Forthcoming in National Tax Journal, September 2017
Timothy J. Goodspeed, Hunter College and Graduate Center, CUNY
A particularly important risk in the financial sector that is often discussed as one of the reasons for the recent collapse of the financial system is that the banks invested in overly risky loan portfolios, particularly those related to the housing market. The riskiness of a bank’s loan portfolio, especially loans related to the housing market, is an important source of instability in the financial system.
I develop a simple model of banks that includes financial regulations and systemic risk and examine various options for the taxation of banks. The model emphasizes systemic risk in a bank’s loan decisions and thus debt in the economy as whole rather than a particular bank’s debt to equity ratio. An externality arises because a bank’s loan decisions affect the economy-wide probability of loan success. The bank takes account of the effect of its loan decisions on itself but ignores the effects on other banks in the system.
The model is utilized to examine the effects of five possible taxes (on bank loans, deposits, liabilities, equity, and profits). Each tax has particular impacts on the market for loans and deposits, and consequent effects on interbank borrowing and the riskiness of a bank’s loan portfolio. All of the taxes except the tax on deposits will decrease the supply of loans and the riskiness of loans in the economy. The tax on deposits does not affect either of these variables due to the assumption of separability of the management costs of deposits and loans. All of the taxes will decrease a bank’s demand for deposits except the tax on loans, again due to the separability assumption. A bank’s borrowing will rise with the tax on deposits, fall with the tax on loans, and will be indeterminate for the other taxes.
I discuss extensions to consider depositor access to international capital markets and tax avoidance by multinational banks. Results for the former case will depend on the degree of substitutability between deposits and funds in international capital markets. An interesting result for the latter case is that tax avoidance by multinational banks tends to increase the riskiness of a bank’s loan portfolio in some cases.