Pre-tax Earnings Research Articles

The Dynamics of Leverage and Profitability: A Comprehensive Review of Pre-Tax Earnings

The Dynamics of Leverage and Profitability: A Comprehensive Review of Pre-Tax Earnings

The Economic Impact of Interim CEOs: The Case of Tax Avoidance

ABSTRACT As interim CEO appointments are common in CEO successions, we examine these temporary executives’ economic impact on their firms. Specifically, we explore how interim CEOs affect corporate tax avoidance. We match each “interim CEO firm” (test firms) with a “direct-succession CEO firm” (control firms) and find that test firms report significantly and economically lower tax avoidance. We also find that test firms’ pre-tax earnings are similar to those of control firms, but their after-tax earnings are significantly lower. Further, we find that this lower tax avoidance holds only when interim appointees have low equity compensation, are not named as permanent/successor CEOs, and have no CFO background. Our paper opens the door for future investigation of the economic impact of interim CEOs, which has been under-investigated by prior studies.

The Speed of Earnings Responses to Taxation and the Role of Firm Labor Demand

This paper studies the speed at which workers' pre-tax earnings respond to tax changes along the intensive margin. We do so in the context of Germany, where a large discontinuity — or notch — in the tax schedule induces sharp bunching in the earnings distribution. We analyze earnings responses to two policy reforms that shift this notch outward. In a frictionless world, the workers that made up the excess mass at the old notch should all increase their earnings. While some of these workers indeed adjust their earnings rapidly, over 38% do not, and instead take several years to adjust. We propose that heterogeneity in firm labor demand plays a key role in generating the observed differences in the speed of workers' earnings responses and predict that adjustment will be quickest at growing firms. We test and find support for these demand-side effects in our linked employer-employee data.

Estimating the late-life effects of social and emotional skills in childhood using midlife mediators

Social and emotional skills are known to affect health and non-health outcomes, but there is limited evidence on whether these skills in childhood affect late life outcomes because of a shortage of long-running datasets containing this information. We develop a three-stage procedure and use it to estimate the effect of childhood social and emotional skills on health and labour market outcomes in late-life. This procedure makes use of mediators in midlife which are shown to be predicted by childhood skills in one dataset and to predict late-life outcomes in another dataset. We use this method to combine estimates from the National Child Development Survey and the British Household Panel Survey. We find that childhood skills predict marital status, education, home ownership, income and health at age 46 years and these midlife variables predict levels of quality-adjusted life years and labour income accumulated by age 63 years. The combined estimates suggest a standard deviation increase in average Bristol Social Adjustment Guide total score at ages 7 and 11 is associated with 4.2% (standard error = 0.6%) additional quality-adjusted life years and more than 9.9% (£14,539, standard error = £2072) additional accumulated pre-tax earnings by age 63 years. Therefore, childhood interventions to increase social and emotional skills would be expected to reduce future healthcare costs and increase wealth. Our three-stage methodology can be used to predict the life-course effects of investments in childhood skills by combining results from datasets across population cohorts.

Do Health Insurers Manage Their Medical Loss Ratios? At What Cost?

We use plan-level data to examine a reporting incentive unique to health insurers—the federal Affordable Care Act’s (ACA’s) Medical Loss Ratio (MLR) provisions—which require that health plans spend a specified percentage of premiums on claims or else pay policyholder rebates. While there are no penalties for noncompliance with the MLR provisions, incentives for insurers to comply include avoiding political and reputation costs, reducing administrative burdens, and eliminating rebate payments. We find that health plans with pre-managed MLRs— i.e., the MLRs that would be reported without reporting discretion—below the required MLR overstate claims, thereby increasing their MLRs and reducing or eliminating rebate payments. Overall, results suggest that overstating claims reduced rebate payments by approximately $190 million to $325 million for 20112013; i.e., about 10–17% of total rebates actually paid. We also find that plans with pre-managed MLRs significantly greater than the minimum required MLR understate claims, thereby improving plan earnings while still complying with the MLR provisions. These understatements average between 14–34% of plans’ pre-tax earnings.

Taxes and Earnings Management: Evidence from the Tax Cuts and Jobs Act of 2017

We examine the influence of corporate income taxes on earnings management. We predict and find that corporate income taxes represent a significant friction in the level of discretion used in financial reporting decisions. Using the Tax Cuts and Jobs Act of 2017 (TCJA) as an exogenous shock to corporate tax rates, we observe a significant change in pretax earnings management following the passage of the TCJA. Consistent with theoretical predictions, we observe opposing changes in pretax earnings management conditional on the pre-TCJA level of discretion and capital market pressure. Additionally, we observe a reduction in non-conforming discretionary tax planning following the TCJA. Finally, we provide evidence that debt contracting provisions in new loan agreements were revised to account for anticipated changes in financial reporting incentives.

Aggressive Tax Avoiders: U.S. Multinationals Shifting Domestic Earnings to Zero

ABSTRACTWe investigate whether U.S. multinational corporations shift income overseas to the point of recording domestic pretax earnings around zero. We label firms with near-zero domestic earnings “Small” firms, and present evidence that Small captures targeted income shifting that minimizes worldwide and domestic current taxes. Because shifting essentially all income out of the U.S. represents a very aggressive form of international tax planning, Small firms represent an important margin for understanding the income shifting of U.S. MNCs. We find that firms facing tax incentives to shift income and firms with greater income shifting ability are more likely to report near-zero domestic earnings. In addition, investors value the earnings of Small firms higher than that of other U.S. multinational firms, conditional on overall profitability, suggesting that, on average, investors hold a positive view of income shifting to the point of recording domestic earnings around zero.Data Availability: Data are available from the public sources cited in the text.JEL Classifications: F23; H25; H26; M40.

Merit, Luck, and Taxes: Societal Reward Rules, Self-Interest, and Ideology in a Real-Effort Voting Experiment

When are high earnings considered a legitimate target for redistribution, and when not? We design a real-effort laboratory experiment in which we manipulate the assignment of payrates (societal “reward rules”) that translate performance on a real-effort counting task into pre-tax earnings. We then ask subjects to vote on a flat tax rate in groups of three. We distinguish three treatment conditions: the same payrate for all group members (“equal” reward rule), differential (low, medium, and high) but random payrates (“luck” rule), and differential payrates based on subjects’ performance on a quiz with voluntary preparation opportunity (“merit” rule). Self-interest is the dominant tax voting motivation. Tax levels are lower under “merit” rule than under “luck” rule, and merit reasoning overrides political ideology. But information is needed to activate merit reasoning. Both these latter effects are present only when voters have “full merit knowledge” that signals precisely how others obtained their incomes.

EARNING PERSISTENCE ON FIRM TAX DIFFERENCES AND FAMILY OWNERSHIP

Abstract- Prior research find evidence consistent with the hypothesis that future earnings influenced by difference between accounting and fiscal earnings (book tax differences). Many investors forming expectations of future earnings information derived from the difference between fiscal and commercial earnings, there were some investors would satisfied to see small differences between fiscal and commercial earnings, otherwise have the opposite view. This study aim to investigate how book-tax difference and family ownership play a role in the persistence of earnings. The authors using a sample 692 firm years of Indonesian listed companies within 2011-2016, they estimate cross-sectional regressions of the proxy for book-tax differences and family ownership on earning persistence. The study found that current pre-tax earnings can predict future earnings and also firm years with large book-tax difference have less earnings persistence than firm years with small book tax difference. Further, this study found no evidence that family ownership have significant role in persistence of earnings. 
 
 Keywords: Earning Persistence, Future earnings, Pre-tax earnings, Book tax difference, Family Ownership.

COVID-19 forces cuts at Ingevity

The pine chemical maker Ingevity is cutting costs because of the COVID-19 pandemic. It will furlough employees and make workforce reductions through early retirement and other measures. It will also suspend some benefits, including matching contributions for 401(k) retirement plans, and reduce outlays for consulting and other services. “Some of these measures are temporary, but many are permanent,” says interim CEO Rick Kelson. Ingevity doesn’t say how much the measures will save but does say that they will help it remain within its 2020 target of $310 million–$350 million in pretax earnings and $1.1 billion–$1.2 billion in sales.

Taxable income, future profitability, and stock returns

AbstractPrior research suggests that investors behave ‘as if’ taxable income contains information about future performance by providing evidence of a positive association between taxable income and stock returns. We draw on the fundamental analysis literature and provide direct evidence on this assertion by examining whether taxable income predicts future pretax performance. We find that taxable income positively predicts future pretax cash flows, pretax book income, and ‘Street’ pretax earnings, suggesting that taxable income provides incremental information to book income regarding performance. Moreover, we find a positive association between taxable income and analysts’ pretax forecasts, consistent with analysts utilizing the information in taxable income when forming earnings expectations. We do not find an association between taxable income and future analyst forecast errors, implying analysts do not overreact or underreact to taxable income's performance signal. Overall, we find that taxable income provides a signal of fundamental value and corroborate the implications of prior research.

Merit, Luck and Taxes: Societal Reward Rules, Self-Interest and Ideology in a Real-Effort Voting Experiment

When are high earnings considered a legitimate target for redistribution, and when not? We design a real-effort laboratory experiment in which we manipulate the assignment of payrates (societal ‘reward rules’) that translate performance on a real-effort counting task into pre-tax earnings. We then ask subjects to vote on a flat tax rate in groups of three. We distinguish three treatment conditions: the same payrate for all group members (‘equal’ reward rule), differential (low, medium and high) but random payrates (‘luck’ rule), and differential payrates based on subjects’ performance on a quiz with voluntary preparation opportunity (‘merit’ rule). Self-interest is the dominant tax voting motivation. Tax levels are lower under ‘merit’ rule than under ‘luck’ rule, and merit reasoning overrides political ideology. But information is needed to activate merit reasoning. Both these latter effects are present only when voters have ‘full merit knowledge’ that signals precisely how others obtained their incomes.

The Speed of Earnings Responses to Taxation and the Role of Firm Labor Demand

This paper studies the speed at which workers' pre-tax earnings respond to tax changes along the intensive margin. We do so in the context of Germany, where a large discontinuity — or notch — in the tax schedule induces sharp bunching in the earnings distribution. We analyze earnings responses to two policy reforms that shift this notch outward. In a frictionless world, the workers that made up the excess mass at the old notch should all increase their earnings. While some of these workers indeed adjust their earnings rapidly, over 38% do not, and instead take several years to adjust. We propose that heterogeneity in firm labor demand plays a key role in generating the observed differences in the speed of workers' earnings responses and predict that adjustment will be quickest at growing firms. We test and find support for these demand-side effects in our linked employer-employee data.

A Quantitative Analysis of Life-Cycle Inequality Across U.S. and Europe

I document that (i) the mean and dispersion of pre-tax labor earnings grow faster over the life-cycle in the U.S. than in some European countries; (ii) these facts are largely driven by individuals with at least a college degree. I study these differences in labor earnings inequality using a life-cycle model of human capital accumulation and elastic labor supply which features non-linear taxation, in conjunction with a college choice and complementary investments during college. The model economy accounts for the differential mean earnings growth patterns of individuals with and without a college degree in the United States, as well as the observed within-group inequality over the life cycle. I find that non-linear taxation significantly suppresses pre-tax earnings, reduces college attendance, and investments during college. More generous subsidies and transfers for college exacerbate labor earning inequality. I find that differences in taxation and college subsidies alone account for 94% of the differences in mean earnings, and 80% of the differences in variance of log earnings over the life-cycle across the U.S. and European countries. To fully reconcile the model with data, the role of differences in initial conditions appear key.

Framing Flexible Spending Accounts: A Large-Scale Field Experiment on Communicating the Return on Medical Savings Accounts.

Tax-preferred health savings devices such as Flexible Spending Accounts (FSAs) and Health Savings Accounts (HSAs) offer employees potentially valuable financial instruments for directing pre-tax earnings to eligible medical expenses. Despite their increasing popularity as an employee benefit, however, there is little causal evidence around individual demand for these accounts. This paper seeks to address this gap in the literature, reporting on a randomized controlled field experiment conducted with over 11,000U. S federal employees in 2017 in order to evaluate the effectiveness of targeted messages designed to increase FSA contributions. Our results suggest that the provision of basic information about FSAs delivered via an emailed employee newsletter did not affect the likelihood of contribution or the contribution level. The addition of statements about the absolute returns or relative returns offered by the accounts similarly had no significant effects, and these null effects are observed despite relatively high email open rates. We discuss explanations for the null results and the policy implications of findings from what appears to be the first health economics experiment analyzing tax incentives around health care savings.

The Valuation of Discontinued Operations and Its Effect on Classification Shifting

ABSTRACTResearch documents that firms shift operating expenses into income-decreasing, but not income-increasing, discontinued operations. We argue that valuation considerations explain this asymmetric result, as acquirers are likely to value the earnings of income-increasing discontinued operations more highly than the earnings of income-decreasing discontinued operations. Using a large sample of hand-collected data, we show that pre-tax earnings and operating expenses are significantly more value-relevant for income-increasing discontinued operations, supporting our economic explanation for why firms do not shift operating expenses into income-increasing discontinued operations. Additional analysis shows that in situations where managers are constrained from shifting operating expenses due to valuation concerns, they shift tax expense (an expense that is less value-relevant) from continuing operations into income-increasing discontinued operations. Overall, we conclude that valuation considerations constrain firms from shifting operating expenses into income-increasing discontinued operations, but do not constrain firms shifting tax expenses.

Behavioral Response to State Income Taxation of High Earners: Evidence from California

In November 2012, California voters passed increases to state marginal income tax rates of 1 to 3 percentage points for upper-income households. Drawing on the universe of California income tax filings, we present new findings about the effects of personal income taxation on household location choice and pre-tax income. First, over and above baseline rates of taxpayer departure from California, an additional 0.8% of the California residential tax filing base whose 2012 income would have been in the new 12.3% top tax bracket were no longer full year residents of California in 2013. Second, to identify the impact of the California tax policy shift on the pre-tax earnings of high-income California residents, we use as a control group high-earning out-of-state taxpayers who persistently file as California non-residents. Using a differences-in-differences strategy paired with propensity score matching, we estimate a substantial intensive margin response which begins in 2012 amongst California top-bracket taxpayers. Our estimates imply an intensive margin elasticity of income with respect to the marginal net-of-tax rate of 2.5 to 3.2. Among top-bracket California taxpayers, outward migration and behavioral responses by stayers together eroded 45.2% of the windfall tax revenues from the reform within the first year and 60.9% within two years, with the extensive margin accounting for 9.5% of this total response.

The Cadbury Schweppes judgment and its implications on profit shifting activities within Europe

In 2006, the European Court of Justice (ECJ) decided with the Cadbury Schweppes judgment that European Controlled-Foreign-Company (CFC) rules infringe the principle of freedom of establishment and restricted the applicability thereof. This paper analyzes the impact of mandatory amendments to European CFC rules on tax planning activities within Europe. Using a difference-in-differences approach, my results provide robust evidence that pre-tax earnings of subsidiaries located in European low-tax jurisdictions have increased by around 10% after the Cadbury Schweppes judgment. My analysis shows further that the increase in pre-tax earnings is related to facilitated profit shifting activities. Multinational corporations with high incentives or enhanced profit shifting opportunities react more to the Cadbury Schweppes judgment. The findings point out that CFC rules became less effective, and thus, profit shifting activities within Europe are less restricted after the ECJ judgment. Additional tests suggest further that on average 85% of the increase in pre-tax earnings is attributable to strategic transfer pricing determination, while less than 15% is attributable to debt shifting activities.

How Do Auditors Learn to Forecast? Evidence from the Predictive Power of the Deferred Tax Asset Valuation Allowance

This paper investigates auditor influence on the association between discretionary changes in the deferred tax asset valuation allowance (VA) and changes in future pretax earnings. Investors should be able to infer changes in future earnings from changes in the VA because the VA estimation depends on management’s forecast of future taxable earnings. Our study finds discretionary VA changes are significant and persistent predictors of future earnings changes. We focus on the effects of auditor expertise on the relationship between VA changes and future earnings changes, with expertise stemming from industry knowledge (measured by local market share) and firm-specific knowledge (measured by substantial auditor-provided tax services (APTS). We find that both types of knowledge build valuable expertise. However, when we examine a high judgment setting (i.e., VA releases despite ongoing losses), we find that VA predictive value improves with substantial APTS but diminishes with auditor industry expertise.

How Costly Is Tax Avoidance? Evidence from Structural Estimation

I develop a structural model to quantify the costs of tax avoidance. In the model, the firm trades off tax savings with tax-audit risk, financial-reporting benefits, and non-tax costs (which affect pre-tax income). The comparative statics suggest tax avoidance is path-dependent, which can help resolve the unexplained persistent differences across firms. The estimated parameters suggest non-tax costs, which are difficult to observe, decrease pre-tax earnings by 7.8%. The large magnitude of this estimate can explain why firms appear to under-utilize tax-avoidance strategies. When I estimate the model on different subsamples, I find larger firms engage in more tax avoidance primarily because they can better identify lower-risk opportunities. I find multinationals have lower-risk opportunities to avoid taxes but incur more non-tax costs relative to domestic firms, which helps to explain similar levels of tax avoidance. Overall, the estimated parameters help to explain the “undersheltering puzzle” and the cross-sectional variation in tax avoidance.