Examining Which Tax Rates Investors Use for Equity Valuation

Although income tax expense is a significant input to valuation models, little empirical evidence exists about which rates investors incorporate. The limited guidance available suggests investors should use the marginal tax rate (MTR), but it is unclear whether investors follow this guidance. We therefore examine the value relevance of simulated MTRs along with tax rates that are less costly to obtain. Across a battery of tests, we find that the top U.S. statutory rate (STR) is more associated with firm value than estimated MTRs, prior-year effective tax rates (ETR), prior three-year average ETRs or prior-year industry-average ETRs. However, we find some evidence that the value relevance of other tax rates increases when those rates reflect firm-specific tax benefits not captured by the STR. This study advances the valuation of tax literature and informs management and standard setters of investors' use of tax information