sou · H2B340 · 2014-06-12 00:00:00 — With such play and uncertainty in defining incomes of entities, and with differences in national corporate income tax rates and tax rules, it is no surprise that multinationals (as well as tax authorities) try to take advantage. After all, management in a multinational enterprise is employed to maximize shareholder value and keep down costs, including the tax burden of the company. The newly issued report on Base Erosion and Profit Shifting (BEPS henceforth), (2013a), contains ample evidence of multinationals shifting their incomes from high tax countries to low tax countries. This is accomplished by twisting prices for internal shipments and loan arrangements. It is also accomplished by tricky organizational structures including Special Purpose Entities (SPEs) which may be financial centers, holding companies, etc. designed to lower the overall tax burden. In fact, the BEPS report notes that has counted more than 400 schemes and included these in the aggressive planning directory. These schemes are all created with tax minimization as the goal. The report even explains selected popular structures in an appendix to show how the organizational design can exploit differences in tax rates and tax laws across countries.30 The existence of multinationals and their tax planning efforts represents a major external pressure on national tax legislation and enforcement. Another external pressure comes from outright tax evasion by domestic individuals or firms that place funds in foreign financial institutions without informing domestic tax authorities about returns to said placements. Despite concerted efforts to acquire information from such tax havens which, incidentally, include EU members and other European countries, there is still much room for manoeuvre for those who wish to escape domestic taxation. Summing up, in designing a tax system for the open economy, the realities of home bias; internal transactions in multinational 30 On 18, 2013, issued a preliminary version of its Action Plan on Base Erosion and Profit Shifting, cfr. (2013b). In effect, it is a framework for adjustments of the reigning regime of international taxation, with a focus on hybrid mismatch arrangements, interest deductions, CFC rules, harmful tax practices, treaty abuse, and erroneous transfer pricing. It is remarkably devoid of more radical approaches such as movements towards putting debt and equity on an equal footing and towards harmonization of tax bases and tax rules. enterprises; mobility of firms and income; and outright international tax evasion all have to be taken into account. 5 TAXATION AND ENTREPRENEURSHIP 5.1Entrepreneurship and the risk of loss Decisions of agents in the economy would be simpler without uncertainty and risk. Risk (estimable uncertainty) forces decision makers to take into account different possible outcomes and altogether decide whether a given decision is the most appropriate one. In the case of businesses, possible outcomes may include going out of business or at least registering losses and negative income. If tax systems were fully symmetric, the income tax treatment of good and bad outcomes would be similar; the same tax at which positive income would be taxed would also apply, when the extent of tax rebate were to be computed in case of negative income. In this case, government would effectively become a silent partner in all business endeavours – it would share the consequences of good and bad outcomes. At the same time, the tax lowers the incentive to exert effort to reach good outcomes. This merely generates the usual distortion to economic behavior. But worse, the government would also lower the incentive to avoid losses. For ill-conceived business ideas,31 the government would be all-in in sharing the consequences of bad outcomes without having a say. To avoid this, all real-world tax systems are not fully symmetric and imply some limitation of rebates in case of loss or negative income. For steady and mature businesses, the limits to rebates in case of loss and to loss offset are but a minor nuisance. But for new businesses for which bad outcomes are real possibilities, and where good outcomes on the other hand can be very good, the tax treatment of losses becomes essential. Therefore, speculating about how the tax system affects entrepreneurship is important. The aim is to not (overly) hold back the type of entrepreneurship which could generate significant value to society. 31 Start-ups based on erroneous expectations or designed for personal pleasure and enhancement of personal consumption. Which type of entrepreneurship do we have in mind? That would be high-risk, potentially high-value entrepreneurship on innovative ideas. It is important to recognize that many new firms have or no innovative activity and may even merely imitate what is already around. If the tax system reduced such duplication, it would not be a big problem. It is also important to recognize that in fact innovative activity may take place in mature firms as well as in start-up firms, and in large firms as well as in small firms.32 All this makes it difficult for a tax system to promote, or avoid discouraging, entrepreneurship in the form of new, innovative activity in firms. Nevertheless, attention must be given to the consequences of the tax system for entrepreneurship and innovation. What is entrepreneurship? An interesting discussion in the literature attempts to clarify the concept.33 For our purposes, entrepreneurship can be thought of as a process requiring ideas, labor effort and capital input. The preferred way to think about ideas is that they are the output of creative thinking demanding labor effort, so that in the end entrepreneurship becomes the product of labor and capital.34 5.2How taxation may affect entrepreneurship The relationship between entrepreneurship and taxation has generated much interest over recent decades. A worry has been that taxation may be especially harmful to entrepreneurship. To appreciate how entrepreneurship may depend on taxation, several elements must be factored in: -asymmetric information and the financing of entrepreneurship -choice of organizational form for the enterprise -details of the tax system 32See the discussion in et al. (2004). 33See the account given in Parker (2009); Parker focuses on economic dimensions of entrepreneurship. 34There is certainly not agreement here; see, for instance, Henrekson (2012). Henrekson imagines a third production factor, entrepreneurship capital, giving rise to entrepreneurial income (together with labor and capital). The discussion of risk and entrepreneurship must start with the famous Domar-Musgrave mechanism. Taxation in effect means that the entrepreneur takes a silent partner along with whom risk can be shared. If asymmetric information and other issues prevent the entrepreneur from achieving adequate risk sharing prior to taxation, the automatic risk sharing with the government due to taxation may increase the entrepreneurs willingness to take on risk, so should increase entrepreneurship. The argument pre- supposes not only insufficient sharing of risk with outsiders to begin with, but also a proportional tax system with negative tax payments (tax rebates) in case of business loss. Deviating from proportional tax and introducing a progressive tax system, taxation can have the opposite effect on risky entrepreneurship. Good outcomes may result in high income which is taxed at a high marginal tax rate. Bad outcomes may be taxed at a low marginal tax rate, and outright losses may be deducted at such a low rate. The asymmetric treatment of good and bad outcomes could hamper entrepreneurship.35 Both mechanisms in effect rely on entrepreneurs being taxed in the personal tax system. The next step is to open up for choice of organizational form. The opportunity to incorporate the business in case of a promising outcome may take the edge off the previous argument and turn it on its head. Good outcomes may be leniently taxed via the corporate income tax and, eventually, a low effective capital gains tax, if the entrepreneur pursues incorporation. Bad outcomes can, on the other hand, be offset against high income and associated high marginal tax rate, if the entrepreneur abstains from incorporation and remains taxable in the personal income tax system.36 (However, in the possibility for self-employed to offset business losses against other kinds of income is quite limited.) The more flexible the choice of organizational form (choice of form ex post rather than ex ante), the stronger this mechanism can be. And the higher is the personal tax rate compared to the corporate one, the stronger should the mechanism be. (However, in business losses of self-employed is treated as capital losses and thus proportionally taxed, so the mechanism sketched is not likely to have much bite there.) 35Gentry and (2004) stress this mechanism. 36See Cullen and (2007) as well as the broader discussion therein. Furthermore, the tax system may invite individuals to become self-employed rather than regularly employed. A large literature on occupational choice details when this may happen. Self- employment is inherently risky, so risk taking can be increased if self-employment is relatively leniently treated in the tax system. The article by Cullen and (2007) demonstrates that each of these four mechanisms have played themselves out in the US case, and together they have had large effects on the amount of entrepreneurial risk taking. A series of Swedish investigations shed further light on the links between taxation and entrepreneurial behavior. (undated) shows, using a rich Swedish data set from 1990/91, that small business owners taxable income is about twice as responsive to tax rate changes compared to employees. Stenkula (2012) finds that tax policy can indeed affect the rate of self-employment in a modern welfare state like . He concludes from his empirical investigation that payroll taxes have had a negative influence on the unincorporated rate of self-employment, though the effect is modest. No effects can be registered from regular labor income taxation or capital gains taxation. and (2013) carry out a study of the choice of organizational form for businesses in , in particular the choice between a closely held corporation (CHC) and proprietorship (sole or partnership). Lower-income individuals are seen to face relatively neutral incentives, but higher- income households face strong incentives to be corporate. Indeed, the data suggest a strong response to these tax incentives. Together with a series of contributions from other countries these investigations make clear that the decision to become self- employed; entrepreneurial risk taking; the decision to incorporate; and the effort exerted in businesses all are significantly affected by the tax system.37 Given the interest in the innovative part of entrepreneurship it is natural to take a look at start-ups which involve specialized financial agents in the form of venture capital. Compared to more passive financiers like banks, venture capital firms (and business ) take on a more role in supporting new businesses. 37 Parker (2009, chs. 16 and 17) surveys the theoretical and empirical literature on the effects of capital gains, income, payroll and corporate taxes on entrepreneurship. Identifying a series of possible mechanisms triggered by income and payroll taxes he writes that theory alone cannot resolve the question of appropriate taxation of entrepreneurs incomes. He also (on p. 434) concludes about the empirical work that it has generated mixed results about the effects of income taxes on rates of participation in entrepreneurship. They not only provide capital but also screen projects more intensively; give advice to entrepreneurs; hire key personnel; and insist on stronger covenants in their financial contracts with entrepreneurs. The question is how public policy, including taxation, works under such conditions. In a series of papers, Keuschnigg and (2004b, 2006) demonstrate possible links between the quantity and quality of start-up firms on one hand and selected taxes and investment subsidies on the other. Investment subsidies are not helpful in pro- incentives to entrepreneurs and venture capitalists to create value in new firms. Cuts in dividend, capital gains and corporate taxes are more helpful; existing taxes may already have lowered incentives for entrepreneurs and venture capitalists to provide effort within the company, as both feel the full cost of extra effort, while results of extra effort have to be shared with the other part. A cut in taxes will lessen the associated distortion, whereas an increase in taxes will cause a first order negative welfare effect. A leading expert in the area of venture capital (and private equity), , has recently looked at the possible determinants of venture capital supported entrepreneurship together with , cfr. and Tåg (2013). They undertake a major literature review as well as a comparison of conditions in the US and in . The literature has considered the influence of the legal environment; financial market development; labor market regulations; public R&D spending; intellectual property rights (IPRs); technology transfer; and tax policy for the activity in VC-financed firms. The listing of all those other possible determinants serves to remind us that taxation is but one possible determinant of start-up activity. and Tåg draw attention to new research38 which demonstrates that excessive corporate taxes affect not only the investments of mature firms, but also entrepreneurship through diminishing the gains from starting new businesses in the first place (as expected profits when the firm matures will be lower).39 They also refer to a study of the relation between capital gains taxes and the use of convertible preferred equity in VC contracts40 which finds a correlation between decreases in capital gains taxes in and the use of such equity. 38Djankov et al. (2010). 39On this, see also Keuschnigg and (2004). 40Cumming (2005). So, while some insights into the relation between entrepreneur- ship and taxation, in theory and in practice, has been gained, the area is so central and important that we should aim at studying a fuller range of entrepreneurship aspects in models of taxation, as Henrekson and Sanandaji (2008) write. 6 ACTUAL TAX SYSTEMS In this chapter we briefly comment on aspects of actual tax systems in selected countries. We start out with the tax system the author is most familiar with and move on to and a few other countries. 6.1The current tax system in In , the main tax revenue driver has always been the personal income tax. In fact, labor effort has almost exclusively been taxed via the personal income tax, whereas social security contributions, incl. payroll taxes, have always been minimal.41 The tax system in underwent a major change in 1987. Following commission work on the tax system which ended up with the proposal for a split between capital income and labor income, important steps were taken towards a dual income tax system. Previously very high personal income tax rates for comprehensive income, i.e. the sum of personal labor and capital income, were lowered, and the tax treatment of capital income was separated from that of labor income. Since the 1987 reform, the schedule for taxation of personal net capital income has become more progressive, so that at the moment it is characterized by no less than four different marginal tax rates (two for negative, two for positive net capital income) as compared to merely two non- zero marginal rates for the progressive labor income tax. Thus, while a fortiori there is separation of labor income and capital 41 As the comparisons across EU member countries in European Commission (2013) renders clear, has by far the lowest intake of revenue from social security contributions. Personal income tax revenue is correspondingly among the highest in EU, while the overall tax burden on labor is in the middle of the field. income at the personal level, the resulting tax system is clearly far away from a pure dual income tax.42 Personal (net) capital income here is composed of interest on bank accounts and bonds etc. minus interest payments on loans, etc. Dividends and capital gains from share holdings are treated in a separate system with two lower rates (as compared to the two rates applicable to positive capital income). The return to pension savings in occupational or individual pension schemes is subject to one, relatively low, tax rate, irrespective of the source of that return (from bonds, shares, real estate, or other types of placements). Finally, the return to owner-occupied housing is taxed very leniently via a low, effective tax on imputed rent; the so-called tax freeze inserted by the right-wing government in 2003 has almost completely diluted this tax. The corporate income tax is of the traditional sort, with merely one rate. No special concessions are made to small firms in the CIT; however, small, privately traded firms are given special treatment in that dividends and capital gains from these firms to small shareholders are tax-exempt.43 The rates in the personal income tax system (labor income, capital income) and the corporate income tax system bear evidence of a balancing effort. The highest rate of personal labor income tax corresponds rather closely to the combination of the corporate income tax rate and the highest tax rate on dividends and capital gains, which again is not too far from the highest marginal tax rate on (positive) personal capital income. This is all in order to preempt the shifting of income. Apart from this fact, though, capital income is effectively taxed at very different rates, all depending on the actual placement. At the top you have the real, effective rate of tax on interest on bonds and bank accounts (once it is taken into account that part of the interest merely is a compensation for ongoing inflation), while at the bottom you have the effective taxes on pension savings and on imputed rent on housing. Furthermore, while the personal tax on capital income, the taxation of income from shares, and the taxation of imputed rent on housing all feature elements of progression, these elements are entirely uncoordinated. 42For a discussion of the Danish tax system and Danish tax policy through the last three decades see et al. (2013). 43The previous tax was nicknamed the entrepreneur tax and was repealed following successful lobbying. Evaluating the Danish tax system may therefore end up with the conclusion that while the system certainly has traces of careful adjustments with possible income shifting in mind, the taxation of capital income is strictly a mess, and the system is stuck somewhere between a traditional comprehensive income tax and the pure dual income tax. 6.2The treatment of corporate and capital income in the Swedish tax system The Swedish tax system underwent a very substantial change with effect in 1991. That tax reform was even christened the tax reform of the century (cfr. Agell et al. (1996)). With the reform, took a full-scale step away from a comprehensive income tax system to a dual income tax system.44 Since then, the basis of the tax system has been progressive taxation of labor income plus a flat-rate capital income tax. At the moment, labor is taxed at municipal plus state rates of up to around 51 percent (56 percent for the highest incomes); adding social security contributions, the effective marginal rate on wages approaches 67 percent. This may be compared to the basic rate on personal capital income which is As said, the taxation of labor in includes not only the personal income tax, but also sizeable social security contributions (incl. payroll tax) paid by employers as well as employees. In an EU context, though, social security contributions in are at the lower end, and the total tax burden on labor is not quite at the EU top.45 There is no inheritance and gift tax anymore, as it was abolished as of 2005; likewise, the wealth tax was abandoned in 2007. The corporate income tax is of the traditional type. the years the corporate income tax rate has come down substantially, just like in all neighboring countries. At the same time, steps have been taken to broaden its base; again, the same pattern as seen in countries close by. Until recently, the rate of corporate income tax was 26.3 percent, but it was lowered to 22 percent in 2013. 44A fascinating account of Swedish tax policy discussions and changes through the decades can be found in (2011). 45Again, we can refer to European Commission (2013). The taxation of corporate-source income follows the classical system, implying that dividends (and capital gains) from corporations are liable to personal capital income tax. This is double taxation in its purest form. Dividends and capital gains are generally taxable at the 30 percent rate. (Capital gains from housing are taxed at a 22 percent rate.) Other businesses compute their taxable income in precisely the same way as corporations, irrespective of their size or legal status. But the way the tax system handles that taxable income is quite different across organizational forms. To get a sense of this, it is useful to distinguish between -sole proprietorships (SPs) -closely held corporations (CHCs) -widely held, private corporations (WHRs) -widely held, public corporations (WHUs) Absent other considerations, the ideal would be that taxation of business projects will be the more or less the same across organizational forms, so that the decision as to from can depend on more fundamental factors. As Sørensen (2008) demonstrates, the ideal is quite far from reality in . He investigates the extent to which the tax system discriminates between alternative organizational forms, providing a set of computations of effective marginal and average tax rates for the four types above in different settings: a going business concern; a going concern with income volatility; and a stylized life cycle for a new start-up. For the closely held corporations he considers the so-called 3:12 rules. The rules are applicable to qualified owners who together with at most three other owners own at least 50 percent of voting shares in the company and at the same time are in the firm. Various elements of the tax system differ across the business types. the computation of the capital income component of taxable income for SPs and CHCs; the imputed return used is signify- cantly higher for the CHCs than for the SPs the rules as to social security taxes the applicable tax rates on dividends (and capital gains); the dividend tax rate was 30 percent for the WHUs, lower at 25 percent for WHRs, and lower yet for CHCs at 20 percent For some computations, the differences in tax rules have offsetting effects, so that effective tax rates are not too far apart. In other situations, the differences reinforce each other. The most striking result is that choosing a sole proprietorship for a start-up company implies much heavier taxation that if any of the three remaining alternative organizational forms were chosen. In a large report for the Swedish Expertgruppen för studier i offentlig ekonomi (Alstadsæter and , 2012b) and a series of follow-up articles (such as Alstadsæter and (2012a)), Alstadsæter and have performed a major investigation of the Swedish 3:12 rules and the development of the rules over the last decade. Originally, the rules were intended to secure that the labor component of business income in closely held companies would receive labor income treatment in the progressive tax system, while the capital component would be treated as such.