Smoothing Taxable Income, Tax Avoidance, and the Information Content of Taxable Income

Abstract

This study investigates whether the smoothness of estimated taxable income influences its value relevance. Contrary to research that finds that smoothness enhances the value relevance of book income, we find that smoothness reduces the value relevance of taxable income. We decompose the smoothness of taxable income into its innate and discretionary components and find that innate smoothness is not associated with the value relevance of taxable income. However, we find that discretionary smoothness is associated with a reduction in taxable income’s value relevance, suggesting that discretionary smoothness either eliminates or reduces the information contained in taxable income. In additional analysis, we find that discretionary smoothness is also associated with higher levels of future tax avoidance, consistent with managers smoothing taxable income as part of their tax avoidance strategy. In combination, our results suggest that the reduced value relevance of estimated taxable income is a by-product of managers’ tax planning strategy.