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Tax-Deductible Loan Loss Reserves and International Banking

Tax-Deductible Loan Loss Reserves and International Banking

An Economist's Unbiased Analysis

This paper discusses tax deductibility of loan loss reserves, focussing on costs to the budget, hence taxpayers. Economically, reserves bring book values in line with real, impaired values of claims. If reserves equal losses of value, taxing set aside reserves means taxing illusory income based solely on accounting conventions. Tax deductibility recognises economic facts correctly and in line with basic principles of taxation. Under the assumption of a sufficiently well functioning regulatory framework only no or negligibly small costs to the budget are possible. These might be outweighed by greater stability brought about by loan loss reserves. The paper’s arguments strongly support the view that an international convergence of tax régimes should choose deductibility rather than nondeductibility as the common base of treating loan loss provisions. Touching briefly on the problems of capital adequacy the paper proposes how to consider the risk-reducing function of specific loan loss reserves when measuring capital standards.