The Effect of Shareholder Taxes on Bank Risk-Taking

Abstract

This study examines the effect of shareholders’ personal taxes on bank risk-taking. Economic theory predicts that personal tax rates affect individual investment risk-taking through risk sharing with the government via loss offsets. I investigate this relation using a sample of S corporation bank holding companies to isolate the effect of shareholder-level taxes and plausibly exogenous changes in dominant shareholders’ state income tax rates. I find that increases in shareholder tax rates are positively associated with bank risk-taking when shareholders can use loss offsets to share in risk with the government. This positive relation is concentrated in banks that have lower levels of capital, less external monitoring, few shareholder conflicts, and dominant shareholders who are also their bank’s CEO. However, in better-capitalized banks with less external monitoring and few shareholder conflicts, increases in shareholder tax rates are negatively associated with bank risk-taking when shareholders cannot share in risk with the government. Overall, the results suggest that investor-level taxes play an important role in bank risk-taking decisions.