The Profitability Paradox: The Impact of Tax Policy Sentiment on Firm Dynamics and Stock Returns

Abstract

We introduce a novel measure of tax policy sentiment, combining narrative tax policy announcements with stock return data. We demonstrate that firms highly exposed to tax sentiment shocks experience increased profitability following an increase in tax sentiment. Furthermore, our empirical analysis reveals a positive premium associated with tax policy sentiment in the cross-section of stock returns. Interestingly, firms with pre-shock high profitability reap greater benefits from these shocks compared to low-profitability firms. A detailed firm-level analysis reveals that pre-shock high earners are more likely to issue equity, reduce leverage, and increase investment following an increase in tax sentiment. In line with these firm dynamics, we find that the return premium for the tax policy sentiment shock is more pronounced for high-profitability firms.

Keywords: tax news shocks, asset pricing model, Tax Policy Sentiment, Firm Dynamics, Stock Returns

JEL Classification: G12