The Simultaneity of Decisions on the Tax and Non-Tax Cost Tradeoff in the Korean Banking Industry

We investigate whether Korean bank managers consider the tax, regulatory, and financial reporting costs of their decisions concurrently. We specifically concentrate on four decision items that bank managers often employ in achieving their tax, regulatory, and/or financial reporting objectives; actual write-offs, loan loss provisions, securities gains, and external funding. Unlike most prior research in this area in which only one of these four decision items is individually dealt with, we examine all of the four items simultaneously because in reality bank managers would consider these items as a portfolio of decision variables. Our research interest lies in the issue of whether Korean bank managers attempt to trade off tax costs against non-tax costs (i.e., regulatory and financial reporting costs). To test this, we extract a sample of 534 firm-years from the 2001 to 2006 period and analyze these data by using ordinary least squares (OLS) regressions first and then by employing a set of simultaneous equations to factor into the potential simultaneity of the four decision variables. The main discovery of our study is as follows: First, we find that the banks with relatively high tax costs take larger write-offs and loan loss provisions to reduce their tax liability. Second, with regard to regulatory costs, banks increase their Bank for International Settlement (BIS) capital ratios by taking more write-offs, securities gains, and external funding, but fewer loan loss provisions. Furthermore, the banks with high financial reporting costs reduce their loan loss provisions to report higher earnings. Finally, with respect to the tradeoffs between tax and non- tax costs, banks facing high financial reporting costs tend to decrease their loan loss provisions to increase reported earnings, thus forgoing tax savings. Commercial banks with high financial reporting costs are also likely to increase securities gains to boost their reported earnings. However, we are unable to find any significant trade-off effect between tax and regulatory costs.