The Effects of Tax on Bank Liability Structure

Abstract

This paper examines the effects of taxation on the liability structure of banks. We derive testable predictions from a dynamic model of optimal bank liability structure that incorporates bank runs, regulatory closure and endogenous default. Using the supervisory data provided by the Bank of Italy, we empirically test these predictions by exploiting exogenous variations of the Italian tax rates on productive activities (IRAP) across regions and over time (especially since the global financial crisis). We show that banks endogenously respond to a reduction in tax rates by reducing nondeposit liabilities more than deposits in addition to lowering leverage. The response on the asset side depends on the financial strength of the bank: well-capitalized banks respond to a reduction in tax rates by increasing their assets, but poorly-capitalized banks respond by cleaning up their balance sheet.