With the recent passage of the Tax Cuts and Jobs Act of 2017, now is the appropriate time to review the tax rate assumption in your loan pricing model. It is easy to update this key assumption, but you should also carefully consider the impact of a tax rate change on the other configuration areas within your model.
Let’s first take a look at how pricing models calculate the profitability of loans. Below is a typical income statement.
By reducing the tax rate, the Net Income and the Return on Equity (ROE) for a given loan will increase proportionally to the decrease in the tax rate. The following formula summarizes this relationship.
In the example above, if a loan has a 12% ROE using a 34% tax rate, then the ROE will increase to 14.4% after reducing the tax rate to 21%.
ROE Target Impact
Since loans modeled after the tax rate is lowered will immediately have a higher ROE, it is crucial that you adjust your ROE Targets within your model configuration. The ROE targets should be increased by the same factor described above: New ROE Target = Old ROE Target * (1 – New Tax Rate) / (1 – Old Tax Rate)