Empirical implications of incorrect special item tax rate assumptions

• Published in: Review of accounting studies 2023-06, Vol.28 (2), p.958-1002
• Main Authors: Cready, William M., Lopez, Thomas J., Sisneros, Craig A., Stinson, Shane R.
• Format: Article
• Language: English
• Subjects: Accounting; Accounting/Auditing; Business and Management; Corporate Finance; Public Finance; Tax rates
• ISSN: 1380-6653; 1573-7136
• DOI: 10.1007/s11142-021-09661-1

The use of assumed tax rates to adjust special items (e.g., restructuring charges, asset writedowns, etc.) is common in empirical accounting research as these items are reported pre-tax and are often used in research designs that include after-tax earnings. This study explores the potential empirical consequences of assuming an incorrect tax rate in adjusting special items. We focus on special items given their prevelance in the literature as well as the wide variation in tax rate assumptions from these studies. Our investigation shows that the tax rate assumed can be critical to the interpretation of results. Importantly, our evidence suggests extreme tax rate assumptions, in particular the highest statutory rate, are especially problematic and yield dramatically biased estimates. Our review of the tax consequences of special items suggests that, in almost all circumstances, the marginal tax rate is the theoretically correct rate to apply to these items when adjusting for tax. Consistent with this view, our empirical evidence, with a limited exception, suggests that marginal tax rates represent the best estimate of the true tax rate. By providing empirical evidence on the potential empirical consequences of these varied tax rate assumptions, we offer a guide for future researchers on the importance of this critical design choice.