Taxation of Banks and Financial Intermediaries

In most countries banking activity is subject to general taxation (personal and corporate income taxes), but often banking services are treated differently by tax authorities. In some cases, they enjoy favorable treatment. For instance, in the European Union most financial services are exempt from value-added tax (VAT), ostensibly for technical reasons (although the issue is currently under consideration). In other cases, banking services are subject to special taxes, like unremunerated reserve requirements. Unremunerated reserve requirements are an implicit form of bank-specific taxation that work in combination with inflation. Taxation of banks is of particular interest for various reasons.

First, banks are financial intermediaries that perform unique and crucial functions—although in many countries they are subject to increasing competition from investment funds and security markets. Second, banks are heavily regulated and monitored, which reduces the administrative costs of some forms of taxation; at the same time they are subsidized through under-priced deposit insurance and bailouts of insolvent banks. Third, banks often enjoy some monopoly power, especially in the household and small business sectors. The goal of this topic is to develop a theoretical framework to analyze the impact of various forms of taxation. 

The model is based on the modern theory of the banking firm and integrates in a unified framework the most important aspects of banking activity; in particular, monitoring, transaction services, and asset transformation. It is important to understand how each of these functions is affected by taxation. Banks reduce informational asymmetries with their loan applicants by ex ante screening, interim monitoring, and ex post verification of financial returns. Moreover, banks develop long-term, customer-specific relationships that allow them to reuse the information acquired in previous transactions. Bank deposits play an important role in the payment system. 

They can easily be converted into cash or directly used in transactions through checks, credit, and debit cards. Depositors can also set up automatic payments. Some of these transaction services may be separately priced, but to a large extent they are implicitly paid by accepting a rate of return on bank accounts below those of alternative assets. Finally, banks and other financial intermediaries perform an important asset transformation function. In particular, bank assets are riskier and less liquid than their liabilities. The model presented here abstracts from risk diversification and (as for example with Diamond and Dybvig 1983) focuses exclusively on liquidity insurance. The model developed in this topic focuses on how efficiently savings are channeled into various investment opportunities. Thus it takes as given the amount of funds. In this sense it is a partial equilibrium model. The simplest version of the model is presented in the second section and analyzed in the third and fourth sections, and assumes perfect competition in both the deposit and the loan market. A crucial determinant of the incidence of bank taxation is whether the deposit and loan segments are separable: that is,whether deposit and loan interest rates are independently determined.

Under conditions of separability, a tax on deposits does not affect lending, and vice versa a tax on bank loans leaves the level of deposits unchanged. The framework developed in this topic makes heavy use of the separability hypothesis. In particular, it is assumed that banks can invest in a safe asset with an exogenous rate of return. The topic revisits the separability hypothesis and argues that in the real world the necessary conditions to obtain separability may be violated quite often. However, simultaneous deviations may partially compensate one another, and as a result a model assuming separability may still be a useful benchmark. Recent improvements in information technology and innovations in financial contracting have increasingly challenged traditional banking activities.1 The topic considers explicitly the effects of increasing competition from investment funds and more efficient security markets. Investment funds are characterized as perfect substitutesof banks in the asset transformation function.