Tax Reforms and the Capital Structure of Banks

The paper studies the link between corporate income tax reforms and domestic bank entities' financing decisions. We use a dataset of corporate income tax (CIT) reforms and estimate the effect of tax rate changes on leverage, dividend policies and earnings management of banks. The results suggest that taxation influences all three variables in the first three years after the reform. Leverage increases with the CIT rate. The reason is that the statutory CIT rate determines the value of the debt tax shield. A higher tax rate increases incentives to use debt finance when interest payments are deductible from the CIT base. The tax effects we find are statistically and economically significant but considerably lower than those found in previous research. Also, dividend pay-outs increase after an increase of CIT rates. This could indicate that banks actively manage their pay-out policies around tax reforms and adjust their capital structure with changes in dividends. Furthermore, banks increase loss loan reserves in anticipation of tax rate cuts since losses become less valuable with lower CIT rates. In the context of the current regulatory reform in the financial sector, which focuses strongly on improving equity ratios of banks, our results suggest that future tax policies should focus on eliminating the favourable treatment of debt for banks. The reason is that this distortion at least partly undermines the regulatory objectives of increasing (regulatory) capital.