Democratic presidential candidates this cycle continue to outdo each other in proposing new and aggressive tax increases. Senator Elizabeth Warren is among the leaders, pushing $26.3 trillion in new tax hikes. Among her proposals is what she calls a “Real Corporate Profits Tax,” which imposes a 7 percent tax on a company’s so-called “book income,” or its accounting profits. Former Vice President Joe Biden has suggested a 15 percent minimum tax on a company’s book income.
When highlighting her policy idea, Senator Warren often points to Amazon*, arguing that they “made over $10 billion in profits but paid $0 in federal income taxes in 2018.” Senator Warren argues that the tax is necessary, because companies like Amazon employ accounting tricks to maximize the profits they report to shareholders, while minimizing their tax liability owed to the U.S. government. How can a profitable company not pay taxes?
It’s because Senator Warren is shifting the definition of profitability in her statements. The profitability of a company on its financial statements isn’t necessarily its profitability on its tax returns. Yes, both seek to total a company’s income and subtract its costs, but the way the two definitions arrive at the final results vary significantly.
Expensing of Capital Investments
The first major difference between book income and taxable income is the treatment of capital investments. As tax policy experts know and understand, book income and taxable income inherently bias capital investments. A company that hires a worker deducts the cost of that worker’s salary from its revenues, but if the company purchases a machine, they do not deduct the full cost of the outlay. Instead, they deduct a fraction of the cost and the remainder in future years based on the useful life of the asset.
The delay in deductions can be significant. A commercial building is estimated to be “useful” for 39 years, so instead of deducting the total cost of the building when it’s purchased, the company can only deduct a small portion of it. That matters a great deal. Imagine you were offered $100 today or $2.56 ($100 divided by 39) each year for the next 39 years. You would clearly pick $100 today, yet book income, and often taxable income, gives you the second.
Recognizing this inherent mistreatment, policymakers have agreed to accelerated deductions for capital investments. The Tax Cuts and Jobs Act, for example, allows companies to immediately deduct all capital investment if the asset has a useful life of 20 years or less.
Accelerated deduction brings the company’s taxable income in line with its actual economic income, meaning their revenues minus costs. But it also means that a company’s book income will look higher than its taxable income, as the book income calculation will include a small deduction allowance.
Net Operating Losses
Another major difference between taxable income and book income is the treatment of net operating losses. Tax years, calendar years, and profitability don’t always cleanly align. Net operating losses allow companies to smooth their tax liability to ensure they are taxed on their actual economic profit.
Imagine a florist preparing for a busy Valentine’s Day. She preorders dozens of roses to have in stock by early February. She spends $50 in January to preorder the flowers, but receives $100 in revenue in February. We would all agree that she has $50 in taxable income.
But what if she decided to prepare a bit earlier? Instead, she orders her $50 in flowers in December, but still sells the flowers for $100 in February. Here, the calendar year impacts her tax liability. Instead of being taxed $50 for her sales, she’d instead have a loss in the first year and $100 in taxable income in the second. The net operating loss allows her to carry forward her $50 loss from December to reduce her liability for the next year.
Net operating losses are important for many firms, and particularly for those in volatile or seasonal industries. Companies that are just beginning often also use net operating losses, as they haven’t quite reached profitability yet.
Conclusion
Taxable income and book income vary for good reason. Taxable income allows companies to deduct their capital investments and carry forward their previous losses to better align their taxable profits with their economic profits. Taxable income isn’t perfect—expensing, for example, should be made permanent and expanded to all assets—but it serves as a better tax base than book income.
*Note: Amazon has little to no federal tax liability. That is reportedly due to the expensing of capital investments discussed above, but also related to other tax provisions since as research and development tax credits and its corporate stock grants.