A potential increase to the U.S. corporate tax rate to 28% from the current 21% could create a moderate drag on bank earnings and cost FDIC-insured banks over $15 billion per year in aggregate, says Fitch Ratings.
The effect on core earnings profiles is viewed as manageable and largely neutral to credit profiles. However, the impact of one-time remeasurement of deferred tax assets (DTAs) and liabilities (DTLs) is expected to be mixed, and could have a material effect on the quarterly earnings for some banks if and when the tax changes are enacted.
Fitch estimates that the effective tax rate for all US banks would increase to approximately 25% from 20% at 4Q20 if the federal corporate tax rate were to increase to 28%. Aggregate net income for all US banks would have been 7% lower in 4Q20 with a 28% corporate tax rate, and would have resulted in return on average assets of 1.04% vs 1.11% for the sector.
Higher taxes could pressure internal capital generation abilities; however, the impact is expected to be manageable in the context of US bank core earnings levels. Importantly, the increase would be viewed as neutral to credit as it would have no impact on Fitch’s core earnings metric, operating profit to risk-weighted assets, and could vary for individual banks.
An increased corporate tax rate would also affect the value of DTAs and DTLs tied to U.S. federal taxation on banks’ balance sheets. Banks with net DTA positions could see significant one-time gains with an increase in tax rates that would flow through earnings, and banks’ net DTL positions could see one-time earnings charges from the remeasurement of DTLs.
For example, Fitch’s rated Trust & Processing banks (STT, BK and NTRS) all have DTL positions and would be affected, and remeasurement impacts for NTRS and BK could absorb well over half of a quarter’s worth of earnings.
The effect of a tax hike on regulatory capital would be mixed, and depend on each bank’s deferred tax position as well as the composition of DTAs and DTLs. Remeasurement impacts from DTAs, including those generated by allowance for loan losses, and DTLs stemming from temporary timing differences would directly affect capital ratios.
This should be the case for the vast majority of U.S. banks with net DTA positions, as the temporary timing difference of DTAs for most firms would remain below the 25% CET1 threshold allowed by the regulators. However, regulatory capital ratios would not be impacted by changes in the value of DTAs tied to net operating loss (NOL) carryforwards or DTLs related to goodwill or intangible assets since they are excluded from regulatory capital.
An increase in the corporate tax rate could incentivize banks to utilize more tax avoidance strategies to mitigate the impact on net profits. Higher corporate tax rates make the internal rate of return (IRR) for tax avoidance strategies more attractive. A change in the corporate tax rate to 28% from 21% would increase tax savings by over 30% for these types of strategies.
To offset increased tax liabilities banks may choose to invest in assets with preferential tax deductibility of interest income such as municipal bonds. Banks could also increase the use of affordable housing tax credits, which many banks earn through Community Reinvestment Act activities or through alternative energy credits.
Many banks have already grown their investment in social or environmental activities not only as part of a larger focus on ESG, but also as a way to reduce their effective tax rate.
