Tax Expense Momentum

Abstract

We investigate the joint hypothesis that (1) tax expense contains information about core profitability that is incremental to reported earnings and (2) that information is reflected in stock prices with a delay. We find that seasonally differenced quarterly tax expense, our proxy for tax expense surprise, is related positively to future returns. This anomaly is separate from previously documented pricing anomalies based on financial and tax variables. Additional investigation reveals that tax expense surprise is related positively to changes in future quarterly earnings and tax expense, and both those future changes are related positively to future returns. While the returns to investing in predictable future earnings changes has been documented before, these results suggest that predicting changes in future tax expense also generates incremental future returns.

The Information Content of Tax Expense: A Discount Rate Explanation

“…I investigate whether changes in tax expense convey information that is correlated with revisions in discount rates. I posit and find that when investors see a higher-than-expected tax expense, they receive new information that causes them to revise their expectations about future cash flows upward and also revise the discount rate associated with those future cash flows downward because tax expense is useful in predicting future performance (Thomas and Zhang 2011). I also perform cross-sectional tests, which reveal that the discount rate implications of tax expense reflect fundamental economic performance as well as information about a firm's earnings management and tax avoidance activities.…”

“…There is a correlation between surprises in each measure and firms' contemporaneous returns. This positive correlation exists because both book and taxable income convey positive cash flow news and are useful in predicting future earnings (Thomas and Zhang 2011). Recent evidence suggests that earnings also convey information that causes investors to revise expected returns.…”

Is Tax Return Information Useful to Equity Investors?

“…However, Schmidt also shows that investors underweight this information, resulting in annual abnormal returns of up to 4.9 percent. Finally, Thomas and Zhang (2011) find that tax expense surprises are associated with future changes in earnings and tax expense. Despite this predictable association, Thomas and Zhang find that the market does not react to this information until the future changes in earnings and tax expense are observed, resulting in a trading strategy with annual abnormal returns of up to 9 percent.…”

“…Tax returns may not contain additional information, or, to quote former Securities and Exchange Commission Chairman Harvey Pitt: "The tax disclosure in companies' financial statements is more beneficial in helping investors understand a company's tax situation than would be providing public access to tax returns" (Lenter et al 2003, 806). At the same time, another stream of literature shows that there is information in the tax accounts reported in financial statements that equity investors do not use efficiently (Lev and Nissim 2004;Thomas and Zhang 2011) and that even sophisticated market participants, such as analysts, struggle to understand the information contained in the tax accounts (Plumlee 2003;Weber 2009).…”

“…This increase in trading efficiency should occur if TRI provides investors new and value-relevant information, helps investors overcome behavioral biases that lead to market inefficiencies, or reduces various arbitrage costs and investors arbitrage away the newly-available net arbitrage gains. To measure trading efficiency with regards to tax information, I use the existence and size of market anomalies related to various tax metrics, including the imputed taxable income to book income ratio, book-tax differences, the tax change component of earnings, and tax expense surprises (Lev and Nissim 2004;Hanlon 2005;Schmidt 2006;Thomas and Zhang 2011). I focus on tax-related market anomalies, since it is unlikely that these anomalies would be materially affected by the provision of non-tax private information given to lending syndicates.…”