Earnings Management around the Tax Cuts and Jobs Act of 2017

Abstract

This paper examines the earnings management response of firms due to changes in tax planning and financial reporting incentives around the reduction in the federal corporate income tax rate from 35% to 21% as enacted by the 'Tax Cuts and Jobs Act' (TCJA) of 2017. Given the higher level of book-tax conformity of 'real activities manipulations' (RAM) relative to 'accrual-based earnings management' (AEM), we hypothesize that firms concertedly use these techniques for different purposes. Specifically, we predict and find that firms engage in RAM to reduce taxable income in the high-tax period prior to the TCJA. Applying different estimation approaches, our results suggest that the 913 firms of our sample save between $9.1 billion and $11.0 billion in taxes by shifting taxable income from the high-tax to the low-tax period. We also predict and find that firms use AEM, which has lower book-tax conformity than RAM, to simultaneously increase book income in the hightax period. Finally, we document negative future economic consequences of firms engaging in the most RAM activity. Overall, our results document an economically significant effect of the TCJA that should be of interest to policymakers, regulators, and researchers as they examine and debate the economic effects of corporate tax reform.

Keywords: Earnings management, TCJA, tax reform, income shifting, tax avoidance, real activities manipulations, accrual-based earnings management. JEL codes: G12, G14, H25, M41, M48 Earnings management, TCJA, tax reform, income shifting, tax avoidance, real activities manipulations, accrual-based earnings management. JEL codes: G12, G14, H25, M41, M48

JEL Classification: G12, G14, H25, M41, M48.