Temporary Tax Woes

December 14, 2018

Key Takeaways

Temporary tax laws result in critical financial and accounting effects. 

Investors may find value in more explicit disclosure about the effects of temporary tax laws that have expired.

It should come as no surprise that Congress frequently reinstates popular tax breaks after they expire. For instance, the research and development (R&D) tax credit, enacted on a temporary basis in 1981, was repeatedly extended, often retroactively, until its permanent extension in 2015. Research from Gatton professors Brian Bratten and David Hulse uses the temporary R&D credit setting to investigate the financial accounting and market consequences of enacting tax law retroactively.

Their paper, “Retroactive Tax Legislation, Reported Earnings, and Investors’ Responses to Earnings ‘Surprises’: Evidence from R&D Credit Extensions” (Journal of the American Taxation Association), documents that when the R&D credit expired, companies could not report a tax benefit from the credit even if it was expected, and when the credit was retroactively extended, reported earnings included a large, transitory “enactment effect” for the retroactive tax benefit.

We show that temporary tax laws have important financial accounting effects, not just economic policy effects, and that these financial accounting effects can harm investors.

Their study examines how investors responded and found that after the extension, stock returns around earnings announcements were positively associated with this enactment effect, suggesting market mispricing during the R&D credit expiration period. “We show that temporary tax laws have important financial accounting effects, not just economic policy effects, and that these financial accounting effects can harm investors,” says Bratten. “Our findings should interest researchers, investors, and policymakers because the effects we document are likely unintended consequences of congressional delays in extending temporary tax laws that may not have previously been considered. We suggest that more explicit disclosure about the effects of temporary tax laws that have expired may be helpful to investors.”

Retroactive Tax Legislation, Reported Earnings, and Investors’ Responses to Earnings ‘Surprises’: Evidence from R&D Credit Extensions

Authors:

Brian Bratten, Clark Material Handling Company Associate Professor of Accountancy, Gatton College of Business and Economics at the University of Kentucky 
David Hulse, Associate Professor of Accountancy, Gatton College of Business and Economics at the University of Kentucky 

Publication:

Journal of American Taxation Association, Vol. 38, No. 2, pages 87-109, 2016

Read Online