Tax Reform Act of 1986 ; Banks and banking - Taxation

Jonathan A. Neuberger

English

Research Papers in Economics

FRBSF WEEKLY LETTER
December 16, 1988
Tax Reform and Bank Behavior
The Tax Reform Act of 1986 reduced marginal tax
rates for most taxpayers. To finance these reduc-
tions in marginal rates, this legislation reduced or
eliminated many tax deductions and tax prefer-
ences. Such a restructuring ofthe tax code
reflected a concern that the old system's high
marginal rates and cumbersome, differential
treatment of various sources of income inhibited
economic efficiency. Also, important provisions
of the Tax AGt were shaped by a popular percep-
tion that certain groups of taxpayers had unfairly
avoided paying taxes under the old system. In
particular, Congress included provisions in the
Tax Act designed to eliminate certain tax prefer-
ences enjoyed by banks and thrift institutions.
The provisions in the 1986 Tax Act that affect
banking firms influence banks both directly in
their role as taxpayers and indirectly as lenders to
other taxpayers. Changes in the tax treatment of
loan losses and tax-exempt securities directly af-
fect banks as taxpayers. At the same time,
provisions that phase out the tax deductibility of
consumer interest payments but maintain it for
mortgages and home equity loans affect banks
indirectly. These latter provisions affect bank
portfolios by encouraging borrowers to shift debt
from consumer loan instruments to those backed
by real estate.
Following passage of the Tax Act, some analysts
predicted that tax reform would significantly
raisetaxes paid by the banking sector and hurt
bank profitability. Others argued that the effects
of the new law would be quite small because
banks would adjust their portfolios to minimize
the law's impact. This Letter attempts to sort
out these various claims and determine how
banks have in fact responded to the new tax
environment.
Loan losses
The new law governing the tax treatment of loan
losses represents a significant change in the tax
laws governing banking institutions. Under both
the old and new tax codes, loan losses are tax-
deductible expenses for banks. However, prior to
the 1986 Tax Act, banks maintained a loan loss
reserve account for reporting losses in taxable in-
come. Banks were able to deduct from taxable
income additions to this loan loss reserve. Thus
they could directly reduce their tax liability by
diverting a portion of their earnings to this re-
serve. A ceiling on the size of this reserve served
to limit the tax deductions banks could take
without actually having to charge off bad debts.
This ceiling was based on one oftwo calcula-
tions: either the experience method, which tied
the ceiling for the loan loss reserve to the histor-
ical average value of loan losses experienced by
the bank; or the percentage method, where the
ceiling was set at a given percentage of the
bank's outstanding loans.
This reserve approach to the tax treatment of
loan losses enabled banks to spread out the
losses from bad debts. It also may have given
banks greater flexibility in timing the recognition
of loan losses for tax purposes. For example, a
bank with taxable income in a particular year
might choose to add to the reserve (assuming its
reserve was below the ceiling) to reduce its tax-
able income and tax bill, even though it did not
actually charge off any loans as uncollectible
that year. In this way, banks enjoyed some free-
dom to defer taxes as well as'spread out the
negative impact of loan losses.
The 1986 Tax Act eliminates this tax reserve for
banks with assets over $500 million. However,
for financial and regulatory reporting purposes,
all banks continue to use a loan loss reserve for
charging bad debts against income. For tax pur-
poses, bad debts are now claimed directly
against taxable income when the loan is de-
clared worthless and charged off. Rather than
being charged against a loan loss reserve, loan
charge-offs thus become direct items of expense
in taxable income. Because loan charge-offs now
have a direct impact on reported taxable income,
elimination of the tax reserve method will likely
increase the volatility of banks' taxable income.
The volatility of reported income, in contrast,
may not be affected on account of banks' con-
tinued use of a loss reserve.FRBSF
In addition to the new tax treatment of bad debts,
tax reform requires banks to reincorporate pre-
viously built-up tax reserves into taxable income
over a period of several years. This "recapture"
provision is considered particularly burdensome
for banks as they must make direct additions to
taxable income. Alternatively, banks can elect to
deplete existing reserves through chargeoffs of
problem.Ioans and then switch to the specific
charge-off method. The recapture provisions are
delayed for banks with large quantities of prob-
lem loans.
Municipal bonds
A second major changein the 1986Tax Act is in
the treatment.of state and local taxcexempt
bonds.. Under the previouslaw, banks were al-
lowed to deduct from taxable .income 80 percent
of their interestexpenses "attributable" to hold-
ing tax~exemptobligations. Consequently, banks
tendedto hold significant amounts ofstate and
local debt securities. In contrast, the new tax law
eliminates the tax deductibility .ofinter~stpay-
ments on debt used to purchase these securities,
thus raising the effective cost to banks of holding
these assets. Moreover, it includes provisions for
an altern(itive minimum tax on an corporations
equalto 20 percent oftheirtaxable income plus
preference items. For banks, preference items in-
clude interest incomeon certain taxcexempt
securities. These two changes reduce the after-
tax return ontax-exemptdebt. Portfolio theory
suggests that banks will reduce their holdings of
these assets inresponse. .
Consumer interest expense
A third major component ofthe 1986 Tax Act
that affects banks is one that influences the be-
havior ofbank customers .. With the exception of
mortgage intereston first and second homes, the
lawphases out over several years the tax deduct-
ibility of all consumer interest payments.
However, it does.all.ow consumersto borrow
(with certain limitations) against real estate
through home equity loans and still maintain the
interestexpense deduction.
These provisions affect banks by alteringthe rela-
tiveattractiveness ofbank.Ioan products. Basic.
consumer loans, inparticular,should become
less attractive for consumer finance, while home
equity lines ofcredit likelywill become amore
preferred vehicle for financing large purchases.
Households' response to these changing costs
should influence the composition of bank loan
portfolios.
Other provisions
The Tax Reform Act of 1986 also includes a num-
ber oimore genera! provisions that affectall
corporations, including banks. First, the max-
imum corporate tax rate is now 34 percent,
down from the previous maximum of 46 percent.
This lower marginal corporate tax rate is consis-
tent with Administration goals of increasing
economic efficiency by lowering marginal rates
for all taxpayers. This lower marginal tax rate,
however, also reduces the value of corporate tax
deductions and thus may help to offset some of
the negative impacts associated with the other
provisions of the law. Second, the tax bill elimi-
nates the investment tax credit on equipment
investment and lengthens tax depreciation
schedules for most capital equipment and struc-
tures. Banks, like all corporations, thus face
reduced incentives for new capital expenditures.
Third, the tax bill aligns commercial banks with
other corporations in their ability to carry back
and carry forward net operating losses. The old
tax code allowed banks a 10-year carryback and
5-year carryforward; the new law calls for a
3-year carryback and a 15-year carryforward for
all corporations. This provision reduces the extra
flexibility banks once enjoyed to realize net op-
erating losses selectively over several tax years.
How have banks responded?
These changes in the tax law should affect both
the composition of banks' portfolios and their
overall tax burden and profits. The portfolio ef-
fects ofthe Tax Act are fairly straightforward. As
noted earlier,the new law reduces the after-tax
return to banks on.tax-exempt debt obligations.
For borrowers, it also raises the cost of using con-
sumer loan instruments relative to that of home
mortgage instruments. As aresultofthese two
changes, we should see a decline in the sharesof
banks' portfolios taken up by tax-exempt bonds
and consumer loans and a rise in the share held
by real estate loans.
Of course, one difficulty with inferring tax-
induced responses from the data on bankassets
and liabilities is the need to control for other inc
fluences. Changes in bank behaviormaybeThe Changing Composition of Bank Portfolios
% of Assets (All Insured Commercial Banks) % of Assets
caused by new tax policies as well as by any
number of non-tax related factors, such as
changes in interest rates, market risk, etc. None-
theless, the trends in the data are roughly
consistent with the expected changes in the
composition of bank portfolios.
20
The bottom line
The bottom-line effects of tax reform are more
difficult to predict and analyze on the basis of
available data. Bank tax burdens represent a
complicated interaction of several years' results
for earnings and total taxes paid. Temporary
events can disrupt anYofthes~numbersandob­
scure longer-term trends. For 1987, taxes paid by
all commercial banks as a percent of total assets
were 0.18 percent, roughly the same as in other
years in the 1980s. Total bank income relative to
assets, however, fell quite dramatically in 1987.
As a result, taxes relative to income increased
significantly in 1987, perhaps indicating a rising
tax burden for banks.
payments on such indebtedness. Nonetheless, on
balance, bank portfolios appear to be responding
to the change in the tax treatment of particular
classes of assets.
10
6
9
7
8
State and Local
Securities ...
Tax Reform
Enacted
18
12
16
14r------
10+----,-----------,----+----+5
19S3 19S4 19S5 19S6 19S7
Perhaps the most obvious change since the Tax
Act was passed is a significant decline in bank
holdings of state and local government securities,
a large percentage ofwhichare tax-exempt. As a
proportion of assets, holdings ofthese obligations
declined from 7.5 percent in 1986 to 6.3 percent
in 1987, a drop of almost 17 percent. This repre-
sents the lowest share for state and local
government securities recorded any time in the
last ten years. Data for the first half of 1988 indi-
cate that bank holdings of these assets continue
to decline.
It is unlikely, however, that this sharp drop in
bank income was due primarily to tax reform
since the decline was spread unevenly among
banks. The decline was concentrated in large
banks, many of which have sizable exposures to
developing country debt. These banks reported
reserving large sums of money in 1987 against
the declining value of their LDC loans, a pro-
cedure which significantly reduced reported
income in 1987. These actions probably have dis-
torted the tax/income relationship for banks in
the aggregate. Among smaller banks, income rel-
ative to assets was down only slightly in 1987,
indicating a tax burden-on the basis of income
or assets-similar to previous years.
Changes in the tax law have also had noticeable
effects on bank real estate lending. Real estate
loans grew from about 15 percent ofbank assets
in 1984 and 1985 to almost 19 percent in 1987.
Revolving home equity loans have grown from
virtually nothing in 1985 to $25 billion by
mid-1987 and over $36 billion by August 1988.
Surprisingly, consumer loans have maintained
their pre-1986 share of total bank lending, des-
pite the diminishing deductibility of interest
It is clear that tax reform has induced significant
changes in the composition of bank portfolios.
While insufficient time has passed to assess its
impact on the total tax burden of the banking
sector, apparently tax reform per se has not had a
major effect on the net incomes of banks.
Jonathan A. Neuberger
Economist
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank o~
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.Research Department
Federal Reserve
Bank of
San Francisco
Alaska Arizona California Hawaii Idaho
nevada Oregon Utah Washington
,;

Tax reform and bank behavior

http://www.frbsf.org/publications/economics/letter/1988/el88-51.pdf

Tax reform and bank behavior

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics