When Are Effective Tax Rate Decreases Persistent? The Role of Incentives and Tax-Specific Experience

Abstract

This study examines the role of executives’ tax-specific experience and incentives on the persistence of effective tax rate (ETR) decreases. Prior studies typically attribute ETR decreases to either earnings management or tax planning. However, the method used to reduce ETRs can have a significant effect on the persistence of the change, which is important for forecasting future earnings and assessing valuation. We find that, on average, tax-specific experience is associated with more persistent ETR decreases, consistent with tax planning. However, tax-specific experience is also associated with more ETR earnings management, which is associated with less persistent ETR decreases. Importantly, tax-specific experience is not associated with more persistent ETR decreases when the decrease is used to manage earnings. Overall, we document that both tax-related experience and incentives have a significant effect on the persistence of ETR reductions, and the effect of tax-related experience depends on whether the ETR reduction was used to manage earnings. This study has important implications regarding financial reporting quality, forecasting, and firm valuation.