Is bank capital sensitive to a tax allowance on marginal equity?
Author | Jose Martin‐Flores,Christophe Moussu |
DOI | http://doi.org/10.1111/eufm.12163 |
Published date | 01 March 2019 |
Date | 01 March 2019 |
325Eur Financ Manag. 2019;25:325–357. wileyonlinelibrary.com/journal/eufm © 2017 John Wiley & Sons, Ltd.
DOI: 10.1111/eufm.12163
ORIGINAL ARTICLE
Is bank capital sensitive to a tax allowance on
marginal equity?
Jose Martin-Flores
|
Christophe Moussu
ESCP Europe and LabEx-ReFi, 79
Avenue de la République 75543 Paris
Cedex 11, France
Emails: moussu@escpeurope.eu;
jose_maria.martin_flores@
edu.escpeurope.eu
Funding information
This work was achieved through the
Laboratory of Excellence on Financial
Regulation (Labex ReFi) supported by
PRES HeSam under the reference ANR-10-
LABX-0095. It benefitted from French
government support managed by the
National Research Agency (ANR) within
the project Investissements d'Avenir Paris
Nouveaux Mondes (investments for the
future Paris-New Worlds) under the
reference ANR-11-IDEX-0006-02.
Abstract
This paper studies how bank capital changes following the
implementation and removal of a tax incentive on equity.
We examine the impact of the introduction of a tax
allowance in Italy granted to banks (and other firms) that
increase their equity from a base year. Using a difference-in-
differences setting, we observe an 8.83% increase in bank
capital ratios following the implementation of this reform.
When this tax mechanism is phased out, we observe an
opposite effect on the equity ratio, showing the absence of a
hysteresis effect in bank capital. We document a heteroge-
neous effect for large and small banks.
KEYWORDS
tax, bank capital, debt-equity tax bias
JEL CLASSIFICATION
G21, G28, G32
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INTRODUCTION
Bank capital is important but imposing higher capital requirements on banks affects the offer of credit
to the economy (Jiménez et al., 2016) and may result in a credit crunch with procyclical negative effects
The authors thank the Editor, John Doukas and the three referees. They also thank Gunther Capelle-Blancard, Thomas
David, JulienFouquau, Arthur Petit-Romec, Mark Roe, AnjanThakor, Michael Troege and Lei Zhao for helpful comments,
Vincenzo Cuciniello and GiacomoRicotti for providing information on the Italian ACE mechanism and participants in the
LabExReFi Workshop on Bank Taxation (2016), the PhD seminar at ESSEC Business School (2016), the IFABS
Conference in Barcelona (2016), the EFMA Conference in Athens (2017), the 2017 International Advisory Board
Workshop of the LabExReFi in Paris (2017) and the World Finance Conference in Cagliari (2017).
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in crisis periods (Cornett et al., 2011; Dermine, 2013). Another instrument available for policymakers
to strengthen bank capital is to use tax incentives. Since interest payments are in general deductible
from the corporate income tax base whereas equity returns are not, firms have an incentive to use higher
leverage. The effect of interest tax shields on firm leverage has been widely studied for non-financial
firms (e.g., Arena & Roper, 2010; Desai et al., 2004; Faccio & Xu, 2015; Feld et al., 2013; Graham,
1996; Graham & Tucker, 2006; Heider & Ljungqvist, 2015) and for banks (e.g., De Mooij & Keen,
2016; Hemmelgarn & Teichmann, 2014; Horváth, 2013; Milonas, 2016; Schandlbauer, 2017).
However, banks are, in principle, more systemic than non-financial firms so the effect of this tax bias is
particularly pernicious for them. Since bank capital provides some protection against failure in case of
crisis, a tax bias that incentivizes the use of debt undermines to some extent the safeness of the banking
system.
In this paper, we are interested in the impact of the implementation and removal of a tax reform
which reduces this debt-equity tax bias. The tax scheme introduced in Italy in 1997 has similar
characteristics to the Allowance for Corporate Equity (ACE) initially proposed by Devereux and
Freeman (1991). This ACE-like mechanism grants a tax shield on equity to banks that increase their
equity from a reference year. Banks (and other firms) apply a reduced tax rate (19% instead of 37%) on
a notional return computed on equity increases. Using a difference-in differences setting, with Italian
banks as treatment group and a matched sample of banks from other euro area states as control group,
we find an 8.83% increase in bank capital ratios relative to the control group following the
implementation of this tax reform. We also observe that this increase is driven by a higher level of
equity and not by a decrease in bank assets.
However, as the ACE tax incentive was withdrawn in 2002, we are able to provide new
evidence on whether the introduction and removal of the tax allowance mechanism lead to
symmetric effects. We find that once the ACE mechanism is no longer applicable, banks stop
increasing their equity and readjust downward their equity ratios by 4.6% on average relative to
banks in the control group. This finding reveals that there is no hysteresis in bank capital when a
tax incentive to increase equity is removed. This is in line with a static perspective of capital
structure. When an ACE is introduced, the debt tax bias is reduced and banks rebalance their
capital ratio upward. When the ACE is removed, the debt tax bias increases again, and bank
capital is adjusted downward accordingly. Additional robustness tests show that our results are
unlikely to be driven by changes in monetary policy or other economic events. Also, we show
that our findings are robust to different control groups and the introduction of various control
variables.
Our paper contributes to the existing literature on the effects of ACE mechanisms on capital
structure. The most studied ACE mechanism in the finance and economics literature is the one
introduced by Belgium in 2006. Panier et al. (2013) and Princen (2012) document a positive effect
of the tax reform on equity ratios for non-financial firms, and Schepens (2016) for banks.
However, the Italian ACE scheme differs from the Belgian reform of 2006 in three important
respects. First, in Italy, the notional interest is computed only on new equity after the reform is in
place and not on the existing stock of equity as in the Belgian case. This is particularly interesting
as there are no ‘windfall rents’associated with reduced taxation on the existing equity. It therefore
provides a great opportunity to test the effect of a tax incentive to increase equity for banks, as
there are no tax-shields on existing equity in the Italian case. Our results confirm that a positive
impact on bank capital ratios is also observed for a ‘softer’version of the ACE. Second, the Italian
ACE scheme includes an anti-avoidance clause that targets transactions between related parties in
order to avoid abuses and tax planning (Zangari, 2014). In particular, as documented by Hebous
and Ruf (2017), multinational non-financial companies used the Belgian ACE mechanism to
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implement tax planning structures combining the benefits from the Belgian ACE with interest
deductions. Thus, our result on the introduction of the ACE in Italy is important because it shows
that a positive effect on bank capital is also found in an ACE system that limits the scope for tax
planning opportunities. Third, an interesting feature of the ACE experiment in Italy is that it was
phased out in 2002. This phasing-out allows us to provide new evidence on the existence of
symmetric reactions of bank capital to the introduction and removal of a tax shield on equity
increases.
Our paper also contributes to the bank capital structure literature. Previous work on this topic
mainly focuses on the determinants of bank capital structure (e.g., Berger et al., 2008; Gropp &
Heider, 2010) and their adjustments towards the optimal ratio (e.g., De Jonghe & Öztekin, 2015).
Another stream of the bank capital structure literature has focused on the extent to which tax rates
determine equity ratios. These papers show a negative (positive) relationship between tax rates and
bank capital (leverage) ratios for international (e.g. De Mooij & Keen, 2016; Hemmelgarn &
Teichmann, 2014; Horváth, 2013) and single-country samples (Bond et al., 2016; Gambacorta
et al., 2017; Milonas, 2016; Schandlbauer, 2017). Our paper differs from these papers in two
aspects. First, instead of looking at tax rate changes, we focus on a specific tax incentive targeting
equity. We show that an exogenous reduction of the debt-equity tax bias leads to better capitalized
banks. Second, we demonstrate that the effects of a tax incentive targeting equity are unlikely to
last once the incentive is removed. We provide evidence for a symmetric reaction of bank equity
ratios once the tax incentive is phased out. Given that accumulating higher capital in normal
periods determines the ability of a bank to withstand economic shocks (Berger & Bouwman,
2013), it is interesting to know whether a tax incentive on new equity leads to better capitalized
institutions and whether this effect remains after the incentive disappears. However, we are not the
only ones to document a symmetric reaction of bank capital to tax incentives. Bond et al. (2016)
document that bank capital ratios react symmetrically to corporate income tax cuts and tax
increases. In contrast, our paper provides new evidence about the effects of implementing and
removing an explicit policy tool addressing the debt-equity tax bias on the use of equity financing
by banks. This is, to some extent, valuable information for regulators and policymakers who may
consider a different taxation of banks that does not provide incentives that go against capital
adequacy regulations.
1
Finally, we observe that the introduction (removal) of the ACE incentive has a positive
(negative) and significant impact on bank capital only for small banks.
2
This result is in line with
De Mooij and Keen (2016), who reveal that the capital ratio of larger banks is not sensitive to tax
changes at local level. They attribute this effect to ‘too big to fail’considerations. However,
another potential explanation is the ability of multinational banks to exploit tax arbitrage
opportunities at group level. Gu et al. (2015) provide evidence that international banks shift debt
from one country to another to exploit differences in the tax codes between their home countries
and other countries where their subsidiaries operate. Our results can be consistent with the second
line of reasoning. However, they are less supportive of the ‘too big to fail’argument since medium
size banks' capital ratios do not change significantly when the ACE incentive is implemented or
removed.
1
See Roe and Troege (2017) for an extensive discussion on bank taxation.
2
The Italian banking sector has a large number of small cooperative banks that are subject to specific regulatory
requirements. We also test (in unreported tests) whether the effect on smaller banks persists when we remove those
cooperative banks. Our conclusions remain unchanged after applying this treatment.
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