The Impact of State Taxation of U.S. Government Obligations on the Structure of Banks' Investment and Financing Portfolios

Abstract

This paper reports on an examination of the effects of dfferential state taxation of U.S. Government obligations (hereinafter, USOs) on how banks structure their investment and financing portfolios. Twenty-seven states tax banks on their USOs holdings or the income from them and twenty-three states and the District of Columbia do not. We find that banks in states which do not tax these investments hold significantly greater amounts of these assets and, as these assets are the least risky assets banks hold, we also find that banks in non-taxed states hold a less risky mix of assets than banks in taxed states. Consistent with compensating for their riskier asset mix, we also find that banks in states that tax USOs hold a higher ratio of capital to assets. This result is consistent with effective bank regulation in that banks in all states are found to evidence similar overall risk, as measured by the ratio of their capital to risk-weighted assets. Finally, the effects shown in this paper are economically significant. We find that banks operating in untaxed states hold, on average, 125% of the amount of USOs held by banks in taxed states and pay state income taxes, on average, at only 16% of the rate of banks in taxed states.

JEL Classification: E62, G21, G28, H71