The Interaction of Bank Regulation and Taxation
49 Pages Posted: 5 Dec 2013 Last revised: 4 Nov 2018
Date Written: November 3, 2018
The tax benefit of interest deductibility encourages debt financing, but regulatory and market constraints create dependency between bank leverage and asset risk. Using a large international sample of banks in this paper I find that banks located in high-tax countries have higher leverage and lower average asset risk-weights. This trade-off is stronger when regulation is more stringent or when capital constraints are tighter. Non-financial firms' leverage and asset risk are positively related to tax rates, as further evidence of the regulatory induced adjustment of portfolio risk. While the estimated overall effect of taxation on bank risk is modest, it induces significant portfolio reallocation toward less lending. These results suggest that any elimination of the tax bias towards debt may not bring the expected benefits for bank stability.
Keywords: Bank leverage, Bank regulation, Bank risk, Corporate taxation, Debt-bias
JEL Classification: G21, G28, G32, H25
Suggested Citation: Suggested Citation