48 Pages Posted: 30 Aug 2009 Last revised: 27 Jun 2012
Date Written: August 12, 2010
Both intuition and evidence suggest that tax expense reflects value lost to taxes paid. Inconsistent with this traditional valuation role for tax expense, some recent research finds that tax expense surprise, especially its current component, is positively associated with stock returns. Holding pre-tax income surprise constant, a higher tax expense surprise is associated with higher returns, even though net income is lower. To reconcile this apparent conflict, we propose that a) tax expense can reflect both value lost to taxes paid and underlying profitability, and b) the proxy-for-profitability role is more important when profitability is weakly related to pre-tax book income and strongly related to tax expense. As a result, the coefficient on tax expense in valuation regressions varies across samples and specifications based on the relative ability of pre-tax book income and tax expense to reflect profitability. While the conditions that favor the proxy-for-profitability role may appear restrictive and not frequently encountered, in fact that role generally dominates the traditional value-lost-to-taxes role because pre-tax book income reflects profitability poorly for most samples and specifications. The main implication is that inferences based on the valuation coefficients associated with different tax variables should be made with caution, as they could be affected substantially by other correlated factors.
Keywords: Valuation, stock returns, tax expense
JEL Classification: G12, G14, M40, M41
Suggested Citation: Suggested Citation