Bilateral implicit taxes and anti-competitive banking regulation

This paper examines how banks impound implicit taxes into loan interest rates. Economic theory predicts that the most flexible party bears the least tax cost. We hypothesize that mortgagors, being geographically fixed, are less flexible than banks and bear greater implicit tax costs, and that this effect diminishes when banks begin to compete across state lines after the 1994 Riegle-Neal Interstate and Branching Efficiency Act. Using data from 1977 to 2004 on banks' and mortgagors' state and federal taxes and detailed loan-specific data on mortgage originations, we investigate how interest rates vary separately with banks' and mortgagors' taxes. We find that mortgage rates vary positively with both banks' tax costs and the value of mortgagors' interest tax deductions. These findings are consistent with banks both passing on their tax costs to borrowers and capturing portions of borrowers' tax benefits. The estimated annual magnitude of this tax shift is $23 billion, which we find declined after 1993 by approximately 40 percent.