Taxable Income as a Performance Measure: The Effects of Tax Planning and Earnings Quality

Hanlon (2005) and Lev and Nissim (2004) provide rather compelling evidence that book-tax differences, on average, are systematically related to earnings growth, future stock returns, and earnings persistence. Among other implications, these studies suggest that book-tax differences are useful measures in evaluating firm performance. Consistent with these studies, Shevlin (2002) and Hanlon, Laplante, and Shevlin (2005) find that while book income explains a firm’s annual stock returns better than estimated taxable income (i.e., calculated using financial statement disclosures), estimated taxable income, on average, has incremental explanatory power for book income (i.e., estimated taxable income summarizes information reflected in stock returns that is not captured by book income). Beyond these studies, there is little evidence regarding taxable income as an alternative performance measure and, in particular, cross-sectional differences in firms that mitigate or enhance the ability of taxable income to inform investors regarding firm performance. We look to the recent debates on book-tax conformity and extant literature to identify two settings (high tax planning and low earnings quality) that may impair or enhance the information content of taxable income relative to book income. First, recent calls for mandatory book-tax conformity argue that the dual system of reporting both book and taxable income is “the province of much creative decisionmaking” (Desai 2006, 8) that manifests in taxable income that does not reflect the firm’s actual performance.1 This argument identifies aggressive tax planning as a primary source of book-tax differences and suggests that the end result is taxable income devoid of a firm’s economic performance.