Efficiency and the taxation of bank profits

We explore the effect of profit taxation and regulation of banks and other financial intermediaries in a setting in which intermediation is inefficient. The inefficiencies arise from imperfect screening of lenders, which tends to limit lending, and government provision of deposit insurance, which encourages excessive lending. An R+F cash-flow tax with and without full refundability of tax losses is applied to financial sector profits. As well, the government regulates the amount of lending financial intermediaries can do relative to their equity. With full refundability, the cash-flow tax is neutral and has no effect on existing distortions. The tax transfers rents to the government. If tax losses are not refunded in the event of bank insolvency, the tax discourages loans and the optimal tax rate is reduced. The optimal regulation of the loan–equity ratio of banks as a complementary policy instrument is characterized.