In this paper we examine the effects of differential state taxation of U.S. Government obligations (USOs) on how banks structure their investment and financing portfolios, the riskiness of banks' assets, and how implicit tax effects are impounded in investments' returns. Twenty‐seven states tax USOs (taxing states) and 23 states and the District of Columbia do not (nontaxing states). We find that banks in taxing states hold significantly greater amounts of USOs, which are among the least risky assets banks can hold, and we find that these banks hold a less risky mix of assets. Consistent with compensating for the lower risk of their asset mix, we also find that these banks hold less capital. Taken together, these results are consistent with effective bank regulation enforcement, since banks have similar capital to risk‐weighted asset ratios in spite of differing tax‐based incentives to hold riskless assets. We also examine the impact of implicit taxes on banks' USO holdings and related accounts and find that in taxing states banks' USO investments are decreasing in their state tax rate. We also find corresponding increases in asset riskiness for which banks do not appear to fully compensate in the highest state‐tax‐rate states. Finally, the effects shown in this paper are economically significant. For example, we find that banks operating in taxing states hold, on average, 40 percent less USOs than do banks in nontaxing states.
