Abstract This study examines the relation between state corporate tax provisions and the investment portfolios of banks. Consistent with federal tax Jaws, certain states disallow state tax deductions for interest expense incurred in generating tax-exempt income. However, three states have tax-law provisions allowing banks to deduct the Interest expense Incurred to earn tax-exempt interest on U.S. government and municipal securities. Recently, the effects of this difference In state tax policy and its impact on state Income taxes paid by banks and their investment portfolios have been debated. Critics argue that this provision encourages banks In deduction states to Invest more heavily in tax-exempt securities than banks In states without the deduction provision. This study provides insight to the debate by empirically finding that the impact of the deduction provision Is contingent on the bank's state marginal income tax rate. As banks face higher marginal state income tax rates In deduction states, they are significantly more likely to Invest a greater percentage of their assets In U.S. government securities than banks facing low tax rates in deduction states or banks In states not Slowing the interest expense deduction. These results should be relevant to state tax policy makers and banking Industry officials who have a vested interest In the debate of this provision.
Sawyers et al. (Wed,) studied this question.