Tax Reform And Bank Asset Quality: Did 1986 Tax Law Changes Contribute To Banks Loan Problems?

Abstract

The escalation of bank loan losses in the mid/late 1980s, attended by a marked decrease in banking industry profits and an increase in bank failures, has raised numerous questions about the factor contributing to these events. The present study continues this inquiry by examining the effects of the Tax Reform Act of 1986 (TRA86) on the quality of banks assets in the late 1980s. Specifically, the study seeks to attribute changes in bank asset quality following enactment of TRA86 to 1) the two major provisions of the law targeted at banks, namely, interest expense allocable to tax-exempt obligations and the tax reserve for bad debts, particularly bad debts of large banks, along with 2) the pre-TRA86 level of real estate loans that were devalued by other provisions of the statute. Using alternative measures of asset quality, a single-equation regression analysis was applied to a sample of 205 large commercial banks. Empirical results indicate some linkage between TRA86 and changes in bank asset quality during the late 1980s, though not in all areas examined.