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Borsa Istanbul Review xxx (xxxx) xxx
http://www.elsevier.com/journals/borsa-istanbul-review/2214-8450

Full Length Article

Tax expense surprise and emerging markets equity returns

A. Doruk Gunaydin
Sabanci Business School, Sabanci University, Orhanli Tuzla 34956, Istanbul, Turkey
Received 15 January 2021; revised 26 November 2021; accepted 26 November 2021
Available online ▪ ▪ ▪

Abstract

This study investigates the relationship between tax expense surprise and expected equity returns in emerging markets. Using a broad sample
of equities from 27 emerging countries, we find a strong positive link between tax expense surprise and the cross-sectional expected stock returns.
Univariate portfolio analyses of the overall sample show that equities in the highest tax expense surprise quintile earn 9.48% higher risk-adjusted
annual returns than equities in the lowest tax expense surprise quintile. This relationship remains robust to alternative definitions of tax expense
surprise, even after controlling for other anomalies related to financial and tax variables in a regression framework. We also examine whether tax
enforcement enhances the value relevance of tax expense surprise. The findings show that tax expense surprise is related to expected equity returns
only when tax enforcement is high. Thus, tax enforcement plays a significant role in the value relevance of tax expense shocks.
Copyright © 2021, Borsa İstanbul Anonim Şirketi. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-
ND license (http://creativecommons.org/licenses/by-nc-nd/4.0/).

JEL classification: G10; G11; G12

Keywords: Cross-sectional equity returns; Emerging markets; International finance; Tax expense momentum; Tax expense surprise

1. Introduction change in tax expense by showing that a difference in the

A considerable body of financial economics literature has
found that information extracted from GAAP (generally
accepted accounting principles) accounting statements in-
corporates unique and valuable information that correlates
with expected stock returns. One strand of this academic
research focuses on tax-related information and documents a
strong and positive relationship between tax information and
future equity returns. These studies argue that this value-
relevant tax-based information is orthogonal to the informa-
tion incorporated into earnings (Graham et al., 2012; Hanlon
et al., 2005; Thomas and Zhang, 2011). Thomas and Zhang
(2014) further investigate the value relevance of unexpected
seasonally adjusted quarterly tax expense—the proxy for tax
expense surprise—contains unique and valuable information
regarding a stock's current and future core profitability that is
not captured by the unexpected change in earnings. They also
argue that tax-related information is not embedded in equity
prices immediately in US markets, causing predictability
patterns in future stock returns. In a more recent study, Kerr
(2019) presents evidence consistent with the findings on the
US that the link between unexpected changes in tax expen-
ditures and future equity returns remains significant in
developed countries.
In this study, the value relevance of unexpected change in
tax expense is revisited by focusing on an extensive sample of

E-mail address: dorukgunaydin@sabanciuniv.edu.

Peer review under responsibility of Borsa İstanbul Anonim Şirketi.

https://doi.org/10.1016/j.bir.2021.11.001
2214-8450/Copyright © 2021, Borsa İstanbul Anonim Şirketi. Production and hosting by Elsevier B.V. This is an open access article under the CC BY-NC-ND
license (http://creativecommons.org/licenses/by-nc-nd/4.0/).
Please cite this article as: A.D. Gunaydin, Tax expense surprise and emerging markets equity returns, Borsa İstanbul Review, https://doi.org/10.1016/
j.bir.2021.11.001
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A.D. Gunaydin
stocks in emerging countries.1 This paper contributes to the
literature by testing two hypotheses jointly. First, positive un-
expected shocks in tax expenses are good news, and they
encompass unique and relevant information about expected
stock returns in emerging markets. Second, although this value-
relevant information is revealed to the public, investors initially
underreact to these positive unexpected tax expense shocks and
respond in subsequent periods, causing predictability patterns
in equity prices. These hypotheses are tested by collecting
time-series returns and accounting data for 27 emerging market
equities. Our portfolio-level analyses and multivariate cross-
sectional regressions document that positive unexpected
change in tax expense is positively linked to the cross-sectional
future equity returns in the overall sample of emerging markets.
The univariate portfolio analyses of the overall sample docu-
ment that stocks in the highest quintile of unexpected change in
tax expense earn a 11.16% (9.48%) higher risk-adjusted equal-
(value-) weighted annual return than those in the lowest
quintile. The findings from both bivariate portfolio and multi-
variate regression analyses further show that positive tax
expense shocks are economically and statistically positively
linked to cross-sectional future stock returns in the overall
sample of emerging countries.
Our findings remain robust after well-known accounting and
stock-level mispricing variables are controlled for, in both the
portfolio analyses and regressions, such as earnings surprise,
sales surprise, the cash flow-to-price ratio, variations in the
effective tax rate and manufacturing and nonmanufacturing
cost surprises as well as the standard beta, size, book-to-market
ratio, and momentum return. The significant relationship be-
tween tax expense surprise and expected stock returns remains
intact with alternative definitions of tax expense surprise,
namely (1) orthogonalizing tax expense surprise with respect to
earnings surprise, (2) considering only the current (not the
deferred) portion of tax expense when measuring tax expense
surprise, and (3) using standardized tax expense surprise to
control for fluctuation in tax expense differences. Additionally,
the predictive ability of tax expense surprise continues to hold
when loss quarters are excluded from the sample. We further
document that the strong positive relationship between tax
expense surprise and expected returns is also pronounced
among stocks in every geographic region, namely Europe,
1 rate and inflation risk in stock returns on international mar-
This study is based on the wide literature on the significance of information
disclosed in public announcements and financial statements. Earlier studies,
such as Ball and Brown (1968), document a strongly positive relation between
changes in earnings and expected stock returns. This study extends a devel-
oping stream of literature that investigates the value relevance of tax-related
disclosure. Several topics are grouped within this stream. First, Schmidt
(2006) finds a positively significant relationship between the tax change
component and expected earnings. Second, Lev and Nissim (2004) document
that the ratio of book earnings to tax income has predictive power over future
returns. Third, Hanlon et al. (2005) document a positive relation between
changes in taxable income, measured using the current portion of tax expense
and equity returns. Last, Ohlson and Penman (1992) contribute to the literature
by showing a positive link between tax expenses and returns. Other studies,
such as Thomas and Zhang (2011) and Thomas and Zhang (2014), show that
tax expense surprise is related to future returns because the change in tax
expense proxies for a firm's future profitability.
2
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Asia, Latin America, and Africa. These results collectively
prove that positive unexpected change in tax expense is
incrementally value relevant in the cross-sectional emerging
markets equity returns.
After documenting the strong link between positive tax
expense shock and expected stock returns in emerging coun-
tries, we examine the role of tax enforcement on the predictive
power of tax expense shock. Using country-level tax evasion
data to proxy for tax enforcement, we document that tax
expense shock is related to expected equity returns only in
countries with higher tax enforcement. On the other hand, the
findings indicate that the relationship between tax expense
shock and expected stock returns is flat in countries with lower
tax enforcement.
The remainder of the paper is structured as follows. Section
2 details the data, variables, and methodology and provides
summary statistics. Section 3 reports the empirical findings.
Section 4 is the conclusion.
2. Data, variables, and methodology
2.1. Data
We use an extensive sample of companies in 27 emerging
countries: Argentina, Bangladesh, Brazil, Chile, China,
Colombia, Czech Republic, Egypt, Greece, Hungary, India,
Indonesia, Malaysia, Mexico, Morocco, Nigeria, Pakistan,
Peru, Philippines, Poland, Romania, Russia, South Africa, Sri
Lanka, Thailand, Turkey, and Vietnam. Financial and ac-
counting statement data are obtained from the quarterly Com-
pustat Global Database. The sample extends from January
2000 to September 2019. Because Compustat Global has little
tax-related data before 2000, the sample period is limited such
that our analysis begins in 2000. The tax evasion index is
downloaded from IMD World Competitiveness Online.
We obtain the daily stock-level total return index (RI)
from Datastream, provided by Thomson Reuters. This index
is adjusted for stock divisions and dividend payments, and
daily returns are calculated using the total return index.
Monthly and quarterly stock returns are calculated by com-
pounding daily stock returns. Return indices calculated in US
dollars are used to ensure that the returns are comparable
across various countries and eliminate the foreign exchange
kets, following Lee (2011). We use each country's aggregate
equity index as a proxy for the market portfolio provided by
Datastream. The literature on international studies proposes
some screens to mitigate the data errors in Datastream.2
Following the literature, we limit the sample to include eq-
uities that are in the leading stock exchange of each country.
Leading stock exchanges are identified as those on which
most equities are traded. Equities with certain character-
istics—such as preferred shares, depository receipts, and
REITs—are dropped from the sample, and only common
2
See Bekaert et al. (2007), Karolyi et al. (2012), and Lee (2011).
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A.D. Gunaydin
equities are included in the analysis. To avoid self-selection
bias, we retain delisted stocks in the sample. The highest
and lowest 0.1% of daily stock returns within each country
are dropped from the sample. To reduce the effect of extreme
observations observed in the data, we winsorize every
explanatory variable at the 1% and 99% in each country-
quarter. Zero returns, which are calculated using return
indices denominated in local currencies, are excluded from
the last observation of the data to the first non-zero return
day. We exclude any observation from the sample if the re-
turn index for the prior or the prevailing period is less than
0.01. We also remove any day from the sample if more than
90% of equities in a given country have a zero return on that
day.3 The monthly and quarterly risk-free rate is proxied by
the interest rate on one-month US Treasury bills and down-
loaded from Kenneth French's website. To ensure that micro
stocks do not drive the findings, stocks that are in the smallest
quintile in each country-quarter are dropped from the sam-
ple.4 These screens leave 299,991 firm-quarter observations
for which the tax expense surprise variable can be calculated.
2.2. Variables
We follow the variable definitions used by Thomas and
Zhang (2011). The main variable of interest is tax expense
surprise (ΔT ), calculated as the total tax expenditure in the
current quarter, less total tax expenditure in the same quarter
from the prior year, divided by total assets in the same quarter
from the prior year. Earnings surprise (ΔE ) is the basic control
variable, measured as net income in the current quarter, less net
income in the same quarter from the prior year, divided by total
assets in the same quarter from the prior year. Because this
study aims to study the relationship between tax expense sur-
prise and future equity returns, the main dependent variable is
the cumulative future quarterly return (RETq+2 ), beginning the
first day of the fourth month after the current quarter ends. We
wait for three months to construct returns over this interval to
ensure that tax expense and earnings information are released
to the public before the holding period commences.
Other stock-specific control variables are constructed
following prior literature and Thomas and Zhang (2011). The
standard market beta (Beta) is calculated as the slope coeffi-
cient from a regression of daily excess equity returns on the
daily excess market returns during the previous 252 days. Prior
literature documents that company size (book-to-market) is
negatively (positively) correlated with the expected returns. As
3
This screen is implemented using returns calculated based on return indices
denominated in the local currency because the daily non-zero equity return
might be driven only by the fluctuation in exchange rates.
4
In an alternative setting, micro stocks are defined differently, following
Fama and French. (2012). Specifically, stocks are grouped into 3 portfolios
based on size (micro, small, and large) within each country-quarter. Large
stocks combined comprise 90% of a country's cumulative market capitalization.
Small stocks comprise the next 7% of cumulative market capitalization. Micro
stocks make up the remaining aggregate 3% of market capitalization in each
country. The findings are qualitatively robust if micro stocks are defined in this
way and excluded from the sample, following Hou et al. (2020).
3
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control variables, we use company size (Size) as the logarithm
of equity's market capitalization and the book-to-market ratio
(BM ) as the proportion of the book value of equity to the
market value of equity at the end of each quarter. Previous
studies show that momentum returns strongly predict future
stock returns in emerging markets.5 Therefore, we include
momentum (MOM ) (calculated as the eleven-month cumula-
tive past returns of equity beginning two months after the
company's current fiscal-quarter ends) as an additional control
variable.6
Control variables based on other well-documented anoma-
lies are also considered. Jegadeesh and Livnat (2006) docu-
ment that sales surprise is incrementally value relevant to
expected equity returns and not subsumed within earnings
surprise. Sales surprise (ΔS ) is measured as sales in the current
quarter minus sales in the same quarter from the prior year,
divided by total assets in the same quarter from the prior year.
A cash flow control is used in the analyses to eliminate the
possibility that the predictive capacity of an unexpected change
in tax expense might be driven by the correlation between an
unexpected change in tax expense and cash flows. CF/P is
calculated as the operating cash flow per share scaled by the
price per share in the previous fiscal quarter. Additionally, we
follow Schmidt (2006) in controlling for variations in the
effective tax rate. Specifically, the tax change component
(TCC ) is defined as (ETRq−4 − ETRq )*PTEPSq /TAPSq−4 ,
where ETR is the effective tax rate, calculated as the tax
expenditure scaled by pretax income, PTEPS is pretax earnings
per share, and TAPS is total assets per share. In order to
calculate TCC, we require that pretax income be positive in
both the current quarter and in the same quarter in the previous
year.
Sales surprise is one of the three pretax income–based
surprise variables; the other two are nonmanufacturing and
manufacturing costs. In a similar vein, the nonmanufacturing
cost surprise (ΔSGA) is measured as sales, general, and
administrative expenses in the current quarter less sales, gen-
eral, and administrative expenses in the same quarter in the
prior year, divided by total assets in the same quarter in the
prior year. Similarly, the manufacturing cost surprise
(ΔCOGS ) is measured as the cost of goods sold in the current
quarter less the cost of goods sold in the same quarter in the
prior year, divided by total assets in the same quarter in the
prior year.
2.3. Methodology
Three major methodologies are employed to examine the
incremental value relevance of tax expense surprise in
emerging markets.
5
For a detailed review of return determinants in emerging markets, see
Atilgan and Demirtas (2013a,b), and Atilgan et al. (2015).
6
The motivation behind adding one month prior to the beginning of the
period used to calculate the future returns is to mitigate the monthly short-term
reversal anomaly documented by Jegadeesh (1990).
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First, we conduct discrete one-dimensional portfolio ana-
lyses by grouping equities into quintiles each quarter based on
their tax expense surprise in each region.7 The univariate
portfolio analyses used in this study consist of all equities in
each region; thus, equities in each quintile come from various
emerging countries. Quintile portfolios are formed each month
from January 2001 to September 2019. Then, equal- and value-
weighted six-month-ahead mean returns for each portfolio are
calculated to determine whether a hedge strategy with a long
position in high-tax-expense-surprise equities and a short po-
sition in low-tax-expense-surprise equities earns a significant
return. We check whether the Fama and French (2017) five-
factor model can explain the return spread between the
extreme portfolios. As shown in Fama and French (2017), this
five-factor model constructs market, size, book-to-market,
profitability, and investment factors for emerging countries.8
Specifically, we perform monthly regressions of the return
spread between the highest and lowest tax expense surprise
portfolios on the market, size, book-to-market, profitability,
investment factors in emerging countries to test whether the
constant terms (alphas) obtained from these regressions are
statistically significant, as follows9:
RH,t − RL,t = α + β1 MKTt + β2 SMBt + β3 HMLt + β4 RMWt
+ β5 CMAt + εt (1)
where MKT, SMB, HML, RMW, and CMA are market, size,
book-to-market, profitability and investment factors for
emerging markets, following Fama and French (2017).
Second, to eliminate the possibility that the value relevance
of tax expense surprise might stem from an unobserved cor-
relation between tax expense surprise and other stock-specific
characteristics, we conduct two-stage 5 × 5 bivariate depen-
dent sorts based on different stock-specific characteristics and
tax expense surprise. All equities are grouped into quintile
portfolios based on an increasing sort of various stock-specific
characteristics at the end of each quarter. Next, within each
quintile of stock-specific characteristics, all stocks are addi-
tionally grouped into five quintile portfolios based on tax
expense surprise. This conditional two-stage analysis yields 25
conditionally sorted bivariate portfolios. Portfolio 1 consists of
all the stocks in the sample with the least tax expense surprise
in each stock-specific characteristics quintile, whereas Portfolio
5 comprises all the stocks in the sample with the most tax
7
Alternatively, we conduct portfolio analyses by grouping equities into
quintiles for each quarter based on tax expense surprise in each country. In
other words, stocks are first sorted into portfolios in each country, and future
portfolio returns are calculated for the pooled sample. In this setting, equities
are grouped into portfolios in each country to eliminate the concern that
different countries might apply different accounting and tax-related rules. The
untabulated results also show that the predictive power of tax expense surprise
remains robust to this alternative setting.
8 10
These emerging market factors are downloaded from Kenneth French's
website.
9
Statistical significance tests are implemented using Newey and West (1987)
adjusted t-statistics with six lags. The findings in the study are robust to other
lag choices.
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expense surprise in each stock-specific characteristics quintile.
This methodology has the benefit of keeping stock-specific
characteristics steady across the tax expense surprise quintiles
because equities in each tax-expense-surprise quintile come
from every control variable quintile portfolio by design. The
equal- and value-weighted six-month-ahead mean returns are
calculated for every quintile portfolio to investigate whether the
hedge strategy with a long position in the high-tax-expense-
surprise stocks and a short position in the low-tax-expense-
surprise stocks earns a significant return or alpha after con-
trolling for one stock-specific characteristic at a time.
Although the portfolio analyses elucidate the link between
an unexpected change in tax expense and future stock returns,
it only allows us to control for a finite number of return de-
terminants at a time. Therefore, we augment the univariate and
bivariate portfolio analyses with Fama and MacBeth (1973)
stock-level cross-sectional regressions to test whether tax
expense surprise contains unique information after other vari-
ables are controlled for in the regression. Specifically, for each
quarter in the sample, two-quarter-ahead equity returns are
regressed on tax expense surprise and a broader list of control
variables, as follows:
Ri,q+2 = αi,q + βi,q .ΔTi,q + θi,q .CONTROLSi,q + εi,q+2 (2)
where Ri,q+2 is the two-quarter-ahead return for stock i, ΔTi,q is
the tax expense surprise for stock i in quarter q, and
CONTROLSi,q is the group of stock-specific control variables.
These quarterly cross-sectional regressions yield quarterly
regression slope coefficients on return predictors.10 Next, we
average these quarterly slopes and perform statistical signifi-
cance tests using Newey and West (1987) standard errors.11
One potential shortcoming of Fama and MacBeth (1973) re-
gressions is that, by using the ordinary least squares (OLS)
methodology to run regressions, we assign the same weight to
each stock, resulting in the possibility that regressions might be
dominated by small stocks. Furthermore, Asparouhova et al.
(2013) demonstrate that microstructure noise in asset returns
distorts the findings of empirical asset pricing models and
propose an empirical methodology to correct such errors. This
problem is anticipated to be more serious in emerging markets
because of their lack of liquidity. Therefore, we extend the
OLS estimations by performing quarterly cross-sectional re-
gressions that use a weighted least squares (WLS) approach, in
which each variable is scaled by the gross stock return realized
in the prior quarter.
2.4. Descriptive statistics
Table 1 displays descriptive statistics for the stock-specific
characteristics in the sample. The time-series means of the
Because four quarters of past data are needed to construct tax expense
surprise, we perform the cross-sectional regression analysis beginning with the
first quarter in 2001.
11
Newey and West (1987) correction is performed with six lags. Findings are
robust to several other choices, including the optimal lag.
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Table 1
Descriptive statistics for stock-specific characteristics.
Mean SD 25th Median 75th Minimum Maximum Skewness Kurtosis
ΔT 0.0007 0.0076 −0.0014 0.0002 0.0023 −0.0214 0.0723 1.1122 22.9235
RET (q+2) 0.0276 0.2462 −0.1112 −0.0052 0.1268 −0.4223 3.4978 3.0452 45.9016
Beta 0.6358 0.3875 0.3701 0.5541 0.8379 0.0016 2.3800 1.0322 4.9417
Size 5.1508 1.7886 3.8202 5.3816 6.3983 1.2132 10.0563 −0.1719 2.7189
BM 0.9209 1.0049 0.3221 0.6130 1.1368 0.0021 6.4191 3.0210 15.5828
MOM 0.1560 0.5686 −0.1931 0.0252 0.3496 −0.6403 3.0382 2.2967 12.3477
ΔE 0.0024 0.0341 −0.0055 0.0010 0.0084 −0.0939 0.3885 1.7685 42.8082
ΔS 0.0326 0.0927 −0.0073 0.0148 0.0556 −0.1801 0.4618 1.8686 10.1712
CF/P 0.3796 1.1164 −0.0073 0.0367 0.5625 −0.7590 6.9068 5.9944 49.5141
TCC 0.0002 0.0048 −0.0010 0.0000 0.0011 −0.0160 0.0225 0.8210 12.3499
ΔSGA 0.0053 0.0154 −0.0015 0.0023 0.0093 −0.0301 0.0672 1.6829 9.7567
ΔCOGS 0.0291 0.0862 −0.0071 0.0137 0.0512 −0.1743 0.4018 1.6746 9.7450
Note: ΔT is tax expense surprise, measured as total tax expenditure in the current quarter less total tax expenditure in the same quarter from the prior year, divided by
total assets in the same quarter from the prior year. RET is the quarterly stock return. Beta is the standard market beta, calculated as the slope coefficient from a time-
series regression of the excess daily stock return on the excess daily market return during the previous 252 days. Size is the logarithm of equity's market capi-
talization. BM is the book value of equity divided by the market value of equity at the end of each quarter. MOM is the 11-month cumulative stock return leading up
to two months after the company's current fiscal quarter ends. ΔE is earnings surprise, measured as net income in the current quarter less net income in the same
quarter from the prior year, divided by total assets in the same quarter from the prior year. ΔS is sales surprise, measured as sales in the current quarter minus sales in
the same quarter from the prior year, divided by total assets in the same quarter from the prior year. CF/P is the cash flow-to-price ratio, calculated as operating cash
flow per share divided by price per share from the previous fiscal quarter. TCC is the tax change component, calculated as (ETRq−4 − ETRq )*PTEPSq /TAPSq−4 ,
where ETR is the effective tax rate, calculated as tax expense scaled by pretax income, PTEPS is before tax earnings per share, and TAPS is total assets per share.
ΔSGA is the nonmanufacturing cost surprise, measured as sales, general, and administrative expenses in the current quarter less sales, general, and administrative
expenses in the same quarter from the prior year, divided by total assets in the same quarter from the prior year. ΔCOGS is the manufacturing cost surprise, measured
as the cost of goods sold in the current quarter less the cost of goods sold in the same quarter from the prior year divided by total assets in the same quarter from the
prior year. The table presents the mean, standard deviation, 25th percentile, median, 75th percentile, minimum, maximum, skewness, and kurtosis statistics.
Tabulated statistics are calculated as the time-series means of the cross-sectional statistics.

cross-sectional statistics of each variable are presented. The
statistics in the table are the mean, standard deviation, median,
25th and 75th percentiles, minimum, maximum, skewness, and
kurtosis. The average tax expense surprise is 0.07% with a
range between −2.14% and 7.23%. The average quarterly re-
turn is 2.76% with a standard deviation of 24.62%. Note that
the mean market beta is less than one for the typical firm in
emerging countries. The mean value of the book-to-market
ratio is less than one but higher than the corresponding me-
dian of 0.6130. The average momentum return is 15.6%,
almost five times higher than its median value, 2.52%. The
average sample firm shows positive earnings and sales sur-
prises with mean values of 0.24% and 3.26%, respectively. We
find that the cash flow-to-price ratio has a mean value of
0.3796. The mean value is larger than the median because of
the highly skewed (5.9944) and leptokurtic (49.5141) aspect of
this variable. The mean and median values of the tax change
component are both close to zero.
Correlation coefficients for all the variables are shown in
Panel A of Table S1, available online. Surprise in tax expense
and earnings has a correlation of 0.42. Likewise, surprise in tax
expense is slightly positively correlated with surprise in sales,
with a correlation coefficient of 0.32. Stocks that exhibit a large
surprise in tax expense tend to have lower changes in effective
tax rates. The size, market beta, and book-to-market ratio have
low correlations with tax expense surprise. Surprise in tax
expense is positively related to future equity returns. Consistent
with the previous literature on earnings momentum docu-
mented in the US and developed markets, earnings surprise is
positively correlated with future stock returns, albeit the
correlation coefficient is small. Tax expense surprise has a
positive correlation with both nonmanufacturing and
manufacturing costs surprises, with correlations of 0.16 and
0.21, respectively. Earnings surprise and sales surprise have a
correlation of 0.36. Whereas nonmanufacturing costs surprise
(ΔSGA) has a correlation of 0.46 with sales surprise,
manufacturing costs surprise (ΔCOGS ) has a high positive
correlation with sales surprise (over 0.90).12
Panel B of Table S1 (available online) shows the means for
stock-specific characteristics that are used in this paper for
every country, one at a time. Tabulated means are calculated
as the time-series averages of the cross-sectional means. The
average tax expense surprise is between −0.01% and 0.25%.
Argentina has the highest mean tax expense surprise, whereas
Greece has the lowest. The mean quarterly stock return ranges
between −1.34% in Nigeria and 4.38% in Peru. Caution is
needed when comparing the mean returns across countries,
because the sample periods do not overlap for all of them. In
thirteen countries, the book-to-market ratio is less than one,
suggesting that the market capitalization is less than book
equity in almost half the countries examined. Chinese firms
have the lowest book-to-market ratio (0.4034), and the Czech
companies have the highest (2.6944). The highest mean mo-
mentum return for companies is in the Philippines and
Argentina. As in the pattern for tax expense surprise,
Argentina (Greece) has the highest (lowest) mean surprise in
12
When constructing the regression specification, high correlations among
variables mentioned above are taken into account to eliminate the possibility of
multicollinearity.

5
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A.D. Gunaydin
earnings. A similar pattern is documented for sales surprise.
The highest cash flow-to-price ratio is found in South Africa
and Russia, at 1.9194 and 1.02, respectively. All countries
except Chile have experienced positive mean changes in the
effective tax rate. Surprise in nonmanufacturing
(manufacturing) cost is small in magnitude and varies be-
tween 0.08% (0.61%) and 1.09% (5.4%).
To examine the impact of nonlinearity on the correlations
between change in tax expense and other stock-specific control
variables, we group stocks each quarter into quintiles based on
tax expense surprise and calculate the time-series average of
the cross-sectional means for various stock-specific character-
istics for each quintile. These results are presented in Table 2.
The tax expense surprise rises mechanically as one moves from
Portfolio 1 to Portfolio 5. The average surprise in tax expense
for Portfolio 1 is −0.73% and that of Portfolio 5 is 0.98%. The
second row indicates that stocks with high tax expense surprise
also have high contemporaneous returns in the same quarter,
and the relationship is rather monotonic across the quintiles.
The mean market beta for Portfolio 1 (Portfolio 5) is 0.6548
and 0.6419, proving that equities with higher tax expense
surprise are slightly less sensitive to market fluctuations. Eq-
uities with higher surprise in tax expense tend to be larger,
although not monotonic, and have slightly lower book-to-
market equity ratios. The mean momentum return spread be-
tween the extreme tax expense surprise portfolios is close to
29%. Table 2 also reveals a positive and monotonic association
between change in tax expense and change in earnings. Similar
findings are obtained for sales surprise. Stocks that exhibit
higher surprise in tax expense tend to have lower changes in
effective tax rates and higher cash flow-to-price ratios. The
results also show that surprise in tax expense is positively
autocorrelated, indicating that tax expense surprise is a
persistent stock characteristic. Moreover, stocks with higher tax
expense surprise tend to experience higher earnings and sales
surprises in the next quarter, although the effect is more pro-
nounced for sales surprise. These findings align with the hy-
pothesis that stock prices do not include the full information
revealed by tax expense thoroughly and immediately, resulting
in a gradual price reaction. Therefore, we argue that these
findings provide initial support for the value relevance of
positive tax expense surprise.
3. Empirical results
3.1. Univariate portfolio analysis
In this section, we employ discrete univariate portfolio-level
analyses by grouping stocks into quintiles each quarter based
on tax expense surprise and six-month-ahead equal- and value-
weighted returns, and alphas are calculated for every quintile
portfolio in each region to examine whether the long-short
portfolio that takes a long position in the high-tax-expense-
surprise stocks and a short position in the low-tax-expense-
surprise stocks generates a significant return. Panels A and B
of Table 3 document findings for equal- and value-weighted
portfolio returns, respectively.
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For the equal-weighted portfolio returns, as shown in Panel
A of Table 3, the findings reveal that stocks with a higher tax
expense surprise earn higher returns than those with a lower tax
expense surprise in the full sample of emerging market stocks,
and the relationship is almost monotonic. For the full sample,
the portfolio of stocks with a low-tax-expense surprise gener-
ates a positive average monthly return of 0.34%, whereas the
average monthly return on the portfolio of stocks with a high-
tax-expense surprise is positive at 1.40%. The zero-investment
portfolio earns an average return of 1.06% per month (12.72%
per year) with a t-statistic of 4.47. The corresponding alpha
spread associated with the hedge portfolio is 0.93% per month
with a t-statistic of 5.00. Examining each region separately, we
observe that the value relevance of tax expense surprise shows
up almost uniformly in each region, and the findings docu-
mented in the full sample are not driven by specific regions.
For European stocks, the zero-investment portfolio generates a
mean return of 1.01% per month with a t-statistic of 2.92. The
associated abnormal return spread is 0.88% per month with a t-
statistic of 2.10. Likewise, stocks in the high-tax-expense-
surprise portfolio generate a 0.83% higher average monthly
return than those in the low-tax-expense-surprise portfolio in
Asia with a t-statistic of 6.60. The alpha value associated with
this return is 0.91% per month (t-stat. = 7.25). Similar results
are observed in Latin America and Africa. The zero-investment
portfolio earns 0.97% (t-stat. = 2.50) and 1.93% (t-stat. = 5.44)
per month, and the associated abnormal returns are 1.19% (t-
stat. = 2.91) and 1.47% (t-stat. = 3.96) per month in Latin
America and Africa, respectively. Furthermore, the results
indicate that the significant link between tax expense surprise
and future stock returns is attributed mainly to the over-
performance of positive-tax-expense-surprise stocks (i.e.,
undervalued stocks with a high-tax-expense surprise), implying
that the tax-expense-surprise effect is driven by investor de-
mand for companies with a positive tax expense surprise,
resulting in overperformance and high future returns for such
stocks.13
13
In untabulated results, we divide the full sample into two based on the sign
of tax expense surprise each quarter and recalculate Panel A of Table 3 for
these two subsamples to understand whether stocks respond differently to the
positive or negative tax surprise news. In the negative tax-expense-surprise
sample, portfolio 1 includes stocks with the most negative tax expense sur-
prise and portfolio 5 includes stocks with the least negative tax expense sur-
prise. In this subsample, the hedge portfolio earns an average return of 0.54%
per month with a t-statistic of 1.98. The predictive power of tax expense sur-
prise is driven by neither the overperformance of stocks in portfolio 5 nor the
underperformance of stocks in portfolio 1. In the positive tax-expense-surprise
sample, portfolio 1 includes stocks with the least positive tax expense surprise,
and portfolio 5 includes stocks with the most positive tax expense surprise. In
this subsample, the hedge portfolio earns an average return of 0.88% per month
with a t-statistic of 2.85. The predictive power of tax expense surprise in the
positive tax expense surprise subsample is driven by the overperformance of
stocks in portfolio 5 (1.70% per month, t-stat. = 3.36) however, the predictive
power is slightly undermined by the overperformance of the stocks in portfolio
1 (0.82% per month, t-stat. = 1.65). These subsample results indicate that
stocks with high positive (less negative) tax expense surprise generate higher
future returns than stocks with low positive (more negative) tax expense
surprise.
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examining each region separately using value-weighted port-

Table 2
Average portfolio characteristics of equities sorted by the tax expense surprise.
folio sorts, we observe that the positive and significant rela-
tionship between change in tax expense and expected returns
Port1 Port2 Port3 Port4 Port5 High-Low
remains intact in each region, except Europe. The value-
ΔT −0.0073 −0.0010 0.0002 0.0018 0.0098 weighted zero-cost hedge portfolio earns 0.74% per month
RET(q) 0.0003 0.0334 0.0363 0.0461 0.0959 0.0957
(3.99)
for Asian stocks with a t-statistic of 3.89. The alpha associated
Beta 0.6548 0.6176 0.6370 0.6297 0.6419 −0.0128 with this strategy is 0.84% per month with a t-statistic of 4.45.
(−1.86) In addition, stocks in the highest tax expense surprise quintile
Size 4.8100 5.2475 5.4440 5.3377 4.9823 0.1724 generate 1.01% (t-stat. = 2.02) higher risk-adjusted monthly
(5.69) return than those in the lowest tax expense surprise quintile in
BM 1.4366 1.2886 1.1688 1.3148 1.3342 −0.1025
(−0.68)
Latin America. The value-weighted zero-cost hedge portfolio
MOM 0.0706 0.1052 0.1409 0.1881 0.3590 0.2884 generates 1.57% per month (t-stat. = 3.49), and the associated
(9.32) alpha is 1.59% per month (t-stat. = 3.22) in Africa. These re-
ΔE −0.0092 −0.0015 0.0011 0.0038 0.0174 0.0266 sults provide additional support for the notion that tax expense
(22.14) surprise contains value-relevant information for expected eq-
ΔS 0.0060 0.0108 0.0187 0.0370 0.0964 0.0904
(25.20)
uity returns in emerging countries.
CF/P 12.0234 32.3356 3.7209 9.1504 24.1522 12.1288
(2.79) 3.2. Bivariate portfolio analysis
TCC 0.0043 0.0013 0.0002 −0.0007 −0.0030 −0.0072
(−11.84) In this subsection, we investigate the possibility that cau-
ΔSGA 0.0061 0.0036 0.0031 0.0042 0.0135 0.0074
(3.19)
sality might have played a significant role in the strong rela-
ΔCOGS 0.0166 0.0096 0.0182 0.0331 0.0636 0.0470 tionship between tax expense surprise and expected equity
(19.22) returns. To investigate this possibility, we use two-stage 5 × 5
ΔT (q+1) −0.0010 0.0000 0.0003 0.0008 0.0032 0.0042 bivariate dependent analyses based on different stock-specific
(10.49) control variables and tax expense surprise.14 Table 4 (Table
ΔE (q+1) −0.0035 −0.0001 0.0012 0.0024 0.0086 0.0122
(7.44)
S2, available online) presents equal- (value-)weighted time-
ΔS (q+1) 0.0220 0.0169 0.0197 0.0333 0.0697 0.0478 series average returns of these portfolios for each quintile of
(17.75) tax expense surprise, as well as the extreme portfolio differ-
Note: This table displays average portfolio characteristics for stock quintiles ences and the corresponding alphas. In each table, the first
formed quarterly based on the tax expense surprise (ΔT). Portfolio 1 is the column shows the control variable.
collection of stocks in the full sample in the lowest tax-expense-surprise For the equal-weighted portfolio returns, as reported in
quintile, and portfolio 5 is the collection of stocks in the full sample in the Table 4, the findings indicate that portfolio returns display an
highest tax-expense-surprise quintile. The table shows the time-series means of
the quarterly averages for ΔT and various stock-specific characteristics for each
ascending pattern across tax expense surprise quintiles for all
portfolio. The last column reports the differences for the stock-specific char- first-step control variables. For example, when the market beta
acteristics between the extreme quintiles and the associated t-statistics. ΔT and is used as the control variable, the combined portfolio of eq-
the stock-specific characteristics are detailed in Table 1. uities with the lowest tax expense surprise generates an equal-
weighted return of 0.38% per month, whereas the mean equal-
weighted monthly return on the combined portfolio of equities
The equal-weighted portfolio sorts provide initial support with the highest tax expense surprise is significantly positive at
for the hypothesis that the positive surprise in tax expense is 1.54%. The hedge portfolio earns on average 1.16% per month
incrementally value relevant in explaining the cross-sectional with a t-statistic of 7.92. The corresponding abnormal return
expected equity returns in emerging countries. To entertain associated with the hedge portfolio is 0.99% per month with a
the possibility that penny stocks might drive these results, we t-statistic of 7.51. The remaining results indicate that the value
reconstruct the univariate portfolios using the value-weighted relevance of tax expense surprise also persists for other first-
returns. These findings are shown in Panel B of Table 3. The stage control variables. The hedge portfolio spreads between
results illustrate that stocks with a higher tax expense surprise the extreme tax expense surprise quintiles range between
generate higher returns than those with a lower tax expense 0.47% per month with a t-statistic of 3.84 (for earnings sur-
surprise in the full sample of emerging market equities, and the prise) and 1.44% per month with a t-statistic of 6.71 (for
relationship is again monotonic. For the full sample, the port- manufacturing cost surprise). The corresponding alpha spreads
folio of equities with the lowest tax expense surprise loses a
value-weighted mean return of 0.02% per month, whereas the
mean value-weighted monthly return on the portfolio of eq- 14
First, all the stocks in the sample are grouped into quintile portfolios based
uities with the highest tax expense surprise is positive at on an increasing order of control variables each quarter. Next, all stocks are
0.65%. The zero-cost hedge portfolio earns on average 0.67% conditionally sorted into additional quintiles within each control variable
per month (8.04% per year) with a t-statistic of 3.42. The quintile based on tax expense surprise. These conditional bivariate sorts yield
25 double-sorted portfolios. Lastly, each quarter, within each quintile of tax
corresponding abnormal return spread associated with the expense surprise, six-month-ahead equal- and value-weighted average portfolio
hedge portfolio is 0.79% per month with a t-statistic of 3.97. In returns are calculated across all quintiles of the control variable.

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Table 3
Univariate portfolio analysis for regions.
Port1 Port2 Port3 Port4 Port5 High-Low FF5 Alpha
Panel A. Equal-Weighted Returns
Full Sample ΔT −0.0073 −0.0010 0.0002 0.0018 0.0099
RET 0.0034 0.0068 0.0085 0.0099 0.0140 0.0106 0.0093
(0.75) (1.35) (1.70) (2.04) (2.75) (4.47) (5.00)
Europe ΔT −0.0100 −0.0018 0.0001 0.0027 0.0131
RET 0.0057 0.0055 0.0043 0.0113 0.0159 0.0101 0.0088
(0.80) (0.76) (0.58) (1.64) (2.24) (2.92) (2.10)
Asia ΔT −0.0057 −0.0008 0.0003 0.0018 0.0078
RET 0.0027 0.0067 0.0071 0.0078 0.0110 0.0083 0.0091
(0.55) (1.22) (1.23) (1.40) (2.07) (6.60) (7.25)
Latin America ΔT −0.0099 −0.0013 0.0004 0.0024 0.0136
RET 0.0075 0.0144 0.0113 0.0126 0.0172 0.0097 0.0119
(1.25) (2.08) (2.24) (2.28) (2.71) (2.50) (2.91)
Africa ΔT −0.0092 −0.0008 0.0009 0.0033 0.0132
RET 0.0014 0.0100 0.0124 0.0191 0.0208 0.0193 0.0147
(0.27) (1.96) (2.37) (3.20) (3.21) (5.44) (3.96)
Panel B. Value-Weighted Returns
Full Sample ΔT −0.0073 −0.0010 0.0002 0.0018 0.0099
RET −0.0002 0.0035 0.0046 0.0054 0.0065 0.0067 0.0079
(−0.04) (0.73) (0.91) (1.14) (1.28) (3.42) (3.97)
Europe ΔT −0.0100 −0.0018 0.0001 0.0027 0.0131
RET 0.0085 0.0094 −0.0024 0.0110 0.0110 0.0025 0.0061
(1.27) (1.28) (−0.28) (1.57) (1.66) (0.74) (1.61)
Asia ΔT −0.0057 −0.0008 0.0003 0.0018 0.0078
RET 0.0007 0.0036 0.0053 0.0055 0.0081 0.0074 0.0084
(0.13) (0.63) (0.92) (0.94) (1.37) (3.89) (4.45)
Latin America ΔT −0.0099 −0.0013 0.0004 0.0024 0.0136
RET 0.0078 0.0096 0.0118 0.0070 0.0197 0.0119 0.0101
(1.13) (1.74) (2.39) (1.33) (2.78) (1.68) (2.02)
Africa ΔT −0.0092 −0.0008 0.0009 0.0033 0.0132
RET 0.0001 0.0069 0.0130 0.0166 0.0158 0.0157 0.0159
(0.01) (1.38) (2.66) (2.92) (2.60) (3.49) (3.22)
Notes: This table displays findings from univariate portfolio sorts based on the tax expense surprise (ΔT ). The quintile portfolios are constructed each month from
January 2001 to September 2019. Portfolio 1 contains stocks in the full sample in the lowest tax-expense-surprise quintile, and portfolio 5 contains stocks in the full
sample in the highest tax-expense-surprise quintile. The table presents the six-month-ahead returns for every portfolio. The last two columns present the monthly
returns and alpha spreads between the extreme portfolios. FF5 Alpha is the constant term from a regression of extreme portfolio return spreads on the market, size,
book-to-market, investment, and profitability factors for emerging countries calculated by Fama and French (2017). Panel A displays equal-weighted portfolio
returns, and Panel B displays value-weighted portfolio returns. ΔT is detailed in Table 1. The table reports adjusted t-statistics in parentheses using the Newey and
West (1987) methodology.

associated with hedge portfolios range between 0.41% per
month with a t-statistic of 3.40 (for earnings surprise) and
1.19% per month with a t-statistic of 6.54 (for nonmanufac-
turing cost surprise).
The findings for value-weighted portfolio returns are similar
to the previous results, and they are displayed in Table S2
(available online). The findings show that, even after
numerous stock-specific characteristics are controlled for, the
strong and positive relationship between tax expense shock and
expected stock returns persists for value-weighted returns. The
hedge portfolio spreads between the extreme tax expense sur-
prise quintiles range between 0.20% per month with a t-statistic
of 1.83 (for earnings surprise) and 1.33% per month with a t-
statistic of 5.02 (for manufacturing cost surprise). The corre-
sponding alpha spreads associated with hedge portfolios range
between 0.26% per month with a t-statistic of 2.10 (for earn-
ings surprise) and 1.13% per month with a t-statistic of 3.75
(for the cash flow-to-price ratio). These findings document that
the value relevance of tax expense surprise cannot be explained
by other stock-specific characteristics.
3.3. Regression analysis
In this section, we perform quarterly stock-level cross-
sectional regressions to test whether the tax expense surprise
carries unique information that is not captured by other stock-
specific control variables. The two-quarter-ahead stock return is
used as the dependent variable, and tax expense surprise as
well as various stock-specific characteristics are used as the
independent variables. Following Asparouhova et al. (2013),
each quarterly predictive cross-sectional regression is per-
formed using either the OLS methodology or the WLS meth-
odology, in which every variable is scaled by the realized gross
stock return during the prior quarter.

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Table 4 coefficient of 1.3028 with a t-statistic of 4.51. Adding the

Bivariate portfolio analysis. remaining control variables to the regression does not alter the
Port1 Port2 Port3 Port4 Port5 High-Low FF5 Alpha positive link between tax expense surprise and expected eq-
Beta 0.0038 0.0073 0.0081 0.0117 0.0154 0.0116 0.0099 uity returns. The coefficients of tax expense surprise are be-
(0.81) (1.49) (1.65) (2.52) (3.15) (7.92) (7.51) tween 0.8660 and 1.5855 in the regressions in columns 2 and
Size 0.0038 0.0061 0.0103 0.0109 0.0129 0.0091 0.0082 10, with t-statistics ranging from 3.01 to 5.35. Overall, these
(0.80) (1.27) (2.06) (2.24) (2.59) (4.37) (4.87)
BM 0.0030 0.0082 0.0087 0.0111 0.0142 0.0112 0.0098
findings provide additional evidence that the relationship be-
(0.64) (1.57) (1.75) (2.35) (2.86) (6.44) (7.24) tween tax expense surprise and expected equity returns re-
MOM 0.0029 0.0083 0.0096 0.0108 0.0127 0.0098 0.0092 mains significant after other predictors of cross-sectional
(0.62) (1.67) (1.94) (2.23) (2.60) (5.22) (6.81) stock returns are incorporated into the regression
ΔE 0.0060 0.0080 0.0092 0.0087 0.0107 0.0047 0.0041 specifications.
(1.27) (1.61) (1.83) (1.75) (2.31) (3.84) (3.40)
ΔS 0.0044 0.0068 0.0105 0.0098 0.0121 0.0078 0.0089
(0.94) (1.35) (2.15) (1.95) (2.55) (4.21) (6.92) 3.4. The role of tax enforcement
CF/P 0.0008 0.0072 0.0085 0.0122 0.0149 0.0140 0.0117
(0.17) (1.29) (1.56) (2.23) (2.73) (6.88) (5.79) Our main result is that investors initially underreact to un-
TCC 0.0035 0.0075 0.0101 0.0130 0.0167 0.0132 0.0116 expected positive tax expense shocks, therefore, equities
(0.77) (1.58) (1.96) (2.71) (3.35) (8.55) (6.29)
ΔSGA 0.0035 0.0079 0.0110 0.0110 0.0176 0.0141 0.0119
experience abnormally positive future returns until the mis-
(0.69) (1.36) (1.89) (2.07) (3.40) (5.50) (6.54) pricing disappears. We now examine the role of tax enforce-
ΔCOGS 0.0028 0.0100 0.0096 0.0126 0.0172 0.0144 0.0112 ment on the predictive power of tax expense surprise over
(0.54) (1.85) (1.78) (2.49) (3.52) (6.71) (6.39) future stock returns and test whether tax enforcement can
Notes: This table displays return comparisons from bivariate portfolios based provide a complementary explanation to the main findings. We
on dependent two-stage sorts of different stock-specific characteristics and the investigate the hypothesis that higher tax enforcement increases
tax expense surprise (ΔT). First, all equities are sorted into five quintile port- the accuracy of information, thus, one would expect to find a
folios in increasing order of various stock-specific characteristics at the end of
each quarter. Next, within each stock-specific characteristic quintile, all equities
greater predictive power of tax expense surprise in countries
are again sorted into five additional quintile portfolios based on the tax expense with higher tax enforcement and a relatively flat relationship
surprise. Portfolio 1 is the collection of all equities in the sample with the between tax expense shock and equity returns in countries with
lowest tax expense surprise within each stock-specific characteristic quintile, lower tax enforcement. We use country-level tax evasion index
whereas Portfolio 5 is the collection of all equities in the sample with the data that is measured annually to proxy for tax enforcement.15
highest tax expense surprise within each stock-specific characteristic quintile.
The table displays the six-month-ahead equal-weighted portfolio returns for
This index allows us to monitor the impact of changes in tax
each quintile. The last two columns report the monthly returns and alpha regulations on tax expense surprise. It also enables us to
spreads between the extreme portfolios. FF5 Alpha is the constant term from a analyze the same country at different stages, when tax regu-
regression of extreme portfolio return spreads on the market, size, book-to- lations are different. Higher values in the tax evasion index
market, investment, and profitability factors for emerging countries calculated imply greater tax enforcement.
by Fama and French (2017). ΔT and stock-specific variables are detailed in
Table 1. The table reports adjusted t-statistics in parentheses using the Newey
We present evidence using both univariate portfolio and
and West (1987) methodology. regression analyses. Specifically, all countries in the sample
are sorted into two groups every year based on their tax
enforcement scores. The median tax enforcement score across
countries in each year is used as the threshold. The high tax
Table 5 presents the predictive regression estimations for the enforcement group consists of countries with high tax
OLS methodology. In the first column of Table 5, tax expense enforcement scores, and the low tax enforcement group
surprise has a significant and positive slope of 1.3530 with a t- comprises countries with low tax enforcement scores. Panels
statistic of 5.49. Then, we expand the univariate regression by A and B of Table 6 present evidence for these two groups,
appending an additional control variable one at a time. Col- respectively. The results for the high tax enforcement coun-
umns 2 to 10 report these results. The coefficients of tax tries, as shown in Panel A, show that stocks with higher tax
expense surprise range between 0.8670 and 1.9761 in these expense surprise generate higher returns than those with lower
regressions, and they are all statistically significant, with t- tax expense surprise. The hedge portfolio generates an equal-
statistics ranging from 2.99 to 6.43. When all stock-specific weighted (value-weighted) average return of 1.02% (0.78%)
variables are controlled for in the regression (column 10), the per month with a t-statistic of 7.37 (4.18), and the corre-
slope coefficient of tax expense surprise is highly significant, sponding alpha spread associated with the hedge portfolio is
with a value of 1.9761 (t-stat. = 2.99). These findings indicate 0.94% (0.76%) per month with a t-statistic of 6.31 (3.56). The
that tax expense surprise has distinct and value-relevant in- findings paint a different picture for countries with low tax
formation for explaining the cross-sectional expected equity enforcement. The arbitrage portfolio earns an equal-weighted
returns.
Next, we re-estimated the regression coefficients using the
WLS methodology. These findings are reported in Table S3 15
Because this index is not available for Bangladesh, Egypt, Morocco,
(available online). In the univariate regression specification, Nigeria, Pakistan, Sri Lanka, and Vietnam, these countries are excluded from
tax expense surprise has a strong positive regression the analysis.

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Table 5
Stock-level cross-sectional regression analysis.
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
ΔT 1.3530 1.3972 1.4235 1.4847 1.3380 0.8670 0.9337 0.9028 1.5176 1.9761
(5.49) (5.95) (6.43) (6.33) (6.08) (3.58) (3.26) (3.70) (5.57) (2.99)
Beta −0.0082 −0.0091 −0.0124 −0.0172 −0.0170 −0.0165 −0.0195 −0.0230 −0.0249
(−0.60) (−0.73) (−1.02) (−1.54) (−1.52) (−1.45) (−1.68) (−1.82) (−1.72)
Size −0.0071 −0.0058 −0.0052 −0.0053 −0.0053 −0.0066 −0.0057 −0.0068
(−1.41) (−1.31) (−1.30) (−1.34) (−1.33) (−1.44) (−1.57) (−1.55)
Log (BM) 0.0053 0.0055 0.0053 0.0054 0.0061 0.0071 0.0066
(2.18) (2.39) (2.18) (2.25) (2.32) (2.49) (2.22)
MOM 0.0065 0.0045 0.0041 0.0062 0.0111 0.0064
(0.56) (0.39) (0.36) (0.54) (0.82) (0.47)
ΔE 0.2848 0.2872 0.3452 0.4165 0.4054
(5.41) (5.31) (5.73) (2.89) (3.31)
ΔS 0.0023 0.0159 −0.0078 0.0363
(0.22) (1.28) (-0.62) (1.12)
CF/P 0.0000 0.0000 0.0000
(-0.08) (-0.68) (0.30)
TCC 0.3081 0.9746
(1.88) (1.66)
ΔSGA −0.0499
(-0.53)
Intercept 0.0293 0.0390 0.0724 0.0713 0.0632 0.0637 0.0636 0.0710 0.0753 0.0818
(2.02) (2.23) (3.07) (3.16) (3.02) (3.05) (3.08) (3.40) (4.16) (4.06)
Avg R2 0.0051 0.0297 0.0604 0.0669 0.0792 0.0829 0.0856 0.1012 0.1197 0.1453
Notes: This table displays findings from cross-sectional regressions of two-quarter-ahead equity returns on the tax expense surprise and various control variables. The
table displays findings using the ordinary least squares (OLS) methodology. Displayed slope coefficients are time-series means from the quarterly Fama-MacBeth
(1973) cross-sectional regressions, and the corresponding Newey and West (1987) adjusted t-statistics are reported in parenthesis. The average adjusted R-squared
statistics for each cross-sectional regression are reported at the end of the table. ΔT and all control variables are detailed in Table 1.

(value-weighted) average return of 0.66% (0.35%) per month 4. Robustness checks

with an insignificant t-statistic of 1.28 (0.48), and the corre-
sponding alpha spread associated with the arbitrage portfolio
is 0.12% (−0.36%) per month with an insignificant t-statistic
of 0.24 (−0.52). These initial findings are consistent with the
prediction that tax expense surprise incorporates incremental
information only in countries with higher tax enforcement.16
Next, we repeat the quarterly cross-sectional regressions for
high and low tax enforcement countries. These results are
presented in Table S4 (available online). In Panel A, for
countries with high tax enforcement, the average slope co-
efficients of tax expense surprise are between 1.0046 and
2.1010, with t-statistics ranging from 4.05 to 6.45. In Panel B,
the results show that the coefficients of tax expense surprise are
statistically insignificant for countries with low tax enforce-
ment. These results provide additional support for the view that
tax enforcement plays a significant role in the additional value
relevance of tax expense surprise because higher tax enforce-
ment validates the valuable information revealed by tax
expense.
16
These findings are in line with the previous literature. Using a sample of 15
developed countries, Kerr (2019) shows that tax expense information is more
valuable in countries with high tax enforcement. In general, because the level of
information asymmetry is greater in emerging countries than in developed
countries, it is reasonable to predict that the incremental value relevance of tax
expense surprise is more significant and the return spread between higher and
lower tax enforcement groups is wider in emerging countries.
4.1. Orthogonalization with respect to earnings surprise
Several previous studies show a significant relationship
between unexpected earnings and future stock returns
(Bernard & Thomas, 1989; Foster et al., 1984). To ensure that
the significance of tax expense surprise is not driven by
earnings surprise, we use two-stage bivariate sorts that keep
earnings surprise flat across tax expense surprise quintiles in
Table 4 and control for earnings surprise in the stock-level
cross-sectional regressions in Table 5. Because the funda-
mental motivation of this study is to test the additional value
relevance of change in tax expense, we conduct a robustness
check in this section by orthogonalizing tax expense surprise
via quarterly cross-sectional regressions of tax expense sur-
prise on earnings surprise. The error term in these regressions
is denoted ΔT_orth. Specifically, the following quarterly
cross-sectional regression is estimated in each country at the
end of each quarter,
ΔT = α + β ΔE + ε (3)
Next, we conduct univariate and bivariate portfolio analyses
based on orthogonalized tax expense surprise to test whether
ΔT_orth still has a predictive power over expected equity
returns. The findings from univariate and bivariate portfolio
analyses are presented in Table 7 and Table S5 (available on-
line), respectively.

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Table 6 has a positive mean return of 0.76% (t-stat. = 5.05). The FF5
The effect of tax enforcement. alpha of the hedge portfolio is 0.61% (t-stat. = 4.18). We
EW Returns VW Returns further observe that the value relevance of orthogonalized un-
Panel A: Countries with High Tax Enforcement expected tax expense is again evident in each region, and the
Port1 0.0032 0.0014 results documented in the full sample are not driven by specific
(0.75) (0.30) regions. The High-Low ΔT_orth hedge portfolio spreads range
Port2 0.0070 0.0041
(1.58) (0.89)
between 0.48% (t-stat. = 3.95) in Asia and 1.51% (t-
Port3 0.0094 0.0051 stat. = 4.76) in Africa. The associated FF5 alphas of the hedge
(2.07) (1.08) portfolios range between 0.63% (t-stat. = 5.50) in Asia and
Port4 0.0098 0.0059 0.93% (t-stat. = 3.15) in Europe.
(2.15) (1.15) Next, we calculate the value-weighted returns for ΔT_orth
Port5 0.0134 0.0091
(2.98) (1.90)
sorted portfolios, and these findings are documented in Panel B
High-Low 0.0102 0.0078 of Table 7. The findings reveal that stocks with higher
(7.37) (4.18) orthogonalized tax expense surprise generate higher returns
FF5 Alpha 0.0094 0.0076 than those with lower orthogonalized tax expense surprise. For
(6.31) (3.56) the full sample, the portfolio of equities with a low orthogo-
Panel B: Countries with Low Tax Enforcement
Port1 0.0078 0.0064
nalized tax expense surprise has a monthly average return of
(1.13) (0.94) 0.17%, whereas the mean monthly return on the portfolio of
Port2 0.0168 0.0129 equities with a high orthogonalized tax expense surprise is
(2.02) (1.80) 0.75%. The High-Low ΔT_orth hedge portfolio has a positive
Port3 0.0111 0.0107 average return of 0.59% (t-stat. = 3.02) with FF5 alpha of
(1.56) (1.40)
Port4 0.0159 0.0125
0.65% (t-stat. = 2.69). The results remain robust for each
(2.36) (1.73) geographic region. The High-Low ΔT_orth hedge portfolio
Port5 0.0144 0.0099 spreads are between 0.51% (t-stat. = 2.80) in Asia and 1.23%
(1.65) (0.99) (t-stat. = 3.58) in Africa. The corresponding FF5 alphas of the
High-Low 0.0066 0.0035 hedge portfolios are between 0.61% (t-stat. = 3.19) in Asia and
(1.28) (0.48)
FF5 Alpha 0.0012 −0.0036
1.08% (t-stat. = 2.58) in Africa.
(0.24) (−0.52) To further check the value relevance of tax expense surprise,
Notes: This table displays univariate portfolio sorts based on the tax expense
we form bivariate portfolios based on dependent double sorts
surprise for countries with high tax enforcement and low tax enforcement. The of each stock-specific variable and ΔT_orth.17 Panel A of Table
high-tax-enforcement group consists of countries with high tax enforcement S5 (available online) shows that the combined portfolio of
scores, and the low-tax-enforcement group comprises countries with low tax stocks with the highest orthogonalized tax expense surprise
enforcement scores. The median tax enforcement score across countries in each within each stock-specific control variable quintile has a
year is used as the cutoff point to determine the country groups. Portfolio 1
contains stocks in the full sample in the lowest tax-expense-surprise quintile,
significantly higher equal-weighted return than the combined
and portfolio 5 contains stocks in the full sample in the highest tax-expense- portfolio of the stocks with the lowest orthogonalized tax
surprise quintile. The table presents the six-month-ahead returns for every expense surprise within each stock-specific control variable
quintile portfolio. The last two rows in each panel display the monthly returns quintile. The High-Low ΔT_orth arbitrage portfolio returns are
and alpha spread between the extreme portfolios. FF5 Alpha is the constant between 0.33% (t-stat. = 1.98) for sales surprise and 1.12% (t-
term from a regression of extreme portfolio return spreads on the market, size,
book-to-market, investment, and profitability factors for emerging countries
stat. = 3.70) for nonmanufacturing cost surprise. The corre-
calculated by Fama and French (2017). Tax expense surprise is detailed in sponding FF5 alphas of the arbitrage portfolio are between
Table 1. The table displays adjusted t-statistics in parentheses using the Newey 0.39% (t-stat. = 3.66) for sales surprise and 0.95% (t-
and West (1987) methodology. stat. = 4.37) for nonmanufacturing cost surprise. Finally, Panel
B of Table S5 documents that the combined portfolio of stocks
with the highest orthogonalized tax expense surprise within
Panel A of Table 7 shows equal-weighted portfolio returns each stock-specific control variable quintile has a significantly
using ΔT_orth as the sort variable. For all regions, the results higher value-weighted return than the combined portfolio of
show that the average values of ΔT_orth range from −0.0101 the stocks with the lowest orthogonalized tax expense surprise
for quintile 1 to 0.0113 for quintile 5. The results for average within each stock-specific control variable quintile. The High-
returns show that stocks with higher orthogonalized tax Low ΔT_orth arbitrage portfolio returns are between 0.40% (t-
expense surprise generate higher returns than those with lower stat. = 2.45) for sales surprise and 0.98% (t-stat. = 3.83) for
orthogonalized tax expense surprise in the full sample, and the manufacturing cost surprise. The corresponding FF5 alphas of
relationship is again nearly monotonic. In the full sample, the the arbitrage portfolio are between 0.46% (t-stat. = 2.14) for
portfolio of stocks with a low orthogonalized tax expense
surprise generates a positive average return of 0.48%, whereas
the monthly mean return on the portfolio of stocks with a high 17
Because the earnings surprise is used in the regressions to estimate the
orthogonalized tax expense surprise is positive at 1.24%. We orthogonalized tax expense surprise, we do not control for the earnings surprise
also find that the High-Low ΔT_orth zero-investment portfolio in the bivariate portfolio analysis.

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Table 7
Univariate portfolio analysis for regions using orthogonalized tax expense surprise.
Port1 Port2 Port3 Port4 Port5 High-Low FF5 Alpha
Panel A. Equal-Weighted Returns
Full Sample ΔT_orth −0.0075 −0.0015 −0.0002 0.0012 0.0079
RET 0.0048 0.0091 0.0088 0.0089 0.0124 0.0076 0.0061
(1.01) (1.82) (1.73) (1.87) (2.51) (5.05) (4.18)
Europe ΔT_orth −0.0097 −0.0022 −0.0002 0.0023 0.0108
RET 0.0050 0.0066 0.0077 0.0084 0.0149 0.0099 0.0093
(0.65) (0.97) (1.10) (1.16) (2.02) (2.86) (3.15)
Asia ΔT_orth −0.0060 −0.0013 −0.0001 0.0012 0.0064
RET 0.0053 0.0062 0.0095 0.0089 0.0101 0.0048 0.0063
(1.09) (1.14) (1.70) (1.73) (1.96) (3.95) (5.50)
Latin America ΔT_orth −0.0101 −0.0020 −0.0002 0.0017 0.0113
RET 0.0109 0.0127 0.0112 0.0121 0.0177 0.0068 0.0076
(1.65) (2.38) (2.20) (2.15) (2.33) (1.94) (2.80)
Africa ΔT_orth −0.0096 −0.0019 −0.0001 0.0018 0.0100
RET 0.0026 0.0098 0.0158 0.0177 0.0177 0.0151 0.0087
(0.46) (1.86) (3.06) (2.94) (2.79) (4.76) (2.10)
Panel B. Value-Weighted Returns
Full Sample ΔT_orth −0.0075 −0.0015 −0.0002 0.0012 0.0079
RET 0.0017 0.0003 0.0067 0.0041 0.0075 0.0059 0.0065
(0.38) (0.07) (1.35) (0.83) (1.55) (3.02) (2.69)
Europe ΔT_orth −0.0101 −0.0024 −0.0002 0.0024 0.0110
RET 0.0046 0.0132 0.0079 0.0063 0.0136 0.0091 0.0085
(0.59) (1.73) (1.11) (0.72) (1.92) (1.83) (1.82)
Asia ΔT_orth −0.0060 −0.0013 −0.0001 0.0012 0.0064
RET 0.0033 0.0038 0.0078 0.0080 0.0084 0.0051 0.0061
(0.60) (0.65) (1.34) (1.42) (1.44) (2.80) (3.19)
Latin America ΔT_orth −0.0100 −0.0020 −0.0002 0.0016 0.0111
RET 0.0082 0.0120 0.0104 0.0082 0.0159 0.0078 0.0068
(1.24) (2.27) (1.91) (1.45) (2.77) (1.98) (2.04)
Africa ΔT_orth −0.0096 −0.0019 −0.0001 0.0018 0.0100
RET 0.0010 0.0047 0.0164 0.0156 0.0133 0.0123 0.0108
(0.16) (0.93) (3.44) (2.62) (2.23) (3.58) (2.58)
Notes: This table displays findings from univariate portfolio sorts based on the orthogonalized tax expense surprise (ΔT_orth). ΔT_orth is the orthogonalized tax
expense surprise calculated as the residual term from the quarterly cross-sectional regressions of change in tax expense on change in earnings in each country. The
quintile portfolios are constructed each month from January 2001 to September 2019. Portfolio 1 contains stocks in the full sample in the lowest orthogonalized tax-
expense-surprise quintile, and portfolio 5 contains stocks in the full sample in the highest orthogonalized tax-expense-surprise quintile. The table presents the six-
month-ahead returns for every quintile portfolio. The last two columns present the monthly return and abnormal return spreads between the extreme portfolios. FF5
Alpha is the constant term from a regression of extreme portfolio return spreads on the market, size, book-to-market, investment, and profitability factors for
emerging countries calculated by Fama and French (2017). Panel A displays equal-weighted portfolio returns, and Panel B displays value-weighted portfolio returns.
Newey and West (1987) adjusted t-statistics are reported in parentheses.

momentum and 0.95% (t-stat. = 2.70) for the cash flow-to-
price ratio. These results collectively suggest that tax expense
surprise contains unique and independent information about
expected stock returns in emerging markets that is not incor-
porated into earnings surprise.
4.2. Current portion of the tax expense surprise
As mentioned earlier, we estimate the tax expense surprise
as the total tax expenditure in the current quarter minus the
total tax expenditure four quarters ago, scaled by the total as-
sets four quarters ago. However, previous literature suggests
that the current (not the deferred) portion of the change in tax
expense is linked to future stock returns. Moreover, adding the
deferred portion to tax expense surprise would work against
finding significant results in the previous sections. Thus, we
also calculate the tax expense surprise by excluding the de-
ferred tax expense. Table S6 (available online) presents the
12
univariate portfolio and cross-sectional regression results for
tax expense surprise, which is constructed with only the current
portion of tax expense. Panel A of Table S6 documents that the
portfolio of equities with the highest tax expense surprise has a
1.09% (t-stat. = 3.70) higher equal-weighted return than the
portfolio of equities with the lowest tax expense surprise. The
corresponding FF5 alpha is 0.78% (t-stat. = 2.93). Similarly,
Panel B of Table S6 reveals that the hedge portfolio has a
positive average return of 1.11% (t-stat. = 3.80), and the
associated abnormal return to the arbitrage portfolio is 0.87%
(t-stat. = 3.02).
Next, we repeat the cross-sectional Fama-MacBeth re-
gressions of two-quarter-ahead returns on tax expense surprise
and all stock-specific characteristics. Panel C of Table S6
presents these results. The regression estimations reveal that
tax expense surprise retains its significantly positive coefficient
in the presence of alternative stock-specific characteristics. The
coefficients of tax expense surprise are between 0.3120 and

A.D. Gunaydin
0.5945 in these regressions, and they are all statistically sig-
nificant, with t-statistics ranging from 2.04 to 3.66. These
findings suggest that previous results regarding tax expense
surprise are robust to excluding deferred taxes when tax
expense surprise is calculated.
4.3. Standardized tax expense surprise
In this section, we test whether the significant predictive
power of tax expense surprise is robust when tax expense
surprise is standardized. Specifically, standardized tax expense
surprise is defined as differences in tax expense from its value
four quarters earlier, scaled by the standard deviation of this
difference in quarterly tax expense surprise over the past eight
quarters as follows:
Taxq − Taxq−4
SUT =
σq
where Taxq is the total tax expense in the current quarter,
Taxq−4 is the total tax expense four quarters ago, and σ q is the
standard deviation of tax expense surprise over the prior eight
quarters.18 Table S7 (available online) presents the univariate
portfolio and cross-sectional regression results for standardized
tax expense surprise. Panel A of Table S7 documents that the
portfolio of equities with the highest standardized tax expense
surprise has a 1.11% (t-stat. = 5.88) higher equal-weighted
return than the portfolio of equities with the lowest standard-
ized tax expense surprise. The corresponding abnormal return
is 1.02% (t-stat. = 6.80). A similar pattern is observed in the
value-weighted quintile returns reported in Panel B. The zero-
cost arbitrage strategy has a positive average return of 0.82%
(t-stat. = 3.21), and the corresponding abnormal return to the
arbitrage strategy is 0.87% (t-stat. = 3.63).
In Panel C of Table S7, we re-estimate the quarterly cross-
sectional regressions of two-quarter-ahead returns on stan-
dardized tax expense surprise and all stock-specific character-
istics. We find that slope coefficients of SUT are between
0.0075 and 0.0126, with t-statistics ranging from 3.09 to 7.82.
These findings demonstrate that the significant relationship
between tax expense surprise and expected equity returns re-
mains robust when standardized tax expense surprise is used as
the primary explanatory variable.
4.4. The effect of excluding loss quarters
Prior literature since Hayn (1995) argues that profits are
more informative than losses about the company's future as-
pects. To examine the effect of loss quarters on the positive
link between surprise in tax expense and expected stock
returns, we repeat the previous tests excluding the loss quarters
from the sample, and these results are shown in Table S8
(available online). Panel A documents that the excess return
18
The calculation of standardized tax expense surprise is similar to the
calculation of standardized unexpected earnings (SUE), as in Bernard and
Thomas (1989) and Foster et al. (1984).
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spread between the extreme tax expense surprise portfolios is
1.11% (t-stat. = 4.56). The FF5 alpha associated with this re-
turn spread is 0.84% (t-stat. = 4.05). Similarly, for the value-
weighted portfolio returns shown in Panel B, the return to
the hedge portfolio is 0.64% (t-stat. = 2.70). The FF5 alpha
associated with this return difference is significantly positive at
0.65% (t-stat. = 3.33).
In Panel C of Table S8, we rerun the quarterly cross-
sectional regressions excluding the loss quarters. We find
that the regression coefficients of tax expense surprise are
between 0.9970 and 2.0088, with t-statistics between 3.05 and
5.78. Hence, we conclude that the significant relationship
between tax expense surprise and expected returns remains
qualitatively unchanged when loss quarters are dropped from
the sample.
(4) 4.5. The effect of firm size
Prior literature, such as Stambaugh et al. (2015), docu-
ments that stock returns increase when the limits to arbitrage
for undervalued stocks in the market are higher. Following
this literature, we investigate whether the predictive power of
tax expense surprise increases (decreases) when the arbitrage
cost and information uncertainty are higher (lower). We
conjecture that stocks that are costlier to arbitrage should be
more liable to mispricing. Thus, we would expect to observe
that the predictive power of tax expense surprise to be more
pronounced among equities with high limits to arbitrage. We
rely on a company's market capitalization to capture the cost
of arbitrage and information uncertainty. Specifically, at the
end of each quarter, all equities are independently sorted into
terciles based on size and quintiles based on tax expense
surprise. This independent two-stage sorting provides 15
(3 × 5) resulting intersection portfolios of size and tax
expense surprise. Table S9 (available online) presents the
returns for each of the 15 (3 × 5) resulting intersection port-
folios as well as the return and FF5 alpha spreads between the
extreme tax expense surprise quintiles with the associated t-
statistics. For the equal-weighted portfolio returns, as reported
in Panel A, the magnitudes of the hedge portfolio returns that
buy stocks with the highest tax expense surprise and sell
stocks with the lowest tax expense surprise decrease with an
increase in the size of the stocks. The return spreads between
the extreme tax expense surprise portfolios are 1.26% (t-
stat. = 6.69) for small stocks and 0.63% (t-stat. = 1.96) for
big stocks. The corresponding FF5 alphas associated with
these return spreads are 1.12% (t-stat. = 5.70) for small stocks
and 0.72% (t-stat. = 2.30) for big stocks. For the value-
weighted portfolio returns, as presented in Panel B, the
zero-cost portfolio returns also decrease as the stock size in-
creases. The return spreads between the extreme quintiles are
0.87% (t-stat. = 5.43) for small stocks and 0.32% (t-
stat. = 0.83) for big stocks. The associated FF5 alphas with
these return spreads are 0.88% (t-stat. = 5.26) for small stocks
and 0.51% (t-stat. = 1.57) for big stocks. Overall, these results
suggest that the anomaly documented is consistent with
mispricing but not with risk-based explanations.
13
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A.D. Gunaydin
5. Conclusion
The relationship between tax-related information and ex-
pected stock returns has been investigated in prior academic
research. Thomas and Zhang (2011) present evidence that
seasonally differenced quarterly tax expense is value relevant in
the cross-sectional US equity returns. This study contributes to
the literature by investigating the value relevance of surprise in
tax expense in emerging markets. We hypothesize that quarterly
tax expense surprise contains unique and valuable information
about expected stock returns in emerging countries. We test this
conjecture by collecting time-series return and accounting data
for 27 emerging countries. The univariate portfolio analyses
document a strong positive relationship between positive tax
expense shock and expected equity returns. We find that stocks
in the high-tax-expense-surprise quintile earn statistically and
economically higher future returns than stocks in the low-tax-
expense-surprise quintile. The results from bivariate portfolio
analyses and multivariate regressions suggest that the strong link
between tax expense surprise and expected equity returns is not
explained by alternative well-known accounting-based vari-
ables, such as earnings surprise, sales surprise, cash flow-to-
price ratio and change in the effective tax rate. The significant
link between tax expense surprise and expected stock returns
remains robust to alternative definitions of tax expense surprise,
including orthogonalizing tax expense surprise with respect to
earnings surprise, considering only the current (not the deferred)
portion of tax expense when measuring tax expense surprise and
using standardized tax expense surprise. The predictive ability of
tax expense surprise is robust when loss quarters are dropped
from the data. We further document that this relation is also
pronounced in each geographic region. Moreover, the findings
present evidence that higher levels of tax enforcement have an
impact on the incremental value relevance of change in tax
expense. We find that tax expense surprise includes incremental
information about future stock returns only in countries with
higher tax enforcement.
Declaration of competing interest:
There is no conflict of interest.
Appendix A. Supplementary data
Supplementary data to this article can be found online at
https://doi.org/10.1016/j.bir.2021.11.001.
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