Taxes and Bank Capital Structure

41 Pages Posted: 6 Nov 2014 Last revised: 4 Jul 2015

See all articles by Glenn Schepens

Glenn Schepens

ECB -Financial Research Division

Date Written: July 3, 2015

Abstract

This paper shows that a reduction in tax discrimination between debt and equity funding leads to better capitalized financial institutions. In many countries, the cost of debt is tax-deductible while the remuneration for equity (dividends) is not deductible. Theoretically, this unequal treatment gives a bank - as any other firm - an incentive to take on more debt. This paper exploits exogenous variation in the tax treatment of debt and equity created by the introduction of a tax shield for equity in Belgium. This quasi-natural experiment demonstrates that a more equal treatment of debt and equity significantly increases bank capital ratios, driven by an increase in common equity. Additionally, the results illustrate that both high and low capitalized banks react to the change in tax legislation, but that the latter profit more in terms of overall risk reduction. Overall, the findings confirm that reducing the tax discrimination between debt and equity could be an innovative policy tool for bank regulators.

Keywords: Bank capital structure, tax shields, capital regulation, bank risk

JEL Classification: G21, G28, G32, H25

Suggested Citation

Schepens, Glenn, Taxes and Bank Capital Structure (July 3, 2015). Available at SSRN: https://ssrn.com/abstract=2519533 or http://dx.doi.org/10.2139/ssrn.2519533

Glenn Schepens (Contact Author)

ECB -Financial Research Division ( email )

Frankfurt am Main
Germany

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