Do Analysts and Investors Fully Appreciate the Implications of Book-Tax Differences for Future Earnings?

Recent research reports that book-tax differences are not only informative about future earnings but are also associated with future stock returns. The combination of these results suggests the possibility that investors misprice securities by not fully incorporating taxbased information into their earnings expectations. However, because the stock market's expectations are not observable, predictable future returns may instead simply reflect differences in risk. I exploit financial analysts' earnings forecasts to provide evidence on these alternative explanations. I find that analysts' forecasts are more optimistically biased when book income is high relative to tax income, indicating a failure to anticipate that these firms tend to have lower future earnings. I also show that the association between book-tax differences and future returns is only present for firms with weaker information environments and disappears after controlling for analysts' forecast errors. My results suggest that neither analysts nor investors fully appreciate the information in book-tax differences, particularly in settings with weaker information environments and when analysts are less experienced. Overall, the evidence is consistent with the association between book-tax differences and future returns being attributable to mispricing rather than risk.