Abstract

How do taxes affect equity risk and return? In this paper, we examine the relationship between corporate taxes and equity risk and return with a focus on tax-loss carry forwards. Tax-loss carry forward (TLCF), the accumulated corporate losses that can be applied to future taxable income, forms an important and risky corporate asset. We first show theoretically that a firm’s TLCF is a complex contingent claim that has a non-monotonic effect on equity risk: at a high level of TLCF , equity risk is increasing in TLCF because firms are more likely to see their TLCF left deferred or unused after negative cash flow shocks. On the other hand, if TLCF is so low that it will be used with near certainty, then equity risk is decreasing with TLCF since TLCF represents a safe cash flow. Empirically, TLCF positively and significantly forecasts various measures of equity risk, as well as future returns controlling for standard risk measures. The positive relationship indicates that TLCF is risky for the typical firm.