Tax Expense Surprises and Future Returns

We investigate whether surprises in quarterly tax expense predict future returns, after controlling for surprises in after-tax book income. We find that seasonally-differenced quarterly tax expense, our proxy for tax expense surprise, is positively related to future returns over the next two quarters. We confirm that this anomalous link is separate from other anomalies documented in the prior literature, such as size, book-to-market, accruals, and price momentum, as well as two anomalies related to tax variables. While higher expense might intuitively imply bad news, in this case higher tax expense signals good news as it is positively related to pre and after-tax income. Our results suggest that this good news is incorporated in stock prices with a delay because investors do not recognize fully the ability of tax expense surprises to predict two key variables that are released in the next two quarters - future book income and future tax expense.