Tax Enforcement Externalities and the Banking Sector

Governments around the world are considering increasing corporate tax enforcement efforts to mitigate base erosion and improve revenue. It is less known whether such enforcement efforts have unintended consequences. In this study, we examine whether corporate tax enforcement can affect banks via their corporate lending practices. Specifically, we hypothesize that tax enforcement efforts aimed at small-and-medium sized enterprises (SME) can act as a validation of financial reporting information and allow banks to increase information collection at the targeted borrower and other potential borrowers. This improved information set in turn could lead to better lending decisions and greater loan growth. Exploiting the regional structure employed by the IRS between 1992 and 2000, we find that the corporate tax audit probability for SMEs is associated with greater bank performance, loan quality, and commercial lending growth. We find similar evidence when exploiting the IRS reorganization from a regional to federal-based system in 2000 as an exogenous change to tax enforcement at the region level, and our findings are robust to various specifications and placebo analyses. Overall, our findings show that the tax authority’s mandate has important externalities on the banking sector via the latter’s commercial lending practices, and suggest that the benefits to tax enforcement go beyond simply improving tax collections.