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

I examine whether earnings generated by changes in effective tax rates (the tax change component) persist and aid in forecasting future earnings. In addition, this study investigates to what extent investors incorporate the forecasting implications of the tax change component of earnings into stock prices. I find that there is a positive, significant association between the tax change component of earnings and future earnings. I use the interim reporting requirements of APB No. 28 (APB 1973) and FASB Interpretation No. 18 (FASB 1977) to further decompose the tax change component into an initial and a revised portion based on the first quarter estimate of the annual ETR. I find that the initial tax change component is more persistent for future earnings than the revised tax change component. These results are consistent with my hypotheses that the initial and revised tax change components have differential persistence and forecasting implications, and dispute the broad notion espoused by prior literature that ETR-related earnings changes are transitory. Results from market tests indicate that the market underweights the forecasting implications of the persistence of the tax change component and the mispricing appears to be driven by the transitory nature of the revised tax change component.