The Information Content of Tax Expense: A Discount Rate Explanation

Abstract

I investigate the information content of income tax expense using variance decomposition to separate stock returns into cash flow and discount rate news components. While prior literature has focused on linking tax expense with expected future cash flows, I argue that tax expense should also be informative about discount rates because of its ability to summarize fundamental economic performance. Consistent with my arguments, I find that tax expense surprises are correlated with both revisions in future cash flows and revisions in discount rates; however, the economic magnitude of tax expense's impact on returns is primarily through the discount rate channel. I also perform cross‐sectional tests, which reveal that the discount rate implications of tax expense are due not only to its ability to capture fundamental economic performance but also to its ability to convey information about a firm's earnings management and tax avoidance activities.

Taxable Income and Firm Risk

“…Our findings complement studies, such as Goh et al (2013), Henry (2014), and Guenther et al (2016), which explore risk-related information contained in TI. Goh et al find that corporate tax avoidance is associated with an increase in the cost of equity capital.…”

“…6 Goh et al reason that a firm's cost of capital will increase when tax avoidance increases the opacity of the firm's information environment and facilitates aggressive financial reporting. Henry (2014) finds that the level of tax expense conveys discount rate news by revealing information about the firm's level of tax avoidance. Guenther et al (2016) evaluate the consequences of risky or unsustainable tax avoidance strategies using future tax rate volatility and total stock return volatility.…”

Accounting quality deferred tax and risk in the banking industry

“…Henry (2014) argues that unanticipated decreases in tax expenses may imply higher risk for a firm. According to the author, this increase in risk may come from two sources: earnings management and tax avoidance.…”

“…Therefore, it is not surprising that deferred taxation has been found to relate to bank failure (Gallemore, 2012) and higher risk. Henry (2014) also provides evidence of a relation between deferred tax expenses and risk by showing that information in deferred tax expenses may affect a firm's discount rates.…”

Is Tax Return Information Useful to Equity Investors?

“…Prior literature has not examined the usefulness of tax return information to equity investors, although it does provide evidence that tax information contained in the financial statements can provide information about profitability (Hanlon et al 2005;Ayers et al 2009), earnings growth , and firm risk (Henry 2014;Dhaliwal et al 2017) incremental to GAAP income. This evidence suggests that reported tax information contains unique information not contained in GAAP income, yet also raises the question: If this incremental information can be gleaned from tax information in the financial statements, will tax returns contain any additional information beyond that in financial statement tax disclosures?…”