SUMMARIES OF PAPERS IN THIS ISSUE

Abstract

his paper analyzes the implications of using fair value accounting to define taxable income.Although the inclusion of fair values in book income provides value-relevant information to users of financial statements, taxable income typically relies on reliable and verifiable measurements such as historical cost and lower of cost or market.Taxable income, therefore, usually excludes unrealized gains and (partly) unrealized losses, resulting in costly booktax differences.Several countries, such as Germany or Hong Kong, have adopted fair value tax regimes for financial institutions, including any fair value changes of held-for-trading assets in both taxable and book income to eliminate these costly book-tax differences.Fair value tax regimes, however, can have significant effects on banks' liquidity when unrealized gains are fully subjected to tax and unrealized losses are fully tax deductible.We exploit cross-country variation in fair value tax regimes and intertemporal variation in bank tax rates to analyze the effects of fair value taxes on banks' investment portfolios and risk taking.Our results suggest that banks' investment portfolios are sensitive to fair value taxes.First, held-for-trading securities of banks subject to fair value taxes decrease by about 1.9 percentage points of total assets for a one-standard-deviation increase in the tax rate relative to banks not subject to fair value taxes.Correspondingly, securities not subject to fair value taxation increase by about 2.2 percentage points of total assets for a one-standard-deviation increase in the tax rate.Our results are more pronounced for three types of banks.First, savings and cooperative banks, as opposed to commercial and investment banks, are more sensitive to fair value taxation.Second, the negative association between the level of held-for-trading securities and fair value taxes is pronounced for banks that report under local GAAP for tax purposes as opposed to IFRS.Third, the results are pronounced for banks that are comparatively short in liquidity, suggesting that fair value taxes are relatively costly for banks with higher liquidity needs.We also find that banks' risk taking, measured as the three (five) year standard deviation of banks' pretax return on assets and their pretax distance to insolvency, is positively associated with the tax rate when subject to fair value taxes.This effect can only be observed in savings and cooperative banks, which have lower risk tolerances than commercial and investment banks.Further, the effect is more pronounced for banks that report under local GAAP instead of IFRS.Our results provide some evidence that banks' risk taking is sensitive to including unrealized gains and losses in taxable income and is in line with prior evidence in nonfinancial settings, albeit subject to banks' business model.