TAXES IN A MODEL OF BANK PORTFOLIO CHOICE (BAD DEBT RESERVE)

Banks' credit allocation decisions have an important impact on the availability and distribution of capital between businesses, households, and governments. Tax rules that alter the relative rates of return banks earn from different financial assets distort the allocation of scarce capital resources among competing demands.; The Tax Reform Act of 1986 introduced significant changes to tax rules affecting banks. The key economic question in assessing such rules is whether they create a wedge between an asset's economic return and its realized return. This thesis looks at how tax rules affect the asset mix in bank portfolios by developing and testing a model that measures how tax factors affect bank asset returns.; The thesis contributes a theoretical model that describes the interaction between tax factors and uncertainty in banks' operating environment. The theoretical results show that a bank's optimal portfolio equates the marginal expected after-tax net return on each asset. These returns are adjusted for expected liquidation costs and the expected value of available tax benefits affecting the returns on loans and municipal bonds. For example, the tax bad debt reserve rules subsidize the credit risk in loan portfolios, resulting in relatively more loans than if tax rules were neutral. Also, deductibility of interest expenses while earning tax-exempt interest income creates a tax arbitrage, albeit one that is not fully exploited because of withdrawal uncertainty. Thus, bank investment in tax-exempt securities should increase with expected profitability.; Using balance sheet and income data reported by banks from 1976 through 1986, the theoretical results are tested two ways. First, the first-order conditions are estimated directly using an estimating procedure developed for rational expectations models. The results do not support the theoretical results, due in part to a restrictive assumption that all bank assets mature each year.; Dropping that assumption, the theoretical results are incorporated into a partial adjustment model. The empirical tests using the partial adjustment framework include a broader consideration of factors that influence bank asset mix. The results support most of the hypotheses developed, including those relating to the role of tax factors in bank asset mix.