The Impact of State Taxation on the Investment Portfolio of Banks.

Abstract The paper empirically examines whether state taxation policies affect bank asset management policies. While the relation, of changes in federal tax laws associated with the deduction of interest expense incurred in generating tax-exempt income has been documented, there is less information about the prior research examining whether state tax deduction provisions impact the level of bank investment in tax-exempt securities. At the state level, the deductibility of interest expense incurred in generating tax-exempt income from the U.S. government securities and municipal securities differs across states. This difference in deductibility of interest expense incurred in generating tax-exempt income at the state level and its impact on the level of investment in tax-exempt securities is the focus of this research. The incentive created by allowing a deduction for interest expense for state tax purposes is dependent on a bank's state marginal tax rate (MTR). For banks facing low state MTRs, the ability to deduct interest expense incurred in generating tax-exempt income provides little tax incentive. As a bank's state MTR increases, the tax incentive increases.