We plan to examine the interaction between taxing authorities and banking supervisors in the oversight of banks. While both are government agencies, they face very different mandates. The banking supervisor is charged with ensuring the stability of both individual banks and the overall banking sector. This is generally done by ensuring that banks balancing risky lending with greater capitalization and liquid asset holdings. On the other hand, the taxing authority is tasked with collecting all required taxes. Despite their different mandates, it is clear that these two agencies will have overlapping effects on bank behavior. For example, both agencies will likely seek to minimize illegal behavior that jeopardizes both mandates (e.g., the type of actions in the Desai, Dyck, and Zingales (2007) framework that erode shareholder value and lead to tax evasion). Even outside of stopping illegal acts, the act of supervision by one regulator may generally affect the bank’s ability to comply with the other’s mandate, through corporate governance mechanisms such as better managerial oversight and better internal information quality. Furthermore, it could even be the case that weak oversight by one regulator is substituted for by the other.
However, it is equally clear that these mandates will sometimes clash. For example, banking regulators may prefer that banks engage in substantial tax planning that leads to greater capitalization and liquid asset holdings, whereas taxing authorities are likely to push back on this behavior. Given their different but overlapping mandates and the impact of banking sector weakness on the greater economy, we believe it is important to understand how their oversight impacts bank performance and soundness.
To explore the role of tax authorities in bank performance and soundness, we build on the theory by Desai et al. (2007) that the tax enforcer cab as a monitor of corporate insiders. Prior research suggests that stricter tax enforcement can lead to more transparent information environments by reducing the obfuscation that managers may engage in to hide taxable income (Hanlon, Hoopes, and Shroff 2014; Bauer, Fang, and Pittman 2017). Therefore, stricter tax oversight can lead bank managers to engage in less aggressive tax avoidance and resource diversion, and align incentives with shareholders, through the fear of being caught. However, greater oversight from taxing authorities may lead banks to generally improve their information environments even in the absence of aggressive tax avoidance. For example, if bank managers know that taxing authorities will conduct thorough audits, they may improve loan documentation. The improved loan documentation can lead to better lending decisions through improved credit risk assessments, and can aid risk management’s ability to identify excessive risk exposures. Therefore, tax authorities’ monitoring of financial institutions should lead to more value-increasing decisions being taken and better risk management. Therefore, stricter tax enforcement can lead to greater bank performance and soundness (H1A).
However, there is another channel through which stricter tax enforcement can affect banks: their impact on tax collections. Specifically, imposing stricter tax enforcement on banks may have adverse effects because higher effective tax rates reduce after-tax profits, and thus bank capital and liquidity. Lower capital and liquidity ratios are often early warning signs of bank problems, and prior research finds that banks with lower capital ratios were more likely to be targeted by regulatory intervention (Gallemore 2016). Furthermore, these effects can compound over time, with lower liquid assets and equity restricting future loan growth and profitability. Therefore, stricter tax enforcement could actually impair banks’ performance and stability (H1B).
Next, we plan to explore the interaction between tax authority oversight and monitoring by bank regulators. First, it could be the case that when regulators are weaker or less diligent, tax authority oversight can provide an important corporate governance mechanism. In this way, tax authorities may act as a substitute for banking regulators in overseeing banks. This suggests that the effect of strict tax enforcement on bank performance and stability should be stronger when bank regulatory oversight is weaker (H2A). On the other hand, prior research suggests that firm information environments are improved when tax enforcement is greater (Hanlon et al. 2014; Bauer et al. 2017). Since both agencies use information (e.g., on-site documentation and off-site reporting) to monitor firms, it could be that strict oversight by both parties leads to improved information environments and corporate governance, increasing each agency’s ability to successful monitor banks. This suggests that tax enforcement and bank regulatory oversight are complements, and that bank performance and stability are greater when strict tax enforcement is combined with strict banking oversight (H2B).
Our primary contribution is to provide the first empirical evidence on the role of the tax authority as a monitor of banks, and whether tax authorities are complements or substitutes for banking supervisors. We believe this to be a critical question, as it suggests that tax enforcement may have important externalities on the stability of the financial system, and through it, the overall economy. Furthermore, our research provides evidence on the effects of different but overlapping government agency mandates.
Another contribution of our study will be to explore how the tax authority can act as a corporate governance mechanism. Prior research has documented how stronger tax enforcement is associated with lower stock price crash risk (Bauer et al. 2017) and greater financial reporting quality (Hanlon et al. 2014). These studies point to taxing authorities playing a corporate governance role by increasing the quality of the information environment. We plan add to this literature by exploring how taxing authorities may have played a role in bank governance. While we see our bank setting as a laboratory for further exploring the role of the tax authority in corporate governance, bank governance itself is an important topic to understand, because of banks’ critical role in providing capital for individuals and businesses and liquidity for depositors, and because prior research suggests that bank risk-taking affects overall economic stability (Bernanke 1983; Keeley 1990; Calomiris and Mason 2003a, 2003b, 1997).