The Role of Revenue-Expense Mismatching in Explaining the Tax Fundamental's Ability to Predict Earnings Growth

Abstract

Prior research finds that taxable income is a more useful performance metric when book income quality is low (i.e., the “supplemental information role of taxable income”). We predict and find that taxable income’s supplemental information role for future earnings growth increases over time as book income quality declines over time. This time-series increase in the supplemental information role of taxable income is associated with temporal changes in the market pricing of book-tax differences. We find that mispricing disappears over time in firms where the supplemental information role of taxable income is less pronounced, but persists in firms where the supplemental information role of taxable income is more pronounced. Thus, the complexity of tax-based information and the time-series increase in the supplemental role of taxable income appear to be factors that limit investor learning. Investigating the increase in the supplemental information role of taxable income helps researchers and market participants better understand the time-series implications of two different performance metrics for predicting earnings growth and the equity valuation process as book income quality declines over time.