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Valuation of tax expense

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Abstract

As tax expense reflects value lost to taxes paid, it should be negatively associated with value, provided nontax, value-relevant information is controlled for. However, valuation regressions estimated in prior research—using contemporaneous tax expense and nontax variables—document substantial variation in the coefficients on tax expense, ranging from significant negative to significant positive values. We show this variation is (a) caused by the omission of expected future profitability, and (b) explained by many factors that cause variation in the correlations among included variables and omitted future profitability. Unfortunately, difficulties associated with separating the impact of individual factors hampers tax research investigating determinants of the value relevance of tax expense.

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Notes

  1. For example, Thomas and Zhang (2011) find that predictions of next quarter’s tax expense surprise are positively related to next quarter’s returns, even after controlling for earnings surprise for both this quarter and the next.

  2. This emphasis on effective tax rates better reflects tax practice, but it reduces sample size substantially, because many firm-years are deleted if observed effective tax rates in the current or prior year are outside reasonable bounds.

  3. Consistent with this intuition, tax departments are evaluated on (e.g., Robinson et al. 2010) and tax department managers are compensated for (e.g., Armstrong et al. 2012) their ability to lower effective tax rates.

  4. The choice of levels of revenues and expenses (e.g., Easton and Harris 1991), versus first differences, to capture surprises in those items can be linked intuitively to differences in the underlying expectation model: changes represent surprises if expectations of earnings (or revenues and expenses) equal lagged values, whereas levels represent surprises if expectations are a function of lagged prices.

  5. The relation is negative but not significant when the regression is estimated on a smaller sample with nonmissing values for all earnings quality signals (see Table 2 in Lev and Thiagarajan 1993).

  6. Our results are robust to using a random walk with a drift expectation model for both pre-tax income and tax expense. For each firm-year, we use that firm’s historical data since 1970 to estimate the drift term.

  7. Both sets of results, based on partially specified regressions, are consistent with results reported in prior research (e.g., Bell 2012).

  8. We confirm that the positive coefficient on tax expense surprise remains when we replace first differences of tax expense and pre-tax income with levels of those two variables (e.g., Ohlson and Penman 1992). The coefficient on tax expense (pre-tax income) is larger (smaller) when we use levels.

  9. Note that the magnitudes of the coefficients on surprises in pre-tax income and tax expense are not directly comparable when both surprises are proxying for news about future profitability. If both surprises had similar effects and the tax rate is 35 percent, the coefficient on tax expense surprise will be about three times (100/35) that on pre-tax income surprise, ceteris paribus. The magnitude of pre-tax income (tax expense) surprise will be 100/65 (35/65) of the magnitude of the present value of the revision in future profitability.

  10. For example, Lev (1989) reviews a number of extant studies and concludes that “The correlation between earnings and stock returns is very low, sometimes negligible.” Note that the R2 of 5.3 percent reported in the first column of Table 6 declines to about 2 percent when the three control variables are removed.

  11. To confirm that the link between pre-tax income surprise and revisions in future profitability becomes stronger as more extreme observations are deleted, we return to our I/B/E/S sample and regress revisions in abnormal earnings over the five-year forecast horizon and revisions in terminal value on pre-tax income surprise, for subsamples created by the procedure used in Panel A. We find (results not tabulated) that the coefficient on pre-tax income surprise and associated t-statistics increase from left to right.

  12. To confirm that the link between tax expense surprise and revisions in future profitability becomes stronger as more extreme observations are deleted, we return again to our I/B/E/S sample and regress revisions in abnormal earnings over the 5-year forecast horizon and revisions in terminal value on tax expense surprise, for subsamples created using the same process as in Panel B. We find (results not tabulated) that the coefficient on tax expense surprise and associated t-statistics increase from left to right.

  13. Given that the Compustat and I/B/E/S EPS numbers are after-tax measures of earnings, we compute the core and one-time components of pre-tax income as follows: a) PTI_ONE is GAAP EPS minus IBES EPS divided by (1-35 percent), and b) PTI_CORE is PTI minus PTI_ONE.

  14. Consider two firms that report identical pre-tax incomes over their lifetimes, but one firm reports higher tax expense. The value of that firm should be lower.

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Acknowledgments

Discussions with Dave Guenther and Doug Shackelford spurred work on this paper. We received helpful comments and suggestions from an anonymous reviewer, Jeff Gramlich, Michelle Hanlon, Doron Nissim (editor), Gordon Richardson, Cathy Schrand, Terry Shevlin, Jim Wahlen, Jerry Zimmerman, and participants at workshops at Columbia University, University of Kentucky, Penn State University, University of Texas-Austin, University of Toronto, the Yale summer conference, and the 2010 AAA annual meetings. We are grateful for financial support from the Yale School of Management.

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  1. Yale School of Management, Yale University, P.O. Box 208200, New Haven, CT, 06520, USA

    Jacob Thomas & Frank Zhang

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  1. Jacob Thomas
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Correspondence to Frank Zhang.

Appendix

Appendix

See Table 8

Table 8 Variable definitions (annual Compustat data items are provided in parentheses under description)
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Thomas, J., Zhang, F. Valuation of tax expense. Rev Account Stud 19, 1436–1467 (2014). https://doi.org/10.1007/s11142-013-9274-3

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