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Mark J. Roe & Michael Troege, Degradation of the Financial System Due to the Structure of Corporate Taxation (Eur. Corp. Governance Inst. (ECGI) – Law Working Paper No. 317/2016, July 3, 2016).

Abstract: egulators have sought since the 2008 financial crisis to further strengthen the financial system. Yet a core source of weakness and a powerful additional instrument for strengthening the financial system persists unchanged and absent from the regulatory agenda — namely the relentless impact of the corporate tax on the choice between risky debt and safer equity. The tax penalty for equity and the concomitant boost for debt undermines the capital adequacy efforts that have been central to the post-crisis reform agenda. Yet this result is not inevitable. By repurposing tax tools used elsewhere in the world, we show how the safety-undermining impact of the current corporate tax can be ended or even reversed. The best trade-off of goals and practical potential is, first, to reduce the corporate income tax burden on bank equity levels above the required minimum, by according an imputed deduction for the cost of equity capital above the regulatory-required amount. This tax benefit can then, second, be made revenue-neutral to the finances by offsetting it, such as by decreasing the tax deductibility of the riskiest classes of financial system liabilities. That offsetting tax rate can, we show, be quite low, because the financial system’s debt base is wide while its equity base is narrow. Standard bank regulation is command-and-control style. Regulators order what banks can and cannot do; banks resist, lobby to reverse and undermine the commands, find transactional alternatives, and distort their behavior when approaching regulatory constraints. Regulators cannot in many areas know as much as the regulated; with a tax instrument, they do not need to know as much. Existing cross-country and cross-state data show the tremendous potential from this reform to incentivize more safely capitalized banks. The magnitude of the safety benefit should rival the size of all the post-crisis regulation to date. Thus the main thesis we bring forward is not a small or technical claim but a call for a major shift in regulatory style. Authors