The Information Content of Tax Expense: A Firm- and Market-Level Return Decomposition

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Abstract

I examine how a firm’s tax expense is valued by the firm’s investors and whether these effects extend to the aggregate stock market. To determine why tax expense decreases are valued positively, I decompose a firm’s return into its cash flow and discount rate news components. I find that increases in tax expense reduce investor expectations of future cash flow; the positive correlation between a firm’s tax expense surprise and its returns is due to changes expectations of future discount rates. I extend my analysis to the market level to determine whether aggregate tax information is useful in setting macroeconomic expectations. I find that aggregate tax expense is negatively related to market returns and this negative association is driven by the discount rate news channel. This result suggests that the discount-rate news contained in firm-level tax expense surprises is not reflective of systematic risk.

Author

• Erin Emily Henry, University of Connecticut