sou · H2B340 · 2014-06-12 00:00:00 — the years, the rules have been altered in such a way that they appear to offer very lenient treatment of income which could have been paid out from the companies in the form of wages. Four factors are especially responsible for this lenient treatment: the tax rate applicable to dividends has been lowered to 20 percent, to be compared to the standard capital income tax rate of 30 percent the so-called gränsbelopp (income limit) which is used to split income in the labor and capital components is computed with the use of a relatively high imputed return (much higher than the risk-free interest rate) there even is a minimum amount, below which this income limit cannot fall unused amounts in situations where imputed capital income falls below the income limit can be saved for future use the owner is allowed to take a certain share of wages paid by the firm (25–50 percent of wages of all employees in the firm) as dividend (löneunderlagsregeln). Add to this, that the minimum capital injection to start a 3:12 company is very modest, at 50,000 SEK. (The minimum amount just mentioned is significantly larger than this figure.) The reason for preparing such lenient tax treatment was to lure more individuals into entrepreneurship. However, the price that seemingly has been paid for this is very significant income shifting. Consistent statistics provided by Alstadsæter and point towards individuals performing tax planning with the intention to have labor income taxed as capital income from a 3:12 company. They write (in my translation): We find clear evidence that the rules are exploited through tax planning. Companies are formed to make it possible for owners to shift income (from earned income to capital income) through the 3:12 rules. It is especially high income earners who found holding companies of shell companies after the reform [of the 3:12 rules in 2006, my addition]. (Alstadsæter and , 2012a, p. They correctly point to multiple effects of such tax planning activities on the economy. The activities hurt efficiency and horizontal activity in the tax system; reduce tax revenue; lead to misleading statistics; and lead to increased income differences in society, as especially high income earners exploit the opportunities. The question of whether the lenient 3:12 rules have led to increased entrepreneurship was not studied in the Alstadsæter- report. But it seems doubtful that possible additional entrepreneurship can have been able to generate so much additional value to society that the benefit-cost analysis of the rules will generate an acceptable outcome. In sum, the Sørensen (2008) calculations and the Alstadsæter- (2012) analysis of the special 3:12 rules together demonstrate how difficult it is to secure a level tax playing field across different organizational forms, plus the undesirable tax planning side effects that are generated when balance in the tax treatment of different forms is severely lacking. It is tempting to supplement with the remark that under the Nordic dual income tax it is also difficult to provide neutral treatment of the occupational choice of becoming an entrepreneur in the first place. This is demonstrated theoretically in an article by Kanniainen et al. (2007) which provides a stylized DIT treatment of a full life cycle of a new company with risky income in the start- up phase. They derive conditions for the DIT to be neutral, and these are found to be stringent, in that profit expectations of The complications and non-neutralities derive from the chance of complete failure and from the differential taxation of low and high earned income relative to capital income. Generally, the DIT encourages (discourages) the of new enterprises who anticipate high (low) profitability. 6.3Some remarks on the tax systems elsewhere46 The tax system in builds, like , on the dual income tax. The corporate income tax is a conventional one for most companies, with a corporate income tax rate of 28 pct., due to come down to 27 pct. Special regimes apply to activities related to the exploration and exploitation of resources, where the tax base for the special tax on income is based on the corporate income tax base, but accounting for certain depreciations. In this way, the special regime approaches taxation of rent rather than income. The tax rate in the special regimes is 50 pct., rendering the marginal rate on resource rent as high as 78 pct. A tax reform effective from 2006 led to the shareholder model replacing the previous split model and imputation system. The shareholder model (Rate of Return Allowance, RRA) in principle involves a dividend and capital gains tax, but a cost of capital allowance aims at ensuring neutral treatment of different sources of financing (and no taxation at the shareholder level of the normal return to capital). The taxation of self-employed and partnerships was also adjusted along similar lines. Altogether, only higher returns than a basic cost of capital (normal return) are taxed at more than the basic rate of 28 pct. As a step towards solving the problem of labor income being shifted to shareholder income at lower taxes, the top marginal tax rates on labor income were reduced. Also interesting for the general discussion of taxation of corporate and capital income is the box system in the . The Dutch personal income tax system consists of three boxes: In box (1) labor income and some capital income components are put; these incomes are taxed at progressive rates ranging between 37 and 52 pct. Box (2) contains profit distributions and realized capital gains in connection with closely held companies (CHCs), where shareholders have a substantial interest. 46 These remarks draw heavily on European Commission (2013). income tax on these items is 25 pct., but that comes on top of the corporation tax. Finally, box (3) includes returns to privately held assets such as saving deposits, stocks, bonds, etc. Here, the tax rate is 30 pct. on a deemed return of 4 pct. above an exempted value of net assets. This last element is an example of a presumptive tax in an otherwise relatively sophisticated tax system. Further, the Dutch tax system features several tax reliefs and allowances for self-employed entrepreneurs and starting companies (deduction, partial profit exemption). The corporate income tax rate is 25 pct., albeit reduced to 20 pct. for profits up to ,000. Finally, several facilities exist for R&D activities, such as a separate innovation box for innovative enterprises, with a tax rate of 5 pct. Inheritance and gift taxes are levied at rates ranging from 10 to 40 pt., depending on the relationship between donor and beneficiary and the amount involved. There is no wealth tax. is an interesting case here, because it actually has an ACE tax already. The ACE system was introduced in 2006 in order to stimulate the self-financing capability of companies. It entails a notional interest deductibility for corporate capital (equity), where the tax-free presumptive rate of return on equity applied under the ACE system is based on the rate of 10-year government bonds, with a cap of 3 pct. The corporate tax rate is 33.99 pct., although lower rates apply to small and medium sized companies. At the personal level, there is a withholding tax of 25 pct. for most interest income and for dividends, and this withholding tax is final. Taxation of private capital gains is almost non-existent, and there are no wealth taxes. 7 TAX REFORM PROPOSALS This chapter considers a few recent tax reform proposals. First of all, we take a brief look at the and the subsequent discussion. Then we move on to some remarks on a Swiss tax reform proposal as well as a US proposal. In the mid-2000s, a group of UK (and foreign) tax economists was formed by to put forth a proposal for wholesale reform of the UK tax system. In the groups report, Tax by Design (Mirrlees et al. (2011a)), the blueprint for such an alternative tax system is laid out.47 Mirrlees et al. (2011b) presents the main points of the review. We briefly go through those points which have to do with corporate income taxation and related parts of the tax system. A few general principles guide the Reviews proposal. The first is that it is necessary to consider the tax system as a whole. The second is that one should seek neutrality. The third is that one should achieve progressivity as efficiently as possible. With some supplementary observations the Review thereafter derives a series of desirable properties for taxes on earnings, indirect taxes, environmental taxes, taxes on savings and wealth, and business taxes. The current situation in the UK is no different from that of many other (Northern) European countries. Non-neutralities abound, and differential tax treatment of competing savings instruments, of types of investment and of organizational forms is the order of the day. Instead, the Review would strive for -no tax on the normal return to savings (plus even additional incentive for retirement saving) -standard income tax schedule applied to income from all sources after an allowance for the normal rate of return on savings -single rate of corporation tax with no tax on the normal return on investment -equal treatment of income derived from employment, self- employment and running a small company. These considerations give rise to the following recommendations: -interest on bank accounts etc. exempt from tax altogether -introduction of rate-of-return allowance (RRA) for substantial holdings of risky assets, so that only excess returns are taxed 47 Mirrlees et al. (eds., 2010) contains a collection of expert reports on various aspects of the tax system. -capital gains above the rate-of-return allowance taxed according to the same rate schedule as earned income (labor income), with reduced rate for dividends and capital gains on shares to reflect corporation tax already paid -simplification of the tax treatment of pensions (with some incentives) -introduction of an allowance for corporate equity (ACE) into the corporation tax to align treatment of debt and equity and to ensure that only excess returns to investment are taxed -alignment of tax treatment of employment, self-employment and corporate-source income The net result of the recommendations is that the ordinary return to postponing consumption should go untaxed, whereas labor effort in all forms should enter the same progressive income tax schedule. It is worth noting that only the earned income tax schedule will contribute with redistribution from the well-to-do to the less well-to-do. The taxation of capital or wealth or, for that matter, estate and inheritances is not seen as an essential part of the tax system. The authors of the Review do propose, though, a comprehensive lifetime wealth transfer tax. In his commentary on the main points of the , (2011) refers to various arguments for some amount of tax on even the normal returns to saving and concludes that there are grounds for seeking a less dramatic change than that envisaged by the Review authors. Further, he questions whether the Review makes the right choice between its proposed system and an expenditure tax – which also does not imply any tax on the normal return to capital – listing a number of problems facing the tax system of the . He also draws attention to the way the tax system affects the burden of risk taking of entrepreneurs, arguing that risk-sharing with the government can encourage entrepreneurial risk-taking. speculates about the possible tax revenue loss related to exempting the normal return to capital from tax in an ACE system, stating that it may not be that large. The flip side of this possibility is, though, that the stimulation of investment coming from conversion to ACE may also not be very large. All in all, however, he finds the case for a change to ACE strong. is, to mind, too conservative in considering changes in the role of the corporation tax. In fact, he asks whether the dramatic proposed changes in the personal income tax (calling for exemption of interest from tax and the introduction of RRAs) could even justify the repeal of the corporation tax. Relative to no corporate income tax, a higher personal tax on supernormal returns, and RRAs to exempt the normal return to tax at the personal level he considers the corporate income tax a second best instrument which leads to non-neutralities to tax exempt investors and subjects foreigners to tax on their rents.48 Finally, discusses arguments for having an inheritance tax in lieu of an estate tax, noting that the distortions associated with taxing inheritances actually depend a lot on the reason why parents make transfers to their children. Keuschnigg (2011) likewise comments on the Mirrlees Reviews thoughts on taxing capital income. He considers the zero tax on the normal risk-free return to personal capital to be the most radical aspect of Tax by Design. It is natural for him to compare the tax system to his own proposal (see section 7.2 below) which has as its point of departure an explicit decision to tax capital income at the personal level at a low, but positive rate. He further notes that while the ACE leaves marginal investment in firms undistorted, it does distort the location of new firms (earning rents), and it is still vulnerable to profit shifting, especially if the expected loss in revenue from the ACE as compared to the traditional corporate income tax leads to a rise in the tax rate. Finally, he acknowledges the attempt in the Review to prevent tax arbitrage by balancing tax rates on corporate income, personal capital income and labor income (in the same way as his own proposal does, see below). 7.2A Swiss tax reform proposal Keuschnigg (2004), and Keuschnigg and (2007) have suggested what they call a growth oriented dual income tax for . The idea of the system is to combine an allowance for corporate equity (ACE) with a broadly defined flat tax on personal capital income (as well as a progressive tax on labor income). 48 It is interesting here to compare (2011) to the earlier article and Mackie- (1995). system is termed , where the A stands for the ACE part, while the rest stands for dual income tax, DIT. They demonstrate that the system ensures neutrality with respect to investment, firm financial decisions, and organizational form choice. Furthermore, tax rates are chosen to prevent income shifting from labor to capital income. An expected revenue loss related to the removal of the normal return to company capital is made up for by an increase in the value added tax. According to simulations of the reform from the current Swiss tax system to their system, GNP could rise by some 4 to 5 percent in the long run; a slow adjustment process leads to such long run gain, but it itself imposes considerable costs in the short run, giving rise to contemplate whether tax smoothing can offset intergenerationally redistributive effects. In more detail, the system is characterized by the following points: 1.A progressive wage tax with a top rate of tL 2.A proportional profit tax at a (flat) rate of tU, applying to all types of firms, corporate and non-corporate 3.Deduction from this profit tax of a normal return on equity (risk free return on government bonds) 4.A proportional shareholder tax tS at the personal level on all types of capital income; the rate satisfies the restriction (1 – tL) = (1 – tU)(1 – tS) to counter arbitrage via mis-declaration of wages of owners in closely held companies. 5.A surcharge on realized capital gains to offset the interest gains due to tax deferral, so that the effective rate of tax on such gains equals tS. 6.Adjustment of the value added tax to balance the government budget. Apart from stressing the neutrality properties of the system, Keuschnigg and also point to low personal capital income taxes possibly limiting capital flight to other countries. Moreover, the effective capital gains tax should improve the markets efficiency in allocating scarce capital – instead of capital being stuck in mature companies on account of favorable capital gains taxation, it may as well be directed to new and promising invest- ments elsewhere. With the value added tax covering missing tax revenue, an efficiency cost related to dampening labor supply must be included. Interestingly, Keuschnigg and compare their plan to the US debate on the dividend tax relief of the Bush administration and, in particular, to the Growth and Investment Tax Plan of the Presidents Advisory Panel on Federal Tax Reform (2005). The latter plan combines a cash-flow tax (CF) on corporate income with a dual income tax at the personal level. Both the ACE and the CF taxes exempt from tax the normal return to company capital, so the end results of the two reform proposals with regard to income in the long run and the need to invoke an increase in other taxes should be quite similar. ACE and CF primarily differ in the timing of deductions to ensure the exemption of the normal return, so short and medium run revenue effects will be different. 8 A TENTATIVE RECOMMENDATION This report started out with very general deliberations concerning design of the tax system and subsequently moved on to the role of the corporate income tax and delicate balances in the tax system. The particular complications offered by mobility of capital, firms and income in the open economy ought to also be taken into account, as should the particular effect of the tax system on entre- preneurship, not least that part of entrepreneurship which provides room for innovative goods and processes. The report has also taken a brief look at actual tax systems and some reform proposals in various countries which may provide some inspiration as to where to go with the capital and corporate income tax system in a country like . The reflections on basic system design ended up endorsing the ideas behind the dual income tax system which indeed forms the backbone of the tax system in already. precisely the combination of progressive taxation of labor income and a flat-rate tax on capital income. So the focus can become narrower in specifying a consistent implementation of the dual income tax system. Questions to be addressed in this process are 1.Should the corporate income tax rate be maintained in some form, or should it be abolished? 2.Should the CIT treat equity and debt capital equally? If so, how? 3.In particular, should the CIT imply tax on the normal return to capital? 4.Should the normal return to saving be taxed at the personal level? 5.Taking the corporate and personal level together, what should the burden of tax on capital be? Given the focus on distortions caused by capital income taxation in investment and saving decisions, and given the dubious incidence of corporate income taxation in an open economy with high capital mobility, some economists are inclined to take the full step towards abolishing the corporate income tax and rely on taxation of consumption instead, for instance in the form of an expenditure tax.49 We feel that some taxation of capital income is still warranted, and that there still is a role to play for the corporate income tax as a backstop to the personal income tax. Thus, the answer to the first question is in the affirmative. While some arguments for differential treatment of debt and equity capital in the corporate income tax can be put forth, none of them is very strong, and they may even point in different directions in regard to which of the two capital types should be more heavily taxed.50 So the first part of the second question must be answered in the affirmative. The part of the question concerns how to put equity and debt capital on an equal footing. The consequences of introducing either an ACE (or ACC) tax or a CBIT type tax in an open economy may yet be under- researched; since the ACE entails a transition to exempting the normal return to foreign shareholders, whereas a CBIT entails a transition to subjecting the return to foreign debt holders to tax, the international consequences of the two types of tax will be rather different.51 Perhaps it is more critical for CBIT to strive for coordinated transition to this tax system for a bigger group of 49Gordon (2011) plays with this thought. 50See the remarks in section 2.4 above. 51See the last paragraph in section 2.4 plus footnote 21. After all, corporate income taxation is heavily discussed in the EU at the moment. Even though Commission strives for the full CCCTB (Common Consolidated Corporate Tax Base) taxation,52 it obviously has a soft point when it comes to harmonization of the corporate tax base across countries. Common for ACE/ACC and CBIT is that the transition from todays traditional tax system to either involves some technical and distributional issues that have to be solved. The central question in choosing between the two must be, however, whether the normal return to the capital basis of firms ought to be taxed or exempted from tax. With a to go for a flat, but low tax on capital income there appears to be two clear options: Either (I) combine an ACE (or ACC) tax at the company level with a flat-rate tax on personal capital income, the latter covering both the normal and the supernormal return to savings. Or (II) combine a CBIT tax with a rate of return allowance (RRA) system at the personal level, where the latter in effect taxes the supernormal return to what is categorized as capital income, while leaving the normal return untaxed. The arguments in favor of (I) are that this combination avoids distorting investment in businesses, and that it succeeds in avoiding a second-best tax on domestically employed labor in the economy with high international capital mobility. A counter-argument is that the corporate income tax part of it may not generate much revenue and certainly less than the traditional CIT brings in today; that revenue must be recouped somehow in order to allow for unchanged government intake.53 Increased consumption taxation in the form of a higher VAT rate (or a broader VAT base) is an option here. Along the same lines, an increasing number of corporations may end up with zero or negative taxable income; this may be hard to swallow for the general public which may feel that all companies ought to contribute to society. Furthermore, combination (I) when based on ACE does not in itself solve the problems related to distorted interest rates in MNEs internal loan arrangements. The arguments in favor of (II) are that more companies will pay tax, and higher taxes than today. In particular, the likelihood that mobile multinationals contribute will increase. 52The CCCTB proposal can be found in European Commission (2011). 53If the statutory tax rate is increased during the transition to ACE (ACC) to cover loss of revenue, this will especially hit high-risk (and high expected return) investment compared to low-risk investment. interest rates and thinning the equity base are rendered irrelevant. Another argument in favor is the lessened pressure to collect revenue from personal taxation of capital income. However, here the normal return to saving goes from in principle liable to tax to being exempt from tax, meaning that a possible increase in tax revenue from corporate income taxation could be (more than) offset by a decrease in personal capital income taxation. One should remember, though, that on average, personal capital income may be negative, so that exempting the normal return to saving might generate an increase in tax revenue. Furthermore, on the surface RRA appears to be a complicated system, at least for the average tax payer; nevertheless, it is functioning in . The final verdict here depends on yet other factors, such as how the housing sector is treated in the CBIT-RRA combination. The choice between models (I) and (II) is not an easy one.