Estimating the Likelihood of Future Tax Settlements Using Firm Fundamentals and Text Disclosures

Abstract

This study develops an ex-ante measure of the likelihood of future corporate income tax settlements using qualitative (i.e., language) and quantitative information (i.e., firm fundamentals) from the Form 10-K. We find that both qualitative and quantitative information are incrementally useful in predicting future tax settlements. We then use our new measure to examine the association between predicted future tax settlements and cash holdings. In contrast with prior research documenting a positive association between reserves for uncertain tax positions and cash holdings (Hanlon, Maydew and Saavedra 2017), we find that firms with a higher likelihood of future tax settlements hold less cash than firms with a lower likelihood of future tax settlements. In addition to providing an ex-ante measure of future cash outflows paid to tax authorities that can be used by future researchers, our findings suggest a more nuanced relation between tax uncertainty and cash holdings.