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 provide arguments for why tax expense should also be informative about expected returns. 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 through the discount rate channel. After decomposing total tax expense into portions arising from earnings management and tax avoidance activities, I find consistent evidence that earnings management through the tax accounts has a negative effect on discount rates and inconsistent evidence regarding tax avoidance’s role in the discount rate implications of tax expense. Thus, my findings provide a more comprehensive understanding of the valuation implications of and exact mechanisms through which tax expense enters into firm returns.

Keywords: Valuation of tax expense; earnings management through tax accounts; tax avoidance; discount rate news