Earnings Management around the Tax Cuts and Jobs Act of 2017

Abstract

This paper examines earnings management around the reduction in the corporate tax rate from 35% to 21% as enacted by the Tax Cuts and Jobs Act (TCJA) of 2017. Building on a theoretical model that considers a higher level of book-tax conformity of ‘real activities manipulation’ (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 729 firms of our sample save between $14.1 billion and $15.8 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 high-tax 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 on firm behavior that should be of interest to policymakers, regulators, and researchers as they examine the economic effects of the largest tax reform in decades.

Keywords: Tax Cuts and Jobs Act (TCJA), tax reform, income shifting, tax avoidance, real earnings management, accrual-based earnings management.

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