NCPA - National Center for Policy Analysis

Different Effects of Tax and Financial Accounting on Profits

July 8, 2002

WorldCom, Xerox and some other corporations overstated their profits by billions of dollars; but the rash of restated earnings won't affect national economic data, such as for Gross Domestic Product (GDP), says Bruce Bartlett.

Investor data come from corporate reports mandated by the Securities and Exchange Commission, while Commerce Department data on corporate profits used to calculate GDP come from tax returns.

Normally, on their tax returns, companies "expense" or write-off as much as possible of their costs as they can immediately. Bigger write-offs mean lower taxes.

Instead of trying to expense capital, WorldCom capitalized expenses. This artificially lowered their costs, thus increasing their reported profits.

But if they did that on their tax return, it would also increase their taxes. WorldCom probably reported its operating expenses as expenses on its tax return.

But GDP data are calculated from tax returns, not financial statements, such as those reported by Standard and Poor's for the 500 largest companies.

Normally, S&P 500 profits move up and down symmetrically with the Commerce Department's total profits for all corporations.

  • In most years, S&P 500 profits equal about 40 percent of total profits in the U.S. economy (see figure).
  • But in 1999 and 2000, they got up to 50 percent.
  • Last year, they fell to just 32 percent, but have rebounded to 52 percent in the first quarter of this year -- although those figures are subject to revision.

It would be useful to require major corporations to release their tax returns to the public. This would give financial analysts and investors important data on company operations and prevent the kind of games WorldCom played. Alternatively, organizations like the New York Stock Exchange could require the release of tax returns as a condition for listing.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, July 8, 2002.


 

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