sou · H2B340 · 2014-06-12 00:00:00 — These facts constitute an argument for a flat rate of capital income tax across all types of capital income. Coupled with the progressive income tax, the resulting system in effect becomes the Dual Income Tax (DIT). DIT is exactly defined by the differentiation of labor and capital income and the coupling of a progressive tax on labor income and a flat-rate tax on capital income; in its purest version, the capital income tax rate would correspond to the lowest marginal tax rate on labor income. 5See Banks and (2010) and Conesa, Kitao and (2009), among others. 6Eventually, both corporate income taxation and individual taxation of capital gains can be rationalized this way. 1.2Separating capital income from labor income The desirability of labor income and capital income separate in the tax system follows from the contemplations above. Even though both types of income of course can be used to finance consumption and thus enhance consumption opportunities, the origins of labor and capital income are different and the behavioral responses to taxing labor income and capital income, respectively, must therefore also be different (which in itself is an argument for differential tax treatment). Further, as mentioned, the Dual Income Tax system, DIT, which has inspired the tax systems in the Nordic countries, enable the differential treatment of labor and capital income components. DIT represents a significant break-away from the previous reigning principle of income taxation, namely comprehensive income taxation. According to the latter principle, all income should be taxed the same way, irrespective of the source of that income. A further argument for the dual income tax can be given. In a tax system which does tax capital income (at a flat rate), labor income taxation should be subject to a progressive income tax in order to secure balanced (dis)incentives to accumulate financial and human capital, respectively.7 If labor income were taxed via a pro- portional labor income tax, and if the main cost of education is time spent (which otherwise could have been used to earn labor income), then setting time aside for education would lead to tax savings at the same rate as that applicable to the subsequent return to education. Accumulation of human capital via education would then effectively not be subject to tax. If, at the same time, capital income were taxed by a flat-rate tax, physical capital accumulation would be hampered, generating an imbalance in the tax treatment of accumulation of the two types of capital. This can be corrected by a progressive labor income tax. There are good arguments for subjecting all forms of saving to the same tax treatment. If all types of saving were taxed in the same way, then taxation would not determine where individuals place their savings, so that the placement pattern could be determined by where the superior combination of expected income and expected variability of that income were to be found. Moreover, as already mentioned, an important argument for a flat rate for capital income taxation is that it is not difficult to move wealth from one person 7 The argument can be found in and Sørensen (1997). Thus, if two persons faced unequal marginal tax on income from savings, then both could gain from moving savings from the high-tax person to the low-tax person against appropriate compensation. A similar move of human capital from individual to individual is by nature not possible, thus permitting progressive taxation of labor income. 1.3Overall considerations in tax system design When setting up a tax system not only in theory, but also in practice, a series of aims and considerations presents itself. Taxes in general affect the behavior of individuals and firms. Some taxes may not distort behavior, such as taxation of pure profits. Non- distortionary taxes should (notwithstanding possible distributional implications) be exploited in full, but altogether they are not likely to generate much revenue. , distortionary taxes must be activated in order to secure financing of the desired level of public sector activity. A first consideration is to avoid unduly destroying incentives to supply labor, to undertake education, to save and to invest. Tax distortions multiply as the tax in question is being used more and more intensively. , to avoid large distortions associated with individual taxes, a balanced use of all distortionary taxes is called for. Differential treatment of different types of saving (bank accounts, bonds, shares, real estate, a.o. ), of different types of investment (machinery, , immaterial assets, financial assets), of different organizational forms for businesses (sole proprietorship, closely-held corporation, widely held corporation), etc. only serves to cause decisions which should be based on fundamentals to become tax- driven instead. The associated distortions to composition of saving and investment and choice of organizational form are best avoided; so aim for neutrality. One thing is the amount of revenue to be had from a tax, if all potential tax payers comply in full with the rules and the spirit of the tax in question. Another is the actual revenue to be had. latter may be considerably less on account of (in principle legal) tax avoidance and (illegal) tax evasion. Such tax-driven behavior complements the standard behavioral distortions and renders taxes less efficient. be aware of and counter opportunities for tax avoidance and evasion. In chapter 3 which deals with balances in the tax system we come back to these considerations. In particular we consider the possibilities for tax avoidance when income can be declared in another form than intended. We there argue that one should balance the effective taxation of income components when income can be shifted. We also argue that tax system designers should be aware that incorporation (or de-incorporation) and altering company structure are yet further means to alter tax burdens. These considerations concern a closed as well as an open economy. In the open economy, the tax system needs to accommodate the mobility of company investment, firms themselves, their profits, portfolio investments (and consumption purchases and labor services). be aware of pressures from international tax competition related to mobility of tax objects. The two main aims of the tax system are to secure appropriate financing of public expenditures and to take part in redistributing consumption opportunities across citizens. Therefore, one should evaluate consequences for distribution of consumption oppor- tunities/achieve progressivity as efficiently as possible. Finally, it is important that the players in the tax system – tax payers and tax collectors – accept the system. the system should be as simple as possible, as easy as possible to comply with and to administer.8 8 As a comparison we mention in chapter 7 that the (2011b) stresses the analysis of the tax system as a whole; neutrality; and the achievement of progressivity as efficiently as possible. 2 THE CORPORATE INCOME TAX 2.1The role of the corporate income tax The conclusion of chapter 1 was that a desirable tax system, more precisely a desirable taxation of income, would imply separating capital income and labor income and subject labor income to a progressive schedule while the capital income tax flat. The considerations in section 1.3 stressed an appropriate balancing of the taxes in the system; an eye on international com- petitive pressures generally; and aiming for a simple tax system which can be administered and complied with. Furthermore, the implications of the entire tax system for distribution and fairness should not be neglected. All observations really pertain to the tax treatment of individual decisions and hence the burden of taxes on physical persons. This is very much in line with the traditional saying in the theory of taxation that only people pay taxes. The consequences of the tax system (in its entirety) should be gauged at the level of individuals. This does not rule out, though, that taxes can also be paid by entities other than physical persons, on behalf of individuals.9 One example of such a tax is the corporate income tax (henceforth CIT), levied on corporations. Why might it desirable to include a CIT in the tax system? There are multiple answers. First, as corporations collect funds to invest in , machinery, intangible assets, etc. in order to undertake production activities, they eventually generate capital income. In principle, this capital income could, via information on which individuals own how big a share of the corporation be traced to the owners, who could then be subject to personal tax on their capital income. For large corporations, this apportionment of capital income could become a complicated process. A simpler solution is to subject the corporation itself to tax, as a representative of its owners. , a first reason for the existence of the CIT is simply con- venience and cost saving. 9 This strictly speaking is already the case for many taxes and excises. As an example, companies pay VAT to tax authorities when selling goods and services. VAT is actually a consumption tax, an indirect tax, whereas until now we have been discussing direct income taxation. The VAT may even be redundant under certain circumstances, cfr. the famous theorem by and Stiglitz (1976). A close cousin to the labor income tax, a VAT may nevertheless enter the tax system, if income taxation is plagued by tax evasion different from evasion problems for the VAT (or if other assumptions behind the Atkinson-Stiglitz result, for instance regarding separability do not hold). A second reason is that the CIT functions as a backstop to personal income taxation. it not for the CIT, some personal income might not be tracked to individuals, or it might be paid out with such delay that the effective tax on that income would only be small. An immediate CIT will make sure that that income is taxed at least to some extent.10 A third reason to have a CIT is that it is a mechanism to collect rents. Rents – supernormal returns to invested capital – may have several origins; imperfect competition, the exploitation of natural resources, or the use of ideas may all generate rents. Collection of such rents may be close to non-distortionary and thus could in principle constitute a rather ideal tax. This conclusion is a bit premature, though. A quite natural reason for supernormal returns lies in the heterogeneity of firms. At inception, the quality of a business idea may not be known. The average quality of firms that actually start up may reflect a normal return to invested capital (with a premium for risk), but the variance of the quality may be large. Given this spread, low-quality firms cease to exist, leaving only firms with above-average quality and therefore above-normal returns later on. Their supernormal returns balance the losses of the departed firms, so to speak. Taxing the supernormal returns without conceding similar tax rebates to firms that incur losses and do not survive will inevitably dampen start-up activity. Further reasons for having a CIT have been put forth. A fourth one is that the CIT may function as a benefit tax. After all, firms benefit from public infrastructure and other public support, and the CIT can, according to this view, be seen as a way to claim some of those benefits. However, the link between benefits enjoyed and CIT paid for any single corporation will be very weak. A fifth reason for the CIT is that it constitutes a way to tax foreigners, especially on the location-specific rents they may enjoy from investing in the home country. How convincing this argument is depends on when and how foreigners became owners of domestic corporations.11 In any case, the CIT as normally specified can be seen as a tax on both the normal return to capital and the extraordinary return (or 10Gordon and (1995) argue that many aspects of the existing corporate tax law would seem quite sensible, if the primary role of the corporate income tax is to discourage income shifting between the personal and corporate tax bases, or between domestic and foreign subsidiaries. 11See the discussion in Alworth (2010) as well as Huizinga and (1997). rent) on capital. In an open economy with mobile capital, the tax on the normal return will in part become a tax on domestic labor employed in production in lieu of a capital tax. Summing up, the role of the CIT is first and foremost as a convenient collection point for personal capital income tax and for tax on rents, as well as a backstop to personal taxation, a backstop for not only personal taxation of capital income, but also taxation of the fruits of labor effort, and thus the personal labor income tax.12 2.2How to fit in the CIT in the tax system? The value added which is generated in a corporation stems from the insertion of labor and capital. Capital on its side is both equity and debt, and value added minus remuneration of labor forms remuneration of both types of capital together. Capital is invested in the firm in the form of , machinery and equipment, financial assets, intangibles and inventories. The return to capital is spread over several years, and determined by the pace with which the investment depreciates. From this broad description, several versions of a CIT are possible. The traditional CIT is characterized by -deductibility of interest on debt -no deductibility of investment expenditure -tax-related depreciation of investment in , machinery, inventories, and intangibles (which inevitably will differ from economic depreciation) -no deductibility for any imputed return to equity. Other possible versions of the CIT differ from the traditional version in the treatment of interest and return to equity, and in the treatment of depreciation. 12 See and Hausman (2010). There are a number of reasons for discussing alternative versions of the CIT at the moment. One important reason is that it is becoming increasingly difficult to distinguish equity from debt.13 So-called hybrid financial assets have both debt-like and equity-like pro- perties, and whether they are treated as one or the other makes a difference in the current CIT. Furthermore, both equity and debt form the capital base of a company, and there is no compelling reason for treating them differently in regard to levying income tax on the corporation (see section 2.4 below). Both parts of the capital base assist in generating income in the company, and why should the two income parts be subject to differential treatment in the tax system? A number of CIT alternatives therefore rest on (near-)equivalent treatment of equity and debt capital. -Business cash-flow tax (henceforth CF): the CF taxes all inco- ming cash flows minus outgoing cash flows. Investment is treated the following way: the investment expense is deducted immediately, while the cash flows generated later on from the investment are fully taxable. There is no deduction for depreciation of the capital.14 -A CIT with allowance for corporate equity (ACE): the ACE differs from the traditional CIT by allowing a deduction for an imputed return on equity. Capital is depreciated, and the allowance is computed using depreciated book values of capital. -A CIT with allowance for corporate capital (ACC): the ACC differs from the traditional CIT by allowing a deduction for an imputed return on both debt and equity. Capital is depreciated, and the allowance is computed using depreciated book values of capital. Given the deduction for imputed return on debt, there is no deduction for interest payments on debt. -A comprehensive business income tax (CBIT): the CBIT differs from the traditional CIT only by disallowing a deduction for interest expenses. Depreciation for tax purposes is unchanged. 13Another important reason lies in the increased international mobility of financial and physical capital over the last two and a half decades. High capital mobility implies that a small country cannot effectively tax the normal return to capital by means of a source-based corporate income tax; instead, employed labor will have to carry the tax burden. See (1986), and Razin and (1991). 14The CF tax actually comes in several versions, namely the so-called R-base and F-base cash flow taxes. The difference between these lies in how the financial sector will be treated in the tax system. See and (2003). All the four alternative CITs listed have the same property that equity and debt capital receive (nearly) equal treatment in the tax system. The CF, ACE (and ACC) all leave the ordinary return to investment untaxed, whereas they do subject any supernormal return to tax. The CBIT, on the contrary, taxes both the normal and the above-normal return to capital. The chief difference between CF and ACE is the timing of deductions for the cost of investment. In the CF there is immediate deduction for investment outlays. In the ACE, deduction is effectively only gradual in line with the life of the investment. This combined with rules for transitioning to a CF, or to an ACE, will determine how different their impact on corporate tax revenues will be. It belongs to the description of current corporate income taxes that in some countries the corporate income tax is levied at different rates on that part of income which is paid out in the form of dividends, and that part which is retained in the company. A lower tax rate on the dividend part is one way to integrate corporate and personal taxation of capital income. Other methods can be found; it is time to consider capital income taxation at the individual level. 2.3Combining CIT with personal capital income taxation An important thing is to view the choice of type of corporate income tax together with the choice of taxation of capital income at the personal level. At the moment, all countries subject capital income to tax at the personal level. For the most part, taxation includes both the normal return to capital and the supernormal return. Originally, the point of departure for capital income taxation at the personal level was the comprehensive income tax, where all sources of income would be taxed at the same rate. However, todays tax system in countries reflects various departures from the comprehensive income tax. Indeed, tax rates may vary for different categories of capital income, although for any given type of capital income the rate of tax on the normal and supernormal returns are usually the same. As a general feature across countries, the value of owning and occupying a home, i.e. the imputed rent on housing, is either untaxed or taxed at a very low, symbolic rate. Similarly, the return to pension savings in occupational or individual savings schemes is either untaxed or taxed at merely a low rate. Interest income is usually taxed at the highest personal capital income tax rate, and since interest payments include compensation for expected/ongoing inflation, the real, effective rate of tax is even higher. Dividends are in some countries taxed at the same rate as interest income (often called the classical system); in others, the tax rate is lower as a means to integrate personal and corporate income taxation (dividend relief). After all, earnings giving rise to dividends have already been taxed at the company level. Similarly, tax rates for capital gains either follow rates for dividends or, subject to certain conditions, may be considerably lower or equal to zero. In any case, since normally realized as opposed to accrued gains are taxed at the individual level, effective capital gains tax rates tend to be relatively low. One country forms a marked exception to this general picture.15 In 2006, introduced a new tax system aiming at exempting the normal return to capital from tax at the personal level. The means to accomplish this is the so-called rate of return allowance (RRA). The main idea behind the RRA is to keep individual accounts to allow appropriate deductions in capital income (dividends) to ensure that only the supernormal return, not the ordinary return, to saving is taxed at the personal level. For further information on the workings of the RRAs we refer to Sørensen (2005) and the report from the Skauge commission (2003). Summing up, the typical picture of an country is one with a standard corporate income tax coupled with taxation of personal capital income at widely differing rates, depending on type. Usually, corporate and personal capital income taxation is integrated in one form or another. Cutting through all this, there is a basic choice between taxing the normal return to capital at the personal level, or not taxing this normal return, with the understanding that one might attempt to tax the supernormal return in any case. Combining this basic choice with the choice of type of corporate income tax yields a whole list of possible capital income tax systems which then vary between each other in regard to whether -the normal return to capital goes untaxed -it is taxed only once at the company level 15 Also the box system in the forms an exception. We return to these countries in section 6.4. -it is taxed only once at the personal level, or -it is (double-)taxed at both levels. In the (few) countries, where the dual income tax (DIT) is currently practiced, the corporate income tax is fairly traditional. That is, the CIT there allows for interest deductions and has conventional tax- related depreciation of investment. At the personal level, the main tax treatment implies flat-rate taxation.16 It is perfectly conceivable to alter the DIT in several ways so as to elicit a more balanced and consistent taxation of capital income: One way is to introduce RRAs at the personal level in com- bination with a conventional corporate income tax. This basically yields the Norwegian system, in which the normal return to capital is taxed only at the company level (equity income) or only at the personal level (interest income). Call this system RDIT, R signifying the use of RRAs for individuals. Another way is to maintain the tax treatment of capital income at the personal level, but disallow interest deductibility in companies. Thereby, all income to the entire capital base in companies is taxed via the corporate income tax, and capital income from debt or equity capital may or may not be taxed additionally at the personal level. We may call this system SDIT (where the S stands for consistent source-based taxation of the entire capital basis of firms); a dual income tax with no deductibility for interest in the corporate income tax.17 Yet another system can be defined by the combination of an ACE tax at the corporate level and personal capital income taxation along the lines of the dual income tax. This combination has been called (where the A is short for allowance for corporate equity, and DIT as usual stands for the dual income tax).18 These three tax schemes are variants of the dual income tax and thus build on the separation of labor and capital income in the tax system. Of course, further schemes can be defined either on the basis of comprehensive income taxation with parallel treatment of labor and capital income plus one form or other of the corporate income tax. And yet further schemes may supplement the basic 16This applies to and . has a complicated progressive tax on personal net capital income, and another progressive tax on dividends and capital gains, see et al. (2013). 17This version of DIT has been proposed by Cnossen (2000, 2001). 18This particular combination has been put forth by, among others, Keuschnigg (2004) and Keuschnigg and (2007). See section 7.2. idea of dual income taxation with the cash flow tax or allowance for corporate capital (CF, ACC) at the company level. 2.4A closer look at the choice between ACE and CBIT