The Effect of Corporate Taxation on Bank Transparency: Evidence from Loan Loss Provisions

Abstract

We examine how the corporate tax system, through the tax treatment of loan losses, affects bank financial reporting choices. Our identification strategy exploits cross-country and intertemporal variation in corporate tax rates and the tax deductibility of loan loss provisions. Using an international sample of banks, we find that the loan loss provision is increasing in the corporate tax rate for countries that permit the tax deduction of general provisions. Furthermore, we show that this effect is driven by the corporate tax system encouraging timelier loan loss recognition: the extent to which future and current loan portfolio quality deteriorations are incorporated in the loan loss provision is increasing in the tax rate when general provisions are tax deductible. We also find evidence that the corporate tax system encourages provisioning by banks with capital ratios close to the regulatory requirement and in countries with relatively weak banking supervisors. Finally, we find that the rules regarding the tax deductibility of provisions discourage growth of some U.S. banks. Overall, our results suggest that the corporate tax system is an important determinant of timely loan loss recognition and hence the financial reporting transparency of the banking sector.