What Really Determines the Information Content of Tax Expense and Deferred Tax?

Abstract

This study examines the informational role of tax expense and deferred tax and investigates the fundamental determinants of their information content. Our theoretical and empirical analysis shows that the association between tax expense and stock returns after controlling for pre-tax profit should be determined by the difference in the information content between permanent book-tax differences and the other pre-tax profit. Empirical evidence is that the relatively lower informativeness of permanent differences results in the positive relation of tax expense to stock returns. In addition, the earnings persistence of permanent differences is lower than that of the other pre-tax profit, and various firm characteristics, including the composition of permanent differences, affect the information content of tax expense. In addition, it is a temporary book-tax difference that bases deferred tax in substance. Therefore, the control variable in a regression analysis for deferred tax should not include the temporary difference-related items. Using such a revised regression model, this paper shows that deferred tax expense (liability) has a positive association with stock returns (price), contrary to prior studies. Our study contributes to the literature through clarifying the underlying mechanisms behind the information content of tax expense items and providing new findings on their informational role. Particularly, this paper has implications for future study in that it provides a guideline for interpreting the relationship between the regression coefficients regarding tax expense accounts and improves the prior research methodology.