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Abstract
Tax expense is typically presented as a percentage (“effective tax rate”) of pre-tax earnings. In this dissertation research, I use a decomposition approach that views tax expense as a function of both pre-tax earnings and tax rate. I examine the following two topics: (i) the valuation of tax expense, and (2) the accuracy of analysts’ tax forecasts compared with that of their pre-tax earnings forecasts.
In the first essay, I examine how the association between the two decomposed components of tax expense surprises and stock returns explains the two competing roles of tax expense documented in Thomas and Zhang (2014): the proxy-for-profitability role and the matching role. To disentangle these two roles, I decompose tax expense surprise into two components: the pre-tax earnings surprise component (“PTE component”) and the effective tax rate surprise component (“ETR component”). I then examine how these two decomposed components are associated with contemporaneous stock returns. The findings show that the PTE component mainly serves the proxy-for-profitability role of tax expense, while the ETR component is the main channel for the matching role. The manifestation of the proxy-for-profitability and matching roles through the respective components is conditional on several factors, such as (a) the strength of the relationship between nontax variables (i.e., pre-tax earnings) and stock returns, (b) the significance of permanent book to tax differences, and (c) the level of tax avoidance and tax risks.
In the second essay, I examine how the accuracy of analysts’ tax forecasts compares with that of their pre-tax earnings forecasts. The findings suggest that analysts, on average, face more challenges and uncertainty when forecasting taxes. In addition, I find that the relative accuracy of analysts’ tax forecasts vs. their pre-tax earnings forecasts decreases with the increase in tax and firm complexity. The relative accuracy decreases for larger firms, potentially due to the availability of high-quality public information hindering analysts’ efforts in acquiring private information that is the primary source for analysts’ forecasts of taxes. However, with the increase in analysts following that enriches a firm’s information environment, the relative accuracy of analysts’ tax forecasts improves.