The 1993 Tax Rate Increase and Deferred Tax Adjustments : A Test of Functional Fixation

When the U.S. corporate income tax rate was increased from 34 to 35 percent in August 1993, corporations had to remeasure their deferred tax assets and liabilities and include the net adjustment in their 1993 third-quarter earnings. This study shows that, at the time of the earnings announcement, the deferred tax adjustment was mapped into security prices at the same rate as the recurring portion of unexpected earnings. Further analysis reveals that mis-pricing was more pronounced for firms with income-increasing tax adjustments and for firms that did not disclose the tax adjustment separately. In addition, the study finds that financial analysts generally failed to include the deferred tax adjustments in their earnings forecasts, even though it could be estimated beforehand. These findings suggest that investors' ability to understand sophisticated accounting rules is limited