Taxation and Bank Liquidity Creation

Abstract

We investigate the impact of taxes on bank liquidity creation using the Tokyo bank tax as a quasi-natural experiment. This tax is on the gross profit of large commercial banks with business operations in the Tokyo prefecture. This allows for a first-time investigation for a liquidity creation study with taxes that cover banks only. This differs from prior research using taxes that cover both banks and non-financial firms, offering better identification. We find taxes on bank profits significantly decrease liquidity creation, consistent with the empirical domination of the Risk Absorption Hypothesis over the Financial Fragility-Crowding Out Hypothesis. Banks shift from long-term loans liquefying the public and supporting the economy to short-term government securities that decrease public liquidity without economic stimulus. The tax also impairs bank capital and risk management, making the financial system riskier. Our novel findings augment and complement existing research and suggest more research and policy attention to this issue.

Keywords: Bank liquidity creation, Bank Capital, Taxes, Japanese Banks

JEL Classification: G21, G28