The impact of Taxation on Bank Leverage and Asset Risk

Abstract: The tax-bene t of interest deductibility encourages debt nancing, but regulatory and market constraints create dependency between bank leverage and risk. Using a large international sample of banks this paper estimates the short and long run effects of corporate income taxes (CIT) on bank capital structure and portfolio risk accounting for their simultaneous determination. A 10 percentage point increase in the statutory CIT rate is associated with an increase of 0.8-1.4 percentage points in bank leverage and a 2-7-percentage point reduction in the average risk-weight of assets. While the estimated overall effect of taxation on bank risk is modest, it induces signi cant portfolio reallocation toward less lending. These results suggest that any elimination of the tax-bias of debt may not bring the expected benefi ts for bank stability.