Retroactive Tax Legislation, Reported Earnings, and Investors' Responses to Earnings 'Surprises': Evidence from R&D Credit Extensions

Abstract

When Congress retroactively extends a temporary tax rule, the effect on earnings is complex because financial reporting standards require firms to apply the integral method using enacted tax law to determine quarterly income tax expense. We model this effect and examine earnings announcements following retroactive extensions of the federal R&D tax credit to test how investors incorporate the effect into stock prices. We find that investors respond when earnings are announced, even though the effect could have been determined several weeks earlier. We also show that, in recent years, the effects of retroactive extensions of the credit are a substantial part of the average decrease in effective tax rates (ETRs) from the third to fourth quarter for calendar-year firms. Our results have implications for investors and researchers examining earnings and ETRs around retroactive extensions of temporary tax rules and suggest that Congressional delays and GAAP interact to produce unintended consequences.

Keywords: R&D credit, earnings expectations, effective tax rates

JEL Classification: M41, M48, G14, H25