Earnings Management around the Tax Cuts and Jobs Act of 2017

Abstract

This paper examines earnings management around the reduction in the corporate tax rate from 35% to 21% as enacted by the Tax Cuts and Jobs Act (TCJA) of 2017. Building on a theoretical model that considers a higher level of book-tax conformity of ‘real earnings management’ (REM) relative to ‘accrual-based earnings management’ (AEM), we hypothesize that firms concertedly use these manipulation techniques for different purposes. Specifically, we predict and find that firms engage in REM to reduce income in the high-tax period prior to the TCJA. Our results suggest that the 851 firms of our sample save approximately $32 billion in taxes from REM shifting. We also predict and find that firms use AEM, which has a lower degree of book-tax conformity, to simultaneously increase book income. Consistent with intertemporal income shifting, we find that these effects reverse in 2018. Overall, our results document an unintended consequence of the TCJA on firm behavior that should be of interest to policymakers, regulators, and researchers as they evaluate the largest tax reform since 1986.