The Persistence, Forecasting Ability, and Valuation Implications of the Tax Change Component of Earnings

Abstract

I examine whether and under what circumstances changes in net income caused by changes in effective tax rates (ETRs) (the tax change component) persist and whether the tax change component aids in forecasting future earnings incremental to aggregate earnings excluding the tax change. I decompose the tax change component of earnings into an initial and revised portion, which I hypothesize to have differential persistence and forecasting implications. Finally, I utilize the Mishkin (1983) procedure to determine if the market recognizes the forecasting implications of the differential persistence of the initial and revised tax change components. My results indicate that the tax change component is negatively associated with future tax changes. I find that the initial tax change component is more persistent for future tax changes than the revised tax change component. Additionally, I find that the initial tax change component is useful in forecasting future earnings, while the revised tax change component is not. These results are consistent with my hypotheses that the initial and revised tax change components have differential persistence and forecasting implications, and dispute the notion that changes in ETRs are transitory. Mishkin (1983) test results indicate that the market underestimates the persistence of the revised tax change component and the mispricing appears to be driven by firms in industries with above-average intra-year variation in the tax change component of earnings.