The Divergence between Book Income and Tax Income

This paper examines the evolution of the corporate profit base and the relationship between book income and tax income for U.S. corporations over the last two decades. The paper demonstrates that this relationship has broken down over the 1990s, and it has broken down in a manner consistent with increased tax-sheltering activity. The paper traces the growing discrepancy between book income and tax income associated with differential treatments of depreciation, the reporting of foreign source income, and in particular the changing nature of employee compensation. For the largest public companies, proceeds from option exercises equaled 27 percent of operating cash flow from 1996 to 2000. These deductions appear to be fully utilized, thereby creating the largest distinction between book income and tax income. While the differential treatment of these items has historically accounted fully for the discrepancy between book income and tax income, this paper demonstrates that book and tax income have diverged ma...