Corporate Tax Enforcement Externalities and the Banking Sector

ABSTRACT We explore whether corporate tax enforcement can affect bank lending. Specifically, we hypothesize that tax enforcement efforts aimed at small and midsized enterprises (SME) can improve their information environments, which in turn could lead to increased bank commercial lending. Exploiting the regional structure employed by the IRS until 1999, we find that the corporate tax return audit probability for SMEs is associated with greater commercial lending growth for regionally focused banks. We find similar evidence when exploiting the IRS reorganization from a regional to federal system in 2000. Further results show that tax enforcement's impact on SME informational environments is at least partially responsible for this association: The impact of tax auditing on bank lending is stronger for banks facing greater informational disadvantages and in areas where SMEs face greater hold‐up problems. Finally, we find that the tax audit rate is positively associated with loan portfolio quality, suggesting that tax enforcement can lead to better loan decisions. Our findings are consistent with the tax authority's mandate having important externalities on bank lending and SME access to capital, suggesting that the benefits to tax enforcement go beyond improving tax collection.