25 February 2013

IMF Working Paper: 'Taxation, Bank Leverage, and Financial Crises'

The onset of the financial crisis of 2008 quickly prompted many assessments of the role that taxation might have played. Their consensus was clear, but vague: tax distortions did not trigger the crisis, but may have increased vulnerability to financial crises. Prominent among the reasons given for this was ‘debt bias’: the tendency toward excess leverage induced, in almost all countries, by the deductibility against corporate taxation of interest payments but not of the return to equity. By encouraging firms to finance themselves by debt rather than equity, this might have made them more vulnerable to shocks and so increased both the likelihood and intensity of financial crises. The point applies in principle to all firms, but is a particular concern in relation to financial institutions; and these are the focus here.

This paper aims to provide a first attempt to establish and quantify an empirical link between the tax incentives that encourage financial institutions (more precisely, banks, the group for which authors have data) to finance themselves by debt rather than equity and the likelihood of financial crises erupting; and then to try to quantify the welfare gains that policies to address this bias might consequently yield.

The approach is to combine two elements in a causal chain. The first is that between the statutory corporate tax rate and banks’ leverage. This has received substantial attention in relation to non-financial firms, but very little in relation to the financial sector. Keen and De Mooij (2011), however, show that for banks too a higher corporate tax rate, amplifying the tax advantage of debt over equity finance, should in principle lead to higher levels of leverage; the presence of capital regulations does not affect the usual tax bias applying, so long as it is privately optimal for banks to hold some buffer over regulatory requirements (as they generally do). Empirically too, Keen and de Mooij (2012) find that, for a large cross-country panel of banks, tax effects on leverage are significant—and, on average, about as large as for non-financial institutions. These effects are very much smaller, they also find, for the largest banks, which generally account for the vast bulk of all bank assets. One task in this paper is to explore these findings further, using data now available to extend coverage into the crisis period that began in 2008—enabling a comparison of tax impacts pre- and post-onset—and applying the same estimation strategy to country-level data for the OECD.

Importantly, the finding that tax distortions to leverage are small for the larger banks, which are massively larger than the rest, does not mean that the welfare impact of tax distortions is in aggregate negligible: even small changes in the leverage of very large banks could have a large impact on the likelihood of their distress or failure, and hence on the likelihood of financial crisis.

This is where the second link in the causal chain explored here comes in: that between the aggregate leverage of the financial sector and the probability of financial crisis. The authors estimate such a relationship for OECD countries, applying the estimation strategy of Barrell et al. (2010) and Kato, Kobayashi, and Saita (2010) but, in contrast to these earlier studies, capturing data on the recent financial crisis from Laeven and Valencia (2010). The results suggest sizeable and highly non-linear effects of aggregate bank leverage on the probability of financial crisis.

Combining the results from these two estimating equations enables simple calculations of the impact of a variety of tax reforms on the likelihood of financial crisis. Linking this, in turn, with estimates of the output loss that is historically associated with such crises gives some rough sense of the potential welfare gains from policies that mitigate debt bias in the financial sector. Putting aside the overarching debate as to the proper roles of taxation and regulation in addressing the potential for excess leverage in the financial sector, the authors consider three tax reforms that would reduce the tax incentive to debt finance: a cut in the corporate tax rate; adoption of an Allowance for Corporate Equity form of corporate tax (which would in principle eliminate debt bias); and a ‘bank levy’ of broadly the kind that a dozen or so countries have introduced since the crisis.

All this gives a very different perspective on the nature and possible magnitude of the welfare costs associated with debt bias. Previous work, which has not reflected considerations of financial stability, has concluded that these are small: Gordon (2010) estimates the total efficiency loss from debt bias in the US to be less than 1 per cent of corporate income tax (CIT) revenue and concludes that: “tax distortions from corporate financial policy are not an important consideration when setting tax policy”; Weichenrieder and Klautke (2008) put the marginal welfare loss from debt bias somewhat higher, but still only at 0.06–0.16 per cent of the capital stock. The question here is whether considerations of financial stability imply much higher welfare losses—and the conclusion will be that it seems they do.

The next section of the paper sets out methodology and data (more details on the latter being in Appendix 1). Section III presents estimation results and Section IV reports simulations of the impact of the three reforms on the likelihood of a crisis and expected output. Section V concludes.

Full working paper

© International Monetary Fund