The persistence, forecasting, and valuation implications of the tax change component of earnings

This study investigates whether changes in net income caused by changes in effective tax rates (the tax change component) persist and aid in forecasting future earnings. In addition, this study investigates the extent to which the forecasting implications of the tax change component of earnings are reflected in abnormal stock returns. The tax change component of earnings is decomposed into an initial and revised portion, which is hypothesized to have differential persistence and forecasting implications. The Mishkin procedure is utilized to determine if the market recognizes the forecasting implications of the differential persistence of the initial and revised tax change components.; The results indicate that the overall tax change component is more persistent than transitory. When the tax change component is decomposed into an initial and revised portion, the results indicate that the initial tax change component is more useful in forecasting future tax changes and future earnings than the revised tax change component. These results are consistent with the hypotheses that the initial and revised tax change components have differential persistence and forecasting implications, and dispute the notion advanced by prior literature that effective tax rate related earnings changes are transitory. Results from formal mispricing tests indicate that the market underweights the forecasting implications of the persistence of the revised tax change component and the mispricing appears to be driven by firms in industries with above-average intra-year variation in the tax change component of earnings. Supplemental tests confirm that the results obtained from the mispricing tests are a result of market mispricing rather than alternative explanations such as omitted risk factors.