Leveling the playing field: unbiased tests of the relative information content of book income and taxable income

In this study, I document that at least a portion of the superior ability of book income relative to taxable income to explain the market value of equity may be due to market mispricing arising from investors’ fixation on book income and underemphasis on the information contained in taxable income, rather than book income’s superior information content. I find that this result generally intensifies as book earnings quality and tax planning decrease. Indeed, I show that once market mispricing is removed from the valuation model, taxable income possesses statistically equivalent or even superior ability relative to book income to explain firm value among firms with particularly low book earnings quality and firms that engage in a relatively low degree of tax planning. This study adds to the growing literature on the informativeness of firms’ tax-related financial statement disclosures by demonstrating that prior research may have conducted tests of value relevance that are inherently biased in favor of book income and, consequently, understated the relative information content of taxable income.