Prior literature predicts a positive relation between firms' expected pre-tax rates of return and investor-level capital gains tax rates. We show that this relation is more nuanced than suggested by prior literature and that in three circumstances the relation can actually be negative. The first circumstance is when a firm's systematic risk is very high. The second circumstance is when the market risk premium is very high. The third circumstance is when the risk-free rate of return is very low. The circumstances arise because, in addition to reducing investors' expected after-tax cash proceeds, capital gains taxes reduce the risk that investors associate with the expected after-tax cash proceeds.

Prior literature predicts a positive relation between firms' expected pre-tax rates of return and investor-level capital gains tax rates. We show that this relation is more nuanced than suggested by prior literature and that in three circumstances the relation can actually be negative. The first circumstance is when a firm's systematic risk is very high. The second circumstance is when the market risk premium is very high. The third circumstance is when the risk-free rate of return is very low. The circumstances arise because, in addition to reducing investors' expected after-tax cash proceeds, capital gains taxes reduce the risk that investors associate with the expected after-tax cash proceeds.

We classify all institutional investors that file Form 13-F over the period 1995–2013 as either “tax-sensitive” or “tax-insensitive” based on their trading behavior and portfolio characteristics. We examine tests of the effects of investor tax-sensitivity on portfolio rebalancing, price pressure, and fund performance, and compare our measure of tax-sensitive institutional investor ownership to three measures used in prior studies. We show that our measure of tax-sensitive investors dominates other measures in the portfolio rebalancing and price pressure tests. In the fund performance test, our measure of tax-sensitivity is the only one that finds that tax-sensitive investors have significantly lower returns on their portfolio stocks, which is a new result in the literature.

We investigate why firms choose to evaluate a tax department as a profit center (“contributor to the bottom line”) as opposed to as a cost center and the association between this choice and effective tax rates (ETRs). Using data from a confidential survey taken in 1999 of Chief Financial Officers, we develop and test a theory for choosing between these two methods of evaluating a tax department. We find that the likelihood of evaluating the tax department as a profit center is increasing in firm decentralization characteristics and tax-planning opportunities. We then employ instrumental variables to investigate whether evaluating a tax department as a profit center provides an effective incentive for the tax department to contribute to net income through lower ETRs. We find that our instrument for profit center firms is associated with significantly lower ETRs than cost center firms.

FIN No. 48, Accounting for Uncertainty in Income Taxes (FASB 2006), requires firms to disclose tax reserves and to record changes in tax reserves at adoption of FIN No. 48 as cumulative effect adjustments in stockholders’ equity. We predict that between the enactment and adoption of FIN No. 48, relative to historical levels, firms settle disputes more often to potentially decrease visibility to the IRS and release reserves more often to reduce scrutiny and increase earnings (as opposed to retained earnings). We analyze 2005 and 2006 10-Qs and 10-Ks for the 100 largest nonfinancial, nonutility firms followed by analysts. Between enactment and adoption of FIN No. 48, relative to historical levels, firms report more settlements with tax authorities and release reserves more frequently. In addition, firms with higher IRS deficiencies are more likely to settle disputes. Between enactment and adoption of FIN No. 48, firms increased earnings by releasing $4.4 billion of tax reserves, nearly equaling the $4.5 billion released at adoption.