Interpreting the Book-Tax Income Gap as Earnings Management or Tax Sheltering

Abstract

The measured book-tax gap is often used as a surrogate for one of the behaviors that influences the gap - earnings management or tax sheltering - without adjusting for the effect of other influences - GAAP changes, tax law changes, and macroeconomic conditions. This paper provides evidence on the quality of the unadjusted book-tax income gap as a proxy for earnings management or tax sheltering by adjusting for the three measurable factors: GAAP changes, macroeconomic conditions, and earnings management. I find that changes in GAAP alone explain half of the pooled cross-sectional variation in the book-tax gap between 1993 and 2004, marking GAAP changes as an important recent influence on the book-tax gap. Also, replication results using unadjusted and adjusted book-tax gap measures suggest that the unadjusted book-tax gap is a reasonable proxy for earnings management, but that adjusting for the effect of GAAP changes generates a better proxy for tax sheltering in most contexts.

Keywords: Book-Tax Income Gap, Book-Tax Differences, Tax Sheltering, Earnings Management

JEL Classification: H26, M41, M43