Assessing the Relation Between Taxes and Stock Returns: The Critical Role of Choosing the Tax Variable

50 Pages Posted: 16 Aug 2018

See all articles by Zhan Gao

Zhan Gao

Lancaster University

Dan Givoly

Pennsylvania State University, Smeal College of Business

Rick Laux

Purdue University

Date Written: June 15, 2018

Abstract

Firms invest non-trivial resources to avoid paying taxes. One of the presumed incentives for doing so is that it should increase the value of the firm. Surprisingly, a large number of studies find that tax expense is positively related to stock returns, suggesting that paying more taxes is good news. We re-evaluate this puzzling relation and provide new evidence that an increase in tax expense is indeed bad news. We begin by showing that the tax expense variable in a regression of returns on pretax income and tax expense captures the market’s pricing of book-tax differences, and importantly, the different tax variables used in the literature capture different components of book-tax differences. Using a regression that clearly distinguishes between temporary and permanent book-tax differences, we show that both temporary and permanent differences (after controlling for influential observations) are negatively related with contemporaneous returns. We also demonstrate that the positive association between contemporaneous returns and current and total expense documented in prior research is explained by influential observations and the intricacies of the accounting for temporary differences. Finally, we provide evidence that the positive relation between future returns and total tax expense, or tax expense momentum, can be attributed to the same market inefficiency captured by earnings momentum.

Keywords: Income Tax Expense, Book-Tax Differences, Stock Returns

JEL Classification: G12, G14, H25, M41

Suggested Citation

Gao, Zhan and Givoly, Dan and Laux, Rick C., Assessing the Relation Between Taxes and Stock Returns: The Critical Role of Choosing the Tax Variable (June 15, 2018). Available at SSRN: https://ssrn.com/abstract=3225814 or http://dx.doi.org/10.2139/ssrn.3225814

Zhan Gao

Lancaster University ( email )

Lancaster LA1 4YX
United Kingdom
44-1524-593-151 (Phone)

Dan Givoly

Pennsylvania State University, Smeal College of Business ( email )

305 Business Building
University Park, PA 16802
United States
814-865-0587 (Phone)
814-863-8393 (Fax)

Rick C. Laux (Contact Author)

Purdue University ( email )

Rawls Hall 4036
100 S. Grant Street
West Lafayette, IN 47906
United States

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