Valuation of tax expense

Both intuition and empirical evidence suggest that higher revenues increase value whereas higher expenses, including higher tax expense, decrease value. Some prior research, however, suggests that higher tax expense may be good news, despite the resulting reduction in after-tax earnings. We conduct a comprehensive investigation and find that surprises in both the current and deferred components of tax expense are in general strongly positively related to contemporaneous returns and future earnings, even more so than surprises in pre-tax income. These unexpected positive relations appear to be due to regression misspecification and “measurement error” in earnings surprise, which allow tax expense to reflect information that is correlated with underlying profitability. The positive relation declines and even becomes negative when empirical choices made (e.g. dropping firms reporting losses) increase the information content of earnings. Inferences based on valuation of tax expense and its components should therefore be made with caution.