Taxes and Bank Capital Strucucture

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.