Book-Tax Differences and Future Earnings Changes

Prior studies suggest that large book-tax differences (BTDs) are associated with future earnings changes (or earnings persistence), but it is not clear what drives this association. Studies such as Lev and Nissim (2004) examine the association between total BTDs and after-tax earnings changes, but a better understanding of this association requires an examination of the components of the BTDs and earnings changes. I divide total BTDs into temporary and permanent categories, and hypothesize that temporary BTDs (reflected in deferred taxes) predict future changes in pretax earnings, whereas permanent BTDs predict future changes in tax expense. The results are consistent with these hypotheses. Prior studies also suggest that both types of BTDs are associated with earnings management and tax avoidance. I find evidence that tax avoidance firms have a more positive association between their BTDs and both pretax earnings changes and tax expense changes. However, I find only inconsistent evidence on the influence of earnings management on the BTD/earnings changes association, with results dependent on the research design. Overall, the evidence suggests that while tax avoidance and earnings management may contribute to the association between BTDs and future earnings changes, they are not the primary drivers of this association