata shares of prior 

year investment subsidies plus a portion of this year's $32 

subsidy. To fail to do this, a procedure called 

"normalization" by accountants, introduces the possibility of 

overstating the contribution of the subsidy to this year's 

income, as when net additional capacity is being added. 
-28-

Plus a penalty tax of 7.2 percent on $90 of domestic 

dividends received, in any of the above cases.