Measuring the impact of tax loss carryforwards on capital structure choice: the accuracy of earnings-based proxies

Abstract

Empirical studies on capital structure choice frequently control for whether or not a firm has tax loss carryforwards (TLCFs). However, tax data on TLCFs is often not available to researchers. As a consequence, many studies rely upon earnings-based information in order to determine whether a firm has TLCFs. In this paper, we study the accuracy of earnings-based proxies in predicting whether a firm has TLCFs. Our results, which are based upon a panel of Italian listed firms between 2009 and 2012, show that earnings-based proxies correctly predict whether a firm has TLCFs for 70–77% of all firm-year observations. Furthermore, for all but one proxy, we identify a non-random measurement error in TLCF variables that are built upon these proxies. We evaluate the consequences of this measurement error and find that it does not significantly change the estimated effects of TLCFs on capital structure choice for some proxies, including last year’s earnings before taxes. We conclude that last year’s earnings before taxes serves as an accurate proxy for a firm’s true TLCF status. It is easy to determine and leads to statistically and quantitatively similar conclusions as those reached using tax data on TLCFs.