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canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 3, 557 - 602

557

The Nordic Dual Income Tax: Principles, Practices, and Relevance for Canada

Peter Birch Sørensen*

P r é c i s

Le double régime d’impôt sur le revenu combine des taux progressifs d’impôt sur le revenu de travail et un faible taux uniforme d’impôt sur le revenu de capital et le revenu des sociétés. Les pays nordiques ont été les premiers à mettre en place un tel régime fiscal et leur expérience peut servir de guide pour d’autres pays qui pourraient tirer profit de leur expérience. Cet article porte sur les arguments en faveur d’un tel régime, en mettant l’accent sur l’imposition du revenu de travailleur indépendant et du revenu de sociétés à peu d’actionnaires, décrit d’autres méthodes d’imposition du revenu d’entreprise dans le cadre d’un tel régime et passe en revue les pratiques fiscales actuelles dans les pays nordiques. L’auteur présente les arguments à l’appui d’un tel régime au Canada et suggère comment ce régime ou des éléments de ce régime pourraient être mis en place dans le contexte du régime fiscal fédéral existant.

A b s t r A c t

The dual income tax combines a progressive tax schedule for labour income with a low flat tax rate on capital income and corporate income. The Nordic countries have taken the lead in implementing a dual income tax system, and their experience can serve as a guide to other countries that may benefit from this approach. This article discusses the case for the dual income tax; describes alternative methods of taxing business income under such a system, focusing on the taxation of income from self-employment and income from closely held corporations; and reviews current tax practices in the Nordic countries. The author presents arguments for adopting a dual income tax in Canada and suggests how (elements of ) the tax might be implemented in the context of the existing federal tax system.

Keywords: Canada n Capital taxes n Corporate inCome taxes n double taxation n nordiC n personal inCome taxes

* OftheDepartmentofEconomics,UniversityofCopenhagen.ThisarticleisbasedonareportoriginallypreparedfortheCanadianDepartmentofFinance.IhavebenefitedgreatlyfromcommentsbyMiodragJovanovic,JohnLester,andananonymousreferee.Ibearfullresponsibilityforanyremainingshortcomingsandforallviewsexpressed.

558 n canadian tax journal / revue fiscale canadienne (2007) vol. 55, no 3

c o n t e n t s

Introduction 559Alternative Designs for the Income Tax 559

The Progressive Comprehensive Income Tax 559The Expenditure Tax 561The Dual Income Tax 562

The Rationale for the Dual Income Tax 564The Dual Income Tax, Income Distribution, and Public Revenue 564The Case for the Dual Income Tax 565Alternatives for the Design of a Dual Income Tax 566

Taxation of Income from Self-Employment 568The Problem: Income from Self-Employment Derives from Both Capital

and Labour 568Alternative Methods of Income Splitting 568Anti-Avoidance Measures 570The Treatment of Losses and the Choice of the Imputed Rate of Return 571Taxation of the Self-Employed in the Nordic Countries 573Some Final Observations on Income Tax Design for the Self-Employed 573

Taxation of Income from Closely Held Corporations 574The Income-Shifting Problem 574One Solution: Treating Small Companies like Proprietorships 574An Alternative Solution: A Shareholder Income Tax with a Rate-of-Return

Allowance 575Holding Period Neutrality Under the Shareholder Income Tax 578The Imputed Return and the Treatment of Losses 580The Treatment of Debt Versus Equity 581The Treatment of Cross-Border Shareholdings 582The Treatment of Corporate Shareholders 582Small Versus Large Companies 583The Tax Schedule for Shareholder Income: Full Integration of the Corporate

and the Personal Income Tax? 584Introducing and Administering the Shareholder Income Tax 584Double Tax Relief for Companies or for Shareholders? 585Discrimination in Treatment of Proprietorships and Small Companies? 586Taxation of Closely Held Corporations in the Nordic Countries 588

A Dual Income Tax for Canada? 590The Canadian Income Tax System: Current Situation 590Should Canada Move Toward a Dual Income Tax? 591Outline of a Dual Income Tax for Canada 592The Income-Shifting Problem Under a Canadian Dual Income Tax 594Is There a Need for Integration of the Corporate and the Personal

Income Tax? 596A Shareholder Income Tax for Canada? 598Double Tax Relief at the Corporate Level? 600

the nordic dual income tax n 559

intro duc tio n

In theearly1990s, theNordic countries introduceda so-calleddual income tax(DIT),whichsystematicallyseparatesthetaxationofcapitalincomefromthetaxa-tionofothertypesofincome.Morerecently,severalotherEuropeancountrieshaveadoptedelementsofdualincometaxationbyapplyingaseparateflattaxratetoim-portantformsofcapitalincome,suchasinterestanddividends.

ThisarticledescribestheprinciplesoftheDITanddiscussesvariouspolicychoicesandpracticalissuesinvolvedintheimplementationofsuchataxsystem.IbeginbybrieflycomparingtheDITwithotherblueprintsfortheincometax,andthendiscussthevariousreasonswhygovernmentsmightwanttoadoptaDIT.Themainchal-lengeraisedbyaDITsystemisthetaxationofbusinessincomethatincludeselementsoflabourincomeaswellascapitalincome.Usingnumericalexamples,anddrawingoncurrentpracticesintheNordiccountries,IdescribeseveralalternativemethodsoftaxingincomefromsmallenterprisesunderaDIT.Finally,IexplainwhyaDITmightbeappropriateforCanadaandhowthetaxmightbedesignedintheCanadiancontext.

A ltern Ati v e de signs fo r the income tA x

InordertohighlightthespecialfeaturesoftheDIT,thissectionbrieflyconsidersalternative“granddesigns”forasystemofincometaxation.

The Progressive Comprehensive Income Tax

Historically,mostincometaxsystemsindevelopedcountrieshavebeeninspiredbytheprincipleof“comprehensive”or“global”incometaxation.Underaprogressivecomprehensiveincometax,thetaxpayer’sincomefromallsourcesisaddedupandsubjectedtoacommonprogressivetaxschedule.Thisisincontrasttoa“schedular”taxsystem,wheredifferenttypesofincomearetaxedseparately.

Ideally,taxableincomeunderacomprehensiveincometaxwouldequalthemaxi-mumamountthatthetaxpayercouldconsumeduringtheyearwithoutreducinghisorherrealnetwealth.Amongotherthings,thiswouldimplythatallaccruedrealcapitalgainsshouldbetaxed,whetherornottheyhavebeenrealized.Further,onlythecostsnecessaryforacquiringandmaintainingincomeshouldbedeductiblefromtaxableincome,andincomeinkind—including,forexample,fringebenefitsandtherentalvalueofowner-occupiedhousing—shouldbeincludedinthetaxbase.

Thus,thecomprehensiveincometaxisbasedontheideathatallofthetaxpayer’sincome—regardlessofitsform—shouldbetaxedinthesamemanner.Inparticular,underanidealizedcomprehensiveincometax,allincomeshouldbetaxedonce(andonlyonce).Insuchasystem,thecorporationtaxwouldserveonlyasapreliminarywithholdingtaxthatwouldbefullycreditedagainstthepersonaltaxoncorporate-sourceincome,thusavoidinganydoubletaxation.Thedoubletaxationofdividendscanbeeliminatedbygrantinganimputationcreditfortheunderlyingcorporatetax


against the personal tax on distributed profits.1 The double taxation of retainedprofitscanbeeliminatedbyallowingthebasis(costprice)ofsharestobesteppedupbytheamountofretainedearningsthathavealreadybeensubjecttocorporationtax,sothatpersonalcapitalgainstaxisleviedonlyoncapitalgainsinexcessofretainedtaxableprofits.2

Duringthe1980sand1990s,manycountrieswithintheOrganisationforEconomicCo-operationandDevelopment(OECD)madeaseriousattempttomoveclosertoacomprehensiveincometaxbase.Forexample,theambitiousUstaxreformof1986involvedasignificantbroadeningofthetaxbaseasameansoffinancingreductionsinmarginaltaxrates.

Onevirtueofthecomprehensiveincometaxisthat,byimposingthesamemar-ginaltaxrateonallformsofincome,iteliminatesthepossibilitythattaxpayersmayreducetheirtaxbillbytransformingonetypeofincomeintoanother.

Oneprobleminimplementinganidealcomprehensiveincometax—and,indeed,anyincometax—isthedifficultyoftaxingunrealizedcapitalgains,stemmingpartlyfromthedifficultyofassessingthemagnitudeofanunrealizedgain,andpartlyfromthefactthatthetaxpayermaylacktheliquiditytopaytaxonanunrealizedgain.Forthesereasons,taxwillnormallyhavetobeleviedonlyonrealizedgains.

Whenunrealizedcapitalgainsonsharesgeneratedbyretainedcorporateprofitscannotbeincludedinthepersonaltaxbase,acomprehensiveincometaxtendstoworkbestifthecorporateincometaxrateisalignedwiththetopmarginalpersonalincometaxrate.Inthatcase,notaxpayerwillbeabletogainbyaccumulatingin-comewithinacorporation,ratherthantakingoutincomeintheformofdividendsorrealizedcapitalgains,assumingthatthedoubletaxationofcorporateincomeisfullyalleviatedinthemannerdescribedabove.

However,facedwithgrowingcapitalmobility,countriesthroughouttheworldhaveloweredtheircorporatetaxratesinrecentdecadesinanefforttoattractorretaincorporateinvestment.Ifthecorporatetaxratehastobekeptconsiderablybelowthetopmarginalpersonaltaxrateinordertoavoidcapitalflight,acomprehensiveincometaxsystemwithacapitalgainstaxbasedonrealizationswilltendtocausea“lock-in”ofcapitalinthecorporatesector,wheretaxpayerscanaccumulateincomeatthelowcorporatetaxrate,thusdeferringthehighermarginaltaxleviedonlabourandcapitalincomeoutsidethecorporatesector.Inthisway,thetaxsystemallowshighincomeearners to (partly) escape from theprogressivityof thepersonal income tax andhampersthereallocationofcapitalfromexistingenterprisestowardpotentiallymoreproductiveinvestmentprojectsinnewenterprisesorintheopencapitalmarket.

1 Ratherthanrelyingonanimputationsystembasedonactualcorporatetaxespaid,policymakersmaychooseonadministrativegroundstoapplyanotionalimputationsysteminwhichthedividendtaxcreditisbasedontheassumptionthattheunderlyingprofitshavebeensubjecttonormalcorporationtax.

2 sucharegimeforcapitalgainstaxationwasproposedinCanadabytheCartercommissionin1966(Canada,Report of the Royal Commission on Taxation(Ottawa:Queen’sPrinter,1966))andwasappliedinNorwayfrom1992through2005.


Furthermore,becauseofthedifficultiesofenforcingdomestictaxonforeign-sourceinvestmentincome,growingcapitalmobilitymakesitincreasinglydifficulttomaintainhighmarginaltaxratesonpersonalcapital incomewithoutinducingcapitalflight.Hence,theincreasingmobilityofcapitalrelativetolabourmakesitlessattractivetosticktotheprinciplethatcapital incomeshouldbetaxedatthesame(high)marginaltaxrateaslabourincome.

Forthisreason,andbecauseofthepracticalandpoliticaldifficultiesoftaxingcertainformsofcapitalincome(suchasimputedrentsonowner-occupiedhousingandmanytypesofcapitalgains),taxsystemsthatarenominallybasedontheprinci-pleofcomprehensiveincometaxationareinpracticehybridsthatallowexemptionsorpreferentialtreatmentofmanyformsofcapitalincome,oftenresultinginserioustaxdistortionstothepatternofsavingandinvestment.

The Expenditure Tax

The difficulties of implementing a consistent comprehensive income tax on allformsofcapitalincomehaveledmanyobserverstoadvocatethatpersonaltaxationbebasedonconsumptionratherthanincome.Underaconsumption-basedpersonaltax—alsoreferredtoasanexpendituretax—allsavingswouldbefullydeductiblefromthetaxbase.Effectively,thiswouldmeanthatallnormalreturnstocapitalwouldbeexemptfromtax,sointhissenseallcapitalincomewouldbegiventhesametaxtreatment.Asimplenumericalexamplemayillustratethispoint.supposethatataxpayerpurchasesanassetworth$100inyear1andsellstheassetinyear2atapriceof$105,thusscoringa5percentrateofreturnbeforetax.(Forsimplicity,weassumethatallofthereturntakestheformofthe$5capitalgain.)Inyear1,thetaxpayerwillbe able todeduct thepurchasepriceof$100 fromhis taxbase, sothat—assumingamarginaltaxrateof50percent—hisnetoutlaywillbeonly$50.Inyear2,hisafter-taxrevenuefromtheassetsalewillbe$52.50,assumingthathismarginaltaxrateisstill50percent.Thus,thetaxpayer’snetrateofreturnwillbe$2.50/$50=5percent,whichisequaltothepre-taxrateofreturn.

sinceataxpayer’sconsumptionequalshiscashreceiptsminushiscashoutlays,theexpendituretaxisataxonthetaxpayer’snetcashinflowduringtheyear.3Forbusinessowners,thismeansthatallinvestmentspendingisfullydeductibleintheyearofinvestment.Fora“marginal”investmentthatonlyyieldsanormalrateofreturn,thepresentvalueofthecashinflowsfromtheinvestmentisjustequaltotheinitialinvestmentoutlay.Inpresentvalueterms,suchaninvestmentwillthereforegeneratenotaxliability,sointhissensetheexpendituretaxexemptsthenormalre-turntobusinessinvestmentfromtax.However,inframarginalinvestmentsyieldingabove-normal returnswillgeneratepositive tax revenues inpresentvalue terms.Thisisoneoftheattractionsoftheexpendituretax:atthemarginthereisnodistor-tiontosavingandinvestment,butpureprofitswillindeedbetaxed.

3 Insofarasthetaxpayerhasreceivedincomeinkindduringtheyear,thismustbeaddedtohisexpendituretaxbase,aswouldbethecaseunderacomprehensiveincometax.


Despitethetheoreticalattractions,nocountryhasyetadoptedafullydevelopedexpendituretax.4Thecountriesthathaveconsideredthisoptionhavebeendiscour-agedbytheperceivedtransitionproblemsandtheinternationalcomplicationsraisedbyaswitchtoexpendituretaxation.However,itshouldbenotedthatunderexistingincometaxsystems,retirementsavingistypicallytreatedinthesamewayasallformsofsavingunderanexpendituretax:contributionstopensionplansaredeductible,therateofreturnonsavingsistax-exempt,andthepensionspaidoutaretaxable.

The Dual Income Tax

Asacompromisebetweentheprogressivecomprehensiveincometaxandtheex-pendituretax,severalcountrieshaveadoptedaDIT.Thiscombinesaflattaxrateoncapital income with progressive taxation of labour income and (possibly) otherformsofnon-capitalincome.Whereastheexpendituretaxcompletelyexemptsthenormalreturntocapitalfromtax,theDITimposessomeamountoftaxonnormalreturns,butataproportionalratethatistypicallyconsiderablybelowthetopmar-ginaltaxrateonlabourincome.InthepureformoftheDIT,thepersonaltaxrateoncapitalincomeisalignedwithboththecorporateincometaxrateandthemar-ginaltaxrateonlabourincomeinthefirstbracket.

ThekeydistinctioninaDITsystemisthatbetweencapitalincomeandotherin-come.Indeed, theDIT issimplyaparticular formofschedulartaxthatappliesaseparateproportionaltaxtocapital incomeandaprogressivetaxscheduletothesumofthetaxpayer’sincomefromothersources.UnderapureDIT,capitalincomewouldincludeinterest,dividends,capitalgains,rentalincome,imputedreturnsonowner-occupiedhousing,andanimputedreturnoncapitalinvestedinunincorpor-ated firms. Negative capital income such as interest expenses and capital losseswouldbedeductibleonlyagainstotherincomefromcapitalandwouldthusattracttaxreliefatthelowflattaxrateapplyingtosuchincome.Ingeneral,akeyelementofthephilosophyoftheDITisthattheflatcapitalincometaxshouldbeasbroad-basedaspossible,soastoachievethegreatestpossibledegreeofuniformityandneutralityincapitalincometaxation.

TheDITwaspioneeredbytheNordiccountries.Table1providesanoverviewofcurrenttaxpracticesinFinland,Norway,andsweden,whichhaveimplementedthemostconsistentversionsofthesystem.5Inthesecountries,theflatcapitalincometaxraterangesbetween28and30percent.Thisisroughlyinlinewithboththecorporatetaxrateandthelowestmarginalrateinthelabourincometaxschedule,butfarbelowthetopmarginaltaxrateonlabourincome.Becauseofthe“flatness”ofthecapital incometax, inmanycasesitcanconvenientlybecollectedbyfinal

4 sriLankaandIndiadidbrieflyexperimentwitharudimentaryexpendituretaxinthe1960s.

5 DenmarkwasthefirstcountrytointroducetheDIT,in1987,buthassubsequentlymovedtoahybridbetweenthecomprehensiveincometaxandtheDIT.Itisthereforenotincludedintable1.


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withholding.However,forsymmetryandneutrality,theNordiccountriesofferataxcreditfornegativenetcapitalincome,orallowittobeoffsetagainstpositiveincomeinthefirsttaxbracket.WhileitwasoriginallypartoftheDITphilosophytoavoiddoubletaxationofcorporate-sourceincome,theNordiccountrieshavenotfullydoneso—thoughNorwaycomesclosebyexemptinganimputednormalre-turntoallsharesfromtaxesondividendsandcapitalgains.

the r Atio n A le fo r the duA l income tA x

The Dual Income Tax, Income Distribution, and Public Revenue

TheNordiccountrieshaveabandonedprogressivetaxationofcapitalincomeasameansofredistributingincome—notbecausetheyhavegivenuponprogressivity,butbecausetheyhaveconcludedthatprogressivetaxesoncapitalincomearenotgoodatachievingit,andmayevenhavecounterproductiveeffects.Taxingcapitalincomewhenitispositivealsomeansallowingadeductionforitwhenitisnegative.IntheNordiccountriespriortotheDITreforms,highincomeearnerswereoftenabletoachieveaconsiderablereductionintheirtaxliabilitybyexploitingthede-ductibilityofinterestpaymentsagainstearnedincomewhileplacingtheirsavingsintax-favouredassets.Indeed,asaresultofsuchpractices,thenetrevenuefromthepersonaltaxoncapitalincomeinNorwayandswedentendedtobenegativebeforetheintroductionoftheDIT.ByadoptingtheDIT,thesecountriesactuallygainedrevenuethatwasusedtolowermarginaltaxratesonlabourincome.AtthesametimeastheNordiccountriesbroadenedtheircapitalincometaxbaseandloweredthecapitalincometaxrateinordertostrengthenpublicrevenue,theycontinuedtopursuetheirdistributionalgoalsbymaintainingaprogressivetaxschedulefornon-capitalincome.

a seventypercentofdividendsexceedingE90,000butfallingbelowtheimputedreturnaretaxedascapitalincome.

bThatis,(28×0.7).c Appliesonlytodividendsinexcessofanimputedrateofreturnontheshares.dForactiveownersofcloselyheldcompanies,dividendsbelowanimputedreturnaretaxedata

reducedrateof20percentwhiledividendsabovetheimputedreturnaretaxedaslabourincome.Dividendsreceivedby“passive”ownersofunquotedcompaniesaretaxedatareducedrateof25percent.

eAppliesonlytocapitalgainsinexcessofanimputedrateofreturnontheshares.f Foractiveownersofcloselyheldcompanies,capitalgainsbelowanimputedreturnaretaxed

atareducedrateof20percentwhilegainsabovetheimputedreturnaretaxedaslabourincome.Gainsrealizedby“passive”ownersofunquotedcompaniesaretaxedatareducedrateof25percent.

gFordomesticresidents.source:Author’scompilationofinformationfromtheInternationalBureauofFiscalDocumentation.

tAble 1 Concluded


The Case for the Dual Income Tax

Inthescandinaviancountrieswithliberalrulesforinterestdeductibility,therevenueargumentstatedaboveprovidedanimportantmotivationformovingtowardaDIT.Incountrieswithtighterlimitationsonthedeductibilityofnegativecapitalincome,thisargumentmaycarrylessweight.However,severalotherargumentshavebeengiveninfavouroftheDIT.Thesecanbesummarizedasfollows:6

1. Accounting for capital mobility.Ascapitalbecomesincreasinglymobileacrossinternationalborders,thereisagrowingriskthatahighdomesticcapitalincometaxratewillinducetaxpayerstomovetheirwealthtoforeignlow-taxjuris-dictions(makingitveryhardtobringthatincomeintothedomestictaxnet).separatingthecapitalincometaxratefromthelabourincometaxscheduleallowspolicymakerstolowerthecapitaltaxrateandreducetheriskofcapitalflight.

2. Improving tax neutrality. Capital income accrues in many forms. some ofthem(suchasimputedrentonowner-occupiedhousing)arehardtotax,forpracticalorpoliticalreasons.Loweringthetaxrateonthosetypesofcapitalincomethatcanbetaxedreducesthedistortionsthatarisewhencertaintypesof capital income cannot be included in the tax base. A low tax rate alsomakesiteasiertoincluderealizedcapitalgainsinthetaxbasewithoutser-iouslydiscouraginganddistortingassettrades.

3. Accounting for inflation.Theincometaxistypicallyleviedonthefullnominalreturntocapital,includinganinflationpremium,whichonlycompensatesfortheerosionoftherealvalueofnominalassets.Thus,(manyformsof )capitalincomewouldbeovertaxediftaxwerechargedatthetopmarginalrateapplyingtolabourincome.Applyingalowflattaxratetocapitalincomeisapragmaticwayofdealingwiththisproblem.

4. Reducing the scope for tax avoidance.Aligningthecorporatetaxratewiththepersonaltaxrateoncapitalincome,andequalizingmarginalcapitalincometaxratesacrosstaxpayers,eliminatesthescopefortaxarbitrageactivitiesthatseektoexploitdifferencesinthoserates.

5. Reducing discrimination against saving.Bytaxingthereturntosaving,acon-ventional income taxdiscriminates against taxpayerswho savea relativelylargepartoftheirlifetimeincomeintheearlystagesoftheirlifecycle,since

6 ForamoredetaileddiscussionofthecasefortheDIT,seePeterBirchsørensen,“FromtheGlobalIncomeTaxtotheDualIncomeTax:RecentTaxReformsintheNordicCountries”(1994)vol.1,no.1International Tax and Public Finance57-79;PeterBirchsørensen,ed.,Tax Policy in the Nordic Countries(Basingstoke,Hampshire,UK:PalgraveMacmillan,1998);sijbrenCnossen,“TaxingCapitalIncomeintheNordicCountries:AModelfortheEuropeanUnion?”insijbrenCnossen,ed.,Taxing Capital Income in the European Union: Issues and Options for Reform(Oxford:OxfordUniversityPress,2000),chapter8;andRobinBoadway,“TheDualIncomeTaxsystem—AnOverview”(2004)vol.2,no.3CESifo DICE Report3-8.


those individualswillenduppayingahigher lifetimetaxbill thanpeoplewithsimilarearningswhochoosetosaveless.Reducingthecapitalincometaxratealleviatesthisdiscrimination.

IntheNordicpublicdebate,theso-calledinflationargument(thethirdpointabove)playedanimportantroleinhelpingtopersuadeadherentstoredistributionofthefairnessoftheDIT.Theinflationargumenthasconsiderableforceevengivenmoderateinflationrates.Forexample,ifthenominalinterestrateis4percentandtherateofinflationis2percent,a50percenttaxrateonnominalinterestimpliesthatalloftherealinterestof2percentistaxedaway.Thus,ifthetopmarginaltaxrateonlabourincomeis50percent,a25percenttaxrateonnominalcapitalincomewouldsufficetoalignthetaxationofrealincomefromcapitalwiththetaxationofincomefromlabour.

Forpolicymakers,theso-calledcapitalmobilityargument(thefirstpointabove)alsoplayedacrucialroleinthepushfortheDIT.Aligningthemarginaltaxrateoncapitalincomewiththeveryhightopmarginaltaxratesonlabourincomeprevail-ingintheNordicregionwasseenasanunsustainablepolicyinaworldofgrowingcapitalmobility.Moreover,asharpreductioninmarginaltaxratesonlabourincomewasfoundtobetoocostlyforthepubliccoffersandunacceptablefromadistribu-tionalviewpoint.MovingfromacomprehensiveincometaxtoaDITwasawayofescapingfromthisdilemma.

similarconsiderations—especiallytheconcernwithinternationalcapitalmobility—haveledmanycountriesoutsidetheNordicregiontointroduceelementsofdualincometaxation.7Forexample,severalcountries(includingAustria,Belgium,Ger-many,Italy,slovenia,andTurkey)haveintroducedfinalflatwithholdingtaxesoninterestanddividendsatratesfarbelowthetopmarginallabourincometaxrate.

WhileseveralargumentscanbeadvancedinfavouroftheDIT,thistaxsystemalsoraisessomeadministrativechallenges.ThemaindifficultywiththepureversionoftheDITistheneedtosplittheincomeofactiveownersofsmallfirmsintoacapitalincomecomponentandalabourincomecomponent.Indeed,thisisoftenseenastheAchillesheeloftheDIT.Thediscussionthatfollowswillfocusonpossiblesolu-tionstothisproblemandtherelatedproblemofintegratingthecorporateandthepersonalincometaxunderaDIT.First,asanintroductiontosomeoftheissuesin-volved,IwilldescribetwoalternativeversionsoftheDIT.

Alternatives for the Design of a Dual Income Tax

Aswellastakingmanyforms,capitalincomemayhaveseveraldifferentcompon-ents. These include the risk-free return that compensates savers for postponingconsumption,ariskpremiumcompensatinginvestorsfortheirexposuretorisk,and

7 ThesedevelopmentsarereviewedbyWolfgangEggertandBerndGenser,“DualIncomeTaxationinEUMemberCountries”(2005)vol.3,no.1CESifo DICE Report41-47.


anelementofpureprofit(rent)overandabovetheminimumreturnrequiredbyinvestors.InthedesignofaDIT,abasicpolicychoiceiswhetherthelowflattaxrateshouldapplytoallofthecomponentsofcapitalincome,orwhethersomecompon-entsshouldbesubjecttotheprogressivetaxscheduleapplyingtolabourincome.

Apartfromtheimplicationsforincomedistributionandpublicrevenue,thepolicydecisiononthisissueisalsoimportantfromtheviewpointofeconomicefficiency.Whileataxontherisk-freereturninevitablydistortssavingsdecisions,ataxonpurerentsisnon-distortionary;and(asweshallseebelow)itisalsopossibletodesignataxontheriskpremiumthatis,inprinciple,neutraltowardsavingandinvestmentdecisions.Includingriskpremiumsandpurerentsinthebaseforprogressivetaxa-tionthereforeseemsattractive,sinceitenablesthegovernmenttoraiserevenueinanon-distortionarymanner(atleastintheory).

Inpractice,many“pure”profitsarefirm-specific,arisingfromthefirm’sposses-sionofaspecialtechnology,organizationalknowhow,trademark,orinternationalmarketposition.suchfirm-specificrentsareofteninternationallymobile—thatis,theycanbeshiftedabroadbyrelocatingthebusinessactivity.Inanopeneconomy,ahightaxonrentsmaythereforediscouragedomesticinvestment.However,whilefirmsmaybequitemobileacrossborders,theirownerswilltypicallybemuchlessmobile.Hence,itmaybepossibletoimposeanon-distortionaryresidence-basedtaxonrentsattheindividualinvestorlevelwhileaddressingthehighmobilityofbusinessinvestmentthroughalowsource-basedcorporationtax.

TheevolutionoftheNorwegianDITillustratestheimplicationsfortaxdesignofthechoicebetweenthepolicyalternativessketchedabove.TheoriginalversionoftheDITintroducedinNorwayin1992allowedalmostallcomponentsofcapitalincometobetaxedatalowflatrate.Forcompanieswith“passive”owners,thedoubletaxa-tionofdividendswasfullyalleviatedthroughanimputationsystem.Doubletaxationofretainedprofitswaslikewiseavoidedthroughasystemthatallowedshareholderstoaddretainedprofitstothebasisoftheirsharesforthepurposeofcalculatingcap-italgainstax(the“RIsK”system).Asaconsequence,allincomefromwidelyheldcorporationswastaxedonlyonceatthesamelowrateasthatappliedtootherin-comefromcapital.Inthecaseofproprietorshipsandcloselyheldcompanieswith“active”owners,animputedreturntothecapitalinvestedinthefirmwastaxedascapitalincome.Thisimputedreturnwascalculatedbyaddingaconsiderableriskpremiumtotheinterestrateonfive-yeargovernmentbonds.Asaresult,inmostcasestheriskpremium,andprobablyinsomecasesevenanamountofpurerent,wastaxedatthelowcapitalincometaxrate.Bycontrast,underthenewNorwegiantaxsystemprevailingsincethebeginningof2006,onlyalowimputedrisk-free(after-tax)returntoshareholdingescapesdoubletaxation,andonlyasimilarlowimputedrisk-freereturntocapital invested inunincorporatedfirmsis taxedascapital in-come.Thus,thenewNorwegiantaxsystemimposesahighermarginaltaxrateonriskpremiumsandpurerents.

Inthediscussionbelow,Iwilldescribeinmoredetailhowcapitalincomeisde-lineatedunderthetwopolicyalternativesfortheDIT.sincethemechanicsoftaxdesignfortheownersofsoleproprietorshipsandpartnershipsarethesameunder


thetwoversionsof theDIT,Iwill startbyconsideringthetaxationofthesetwogroups,whichIshallrefertocollectivelyastheself-employed.

tA x Atio n o f income from self- emPloyment8

The Problem: Income from Self-Employment Derives from Both Capital and Labour

sincetheself-employedworkintheirownbusiness,partoftheirbusinessincomemustbeseenaslabourincome.Atthesametime,becausetheself-employedhaveinvested(partof )theirwealthintheirbusiness,anotherpartoftheirincomeisare-turntotheirbusinessassets,whichisclearlyaformofincomefromcapital.Ifallofthebusinessincomeoftheself-employedweretaxedaslabourincomeatprogres-siverates,theircapitalincomewouldbeovertaxedrelativetoothertypesofcapitalincome.Ontheotherhand,ifallincomefromself-employmentweretaxedatthelowflatrateapplyingtocapitalandcorporateincome,theself-employedwouldes-capetaxprogressivityaltogether,eventhoughpartoftheirincomestemsfromtheirworkeffort.9

Toavoidsuchunequaltaxtreatment,itisnecessarytosplittheincomeoftheself-employedintoalabourincomecomponentandacapitalincomecomponent.sincetheworkinghoursandeffortoftheself-employedcannotbeobservedbythetaxauthorities,whereasthestockofbusinessassetscan,inprinciple,beobserved,itisnat-ural(andcommonpracticeinDITcountries)tosplittheincomeoftheself-employedbyfirstimputingarateofreturntotheirbusinessassets,whichiscategorizedascapitalincome,andthentreatingtheresidualbusinessprofitaslabourincome.

Alternative Methods of Income Splitting

Theimputedrateofreturntobusinessassetsmaybecomputedoneithera“grossassets”ora“netassets”basis.Underthegrossassetsmethod,thenetfinanciallia-bilitiesofthefirmarenotdeductedfromtheassetbase.Thelabourincomeoftheentrepreneuristhuscalculatedbydeductinganimputedreturntogrossbusinessassets(theassetsrecordedinthefirm’sbalancesheet)fromthegrossprofitsofthefirm(definedasprofitsbeforeinterestonbusinessdebt),andtaxablenetcapitalin-comeiscalculatedbydeductinginterestexpensesfromtheimputedreturntothegrossassets.

8 ThissectiondrawsonK.P.HagenandP.B.sørensen,“TaxationofIncomefromsmallBusiness:TaxationPrinciplesandTaxReformsintheNordicCountries,”inTax Policy in the Nordic Countries,supranote6,chapter2,wherethetaxationoftheself-employedintheNordiccountriesisdiscussedinmoredetail.

9 Notethattheproblemofsecuringequaltreatmentoftheself-employedvis-à-viswageearnersalsoarisesincountriesthatsubscribetoacomprehensivepersonalincometaxinsofarasthesecountriesalsorelyonsocialsecuritytaxesthatareintendedtofallonlyonlabourincome.


Bycontrast,underthenetassetsmethod,capitalincomeisdeterminedbyim-putingareturntothenetassetsofthefirm(businessassetsminusbusinessdebt),andlabourincomeisfoundbydeductingthisimputedreturnfromnetprofits(prof-itsafterthedeductionofinterest).Thesemethodsareillustratedbythesimplifiednumericalexampleintheaccompanyingtable.

Iftheimputedrateofreturnequalstherateofinterestpaidonbusinessdebt,thetwomethodswillbeequivalent.Thus,inthetable,wheretheimputedreturnandtheinterestratearebothassumedtobe10percent,theimputedincomefromcap-ital (20) and the income from labour (200) are exactly the same under the twomethods.

The “Gross Assets” Versus the “Net Assets” Method of Splitting Income from Self-Employment

Income statement

1. salesrevenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500 2. Businessexpenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 3. Grossprofit(beforeinterestonbusinessdebt)(line1−line2) . . . . . . . 300 4. Interestonbusinessdebt(10%ofline8) . . . . . . . . . . . . . . . . . . . . . . . . 80 5. Netprofit(grossprofitlessinterest)(line3−line4) . . . . . . . . . . . . . . . 220

Balance sheet

Assets Liabilities

6. Businessassets . . . . . . . . . . 1,000 8. Businessdebt . . . . . . . . . 800 9. Networth . . . . . . . . . . . 200 7. Totalbusinessassets . . . . . 1,000 10. Totalliabilities . . . . . . . . 1,000

Income splitting on a gross assets basis

11. Grossbusinessassets(line7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,00012. Imputedreturn(10%ofline11) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10013. Labourincome:grossprofitlessimputedreturn(line3−line12). . . . . 20014. Capitalincome:imputedreturnlessinterest(line12−line4) . . . . . . . . 20

Income splitting on a net assets basis

15. Netbusinessassets:grossassetslessdebt(line7−line8). . . . . . . . . . . 20016. Imputedreturn(10%ofline15) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2017. Labourincome:netprofitlessimputedreturn(line5−line16) . . . . . . 20018. Capitalincome:imputedreturn(line16) . . . . . . . . . . . . . . . . . . . . . . . . 20

Theequivalencebetweenthetwomethodsofincomesplittingbreaksdowniftheimputedrateofreturndeviatesfromtheinterestrateonbusinessdebt.Iftheimputedrateofreturnexceedstheinterestrate,alargerfractionofbusinessincomewillbecategorizedascapitalincome(andacorrespondinglylowerfractionwillbe


taxedas labourincome)underthegrossassetsmethodthanunderthenetassetsmethod.Theoppositewilloccuriftheimputedrateofreturnislowerthanthein-terestrate.

Moreover, significantdeviationsbetween the imputed returnand the interestrateondebtwilltendtodistortbusinessinvestmentunderthegrossassetsmethod.Forexample,supposethattheimputedreturnis15percentandtheinterestrateisonly10percent,andthatanentrepreneurcanearnapre-taxreturnof10percentonanadditionalbusinessinvestmentof100.Iftheentrepreneurborrowedtofinancetheinvestment,intheabsenceoftax,hewouldjustbreakeven.However,inthepresenceoftax,hewouldscoreanetgain,becausetheinvestmentwouldadd15tohisimputedcapitalincomebutonly10tohistotaltaxableprofit.Hence,alargershareoftotalprofitwouldbetaxedatthelowcapitalincometaxrateratherthanatthehighlabourincometaxrate,therebyreducingtheentrepreneur’stotaltaxbill.

Incontrast,underthenetassetsmethodofincomesplitting,therecordednetassetsofthefirmwouldnotbeaffectedbyanadditionaldebt-financedinvestment.Norwouldtheinvestmentaffectnetprofitsintheexamplegivenabove:grossprofitswouldriseby10,butsowouldinterestexpenses.Thus,thismethodofincomesplit-tingensuresthattheDITremainsneutraltowardmarginalinvestmentdecisions.

Anti-Avoidance Measures

Theaboveanalysisseemstoimplyapreferenceforthenetassetsmethodontaxneutral-itygrounds,butunfortunatelythismethodalsoallowsgreaterscopefortaxarbitrage.specifically,thenetassetsmethodimpliesthatinterestexpensesbecomedeductibleagainstthehighmarginaltaxrateonlabourincome,becausetheyreducetheresid-ualnetprofitthatistaxedaslabourincomeatthemargin.Thisprovidesastrongincentiveforentrepreneurstorecordprivatedebt(debtincurredfornon-businesspurposes—say,tofinancethepurchaseofaconsumerdurableorahouse)asbusi-nessdebtinordertobenefitfrominterestdeductibility.

Tolimitthescopeforsuchtransactions,theself-declaredbusinessincomeshouldbeadjustedincaseswherethedeclarednetassetsofthefirmbecomenegative,sincenegativenetbusinessassetsareastrongindicationthatprivatedebthasbeentrans-ferredtothebusinesssphere.specifically,businessincomefortaxpurposesshouldberaisedbytheimputedreturntimestherecordednegativenetworthofthefirmto(roughly)offsetthefactthatreportedbusinessincomehasbeenartificiallyloweredbyallocatingnon-businessinterestexpensestothefirm.Totheextentthatthetaxlawallowsthedeductionofnon-businessinterestexpenses,theupwardadjustmentoftaxablebusinessincomeshould,ofcourse,beaccompaniedbyacorrespondingdownward adjustmentof the entrepreneur’snon-business capital income. (If thelatterwerenegative,asitmightwellbe,theentrepreneurwouldreceiveataxcreditequaltothecapitalincometaxratetimesthenegativecapitalincome.)

Thenetassetsmethodmayalsorequireasimilaradjustmentoftaxablebusinessincomeincertainothercasesinordertopreventtaxarbitrage.Forexample,iftheimputedreturnisbasedonnetassetsatthestartoftheyear,theentrepreneurmayreducehistaxablelabourincomebywithdrawingfundsfromthefirmduringthe


year(therebyreducingitsrecordednetprofitbyreducingitsnetinterestincome)andreinjectthefundsintothefirmbeforethestartofthenextyearinordernottoreducethebaseforcalculatingtheimputedrateofreturn.Ofcourse,theinterestearnedoutsidethefirmonthefundswithdrawnfromitwouldattractcapitalincometax; but at the same time, the entrepreneur’s imputed labour income would godown,implyingatransformationoflabourincomeintocapitalincome.Hence,itmaybenecessarytoundertakeanupwardadjustmentofthefirm’srecordednetin-terest income (and a corresponding downward adjustment of the entrepreneur’s“private”netcapitalincome)incaseswheretheproprietorwithdrawsfundsfromthefirmonlytoreinjectthemlaterinthesamefiscalyear.

Thus,thechoicebetweenthegrossassetsandthenetassetsmethodsinvolvesatradeoffbetweenthesuperiorneutralitypropertiesofthenetassetsmethodandthegreatersimplicityandlowervulnerabilitytotaxarbitrageofferedbythegrossassetsmethod.

Anotheravoidanceproblemarisingunderbothmethodsofincomesplittingisthatentrepreneursmaygainbytransferringlow-yieldingnon-businessassets(suchasapieceofrealestateoramotorvehicleusedforprivateconsumption)fromtheprivatespheretothebusinesssphere.Byaddingtotherecordedstockofbusinessassetsanassetwithlittleorzero(taxable)yield,theentrepreneurwillhaveahigherproportionofhisbusinessincometaxedascapitalincome,sincethebaseamountforcalculatingtheimputedreturngoesupwhiletotalbusinessincomestays(almost)unchanged.Topreventsuchtransformationoflabourincomeintocapitalincome,thetaxlawmustincludeclauseslimitingthescopefortransferringnon-businessassetstothebusinesssphere.

The Treatment of Losses and the Choice of the Imputed Rate of Return

When determining the rate of return imputed to business assets, policy makersmustdecidewhethertoincludeariskpremiumintheimputedreturn.Thecasefordoingsodependscriticallyonthetaxtreatmentoflosses.Ifthetaxcodeallowsfulllossoffsets10andthemarginaltaxrateonbusinessincomeisconstantovertime,itisnotnecessarytoincludeariskpremiumintheimputedreturntoavoiddiscourag-inginvestmentandrisktaking.Indeed,inthiscase,theDITwillactuallystimulaterisktakingevenwhentheimputedreturncontainsnoriskpremium,asshownintheanalysisbelow(analysis1).Thereasonisthat,withfulllossoffsets,thehighlabourincometaxrateimposedonresidualbusinessincomeworksasaninsurancedevicethatreducesthevariability(andhencetheriskiness)ofafter-taxbusinessincome.Entrepreneursarethereforeinducedtoincreasethefractionoftheirwealthinvestedinriskybusinessassetsinordertotakeadvantageofthehigherexpectedaveragereturnonsuchassets.

10 Thiswouldinvolveunlimitedcarryforwardoflosseswithinteresttopreservethepresentvalueofthededuction.


However,becauseoftheriskofabuse,thetaxcoderarelyallowsfulllossoffsets.Moreover, if marginal business income is taxed progressively as labour income,lossesincurredinbadyearswilloftenbedeductedagainstalowertaxratethanthemarginaltaximposedonprofitsaccruingingoodyears.Ifthesetaxasymmetriesarestrong,thetaxsystemwilltendtodiscouragerisktaking.Inthatsituation,thereisacaseforincludingariskpremiumintheimputedreturnonbusinessassetsthatistaxedascapitalincome.Ideally,theimputedriskpremiumshouldvarywiththeriskcharacteristicsofeachindividualinvestmentproject;butsincetaxauthoritieslacktheinformationandtheadministrativecapacitytoundertakeadetaileddifferentia-tionofriskpremiums,theymaychoosetoapplythesameriskpremiumacrosstheboard.Inevitably,thispremiumwillbetoohighforsomeinvestmentprojectsandtoolowforothers,implyingsomedistortioninthepatternofrisktaking.

Analysis 1 Taxation and risk taking under full loss offset

Consideranentrepreneurwhomayallocatehiswealthbetweenasafeassetyieldingafixedrateofreturnr*andariskybusinessassetgeneratinganuncertainbutgenerallyhigherrateofreturnr.Asabenchmarkcase,supposeinitiallythattherateofreturnimputedtobusinessassetsundertheDITissohighthattheentirereturntotheriskyaswellasthesafeassetisalwaystaxedatthecapitalincometaxratet.Iftheentrepre-neurallocatesafractionofhiswealth,a1,totheriskyasset,theoverallnetrateofre-turntohiswealthwillbe

y1=(1−a1) r*(1−t)+a1r(1−t) =r*(1−t)+a1(r−r*)(1−t), (1)

wherethefirsttermontheright-handsideoftheupperlineinequation1istheafter-taxreturntoinvestmentinthesafeasset,andthesecondtermistheafter-taxreturntotheriskyasset.

Wemaynowcomparetheoutcomeinequation1withtheoutcomeunderaDITwhereonlyarisk-freeimputedreturn,r*,ontheentrepreneur’sbusinessassetsistaxedascapitalincome,whereastheremainingreturnr−r*istaxedaslabourincomeatthehigherratem.supposethat,inthissituationwheretheimputedreturnincludesnoriskpremiumatall,theentrepreneurdecidestoallocateaproportionofhiswealth,a2,totheriskybusinessasset.supposefurtherthatthetaxcodeoffersafulllossoffsetsothatalllossesmaybedeductedagainstthemarginallabourincometaxratem.Theentrepreneur’soverallreturnwillthenbe

y2=(1−a2) r*(1−t)+a2[r−t r*−m(r−r*)] =r*(1−t)+a2(r−r*)(1−m). (2)

Comparingequations1and2,oneeasilyseesthattheentrepreneur’safter-taxreturnwillalwaysbethesameunderthetwotaxregimesifheadjustshisportfoliosharea2inaccordancewiththerule

a atm2 1

11

=−−

.

(3)


Inotherwords,ifhecanfreelyadjusthisportfolio,theentrepreneurcanneverbeworseoffunderaDITregimethatdoesnotincludeariskpremiumintheimputedreturn(comparedwithonethatdoes).Notealsothattheentrepreneurwillinfacthaveanincentivetoadjusthisportfolioinaccordancewithequation3inordertoavoidadecreaseinhisexpectednetreturnwhentheimputedreturnnolongerincludesariskpremium.sincemt,itfollowsfromequation3thattheentrepreneurshouldincreasetheportfoliosharedevotedtoriskyassetswhentheresidualreturnstohiswealthbe-comesubjecttothehighlabourincometaxrate.Bydoingso,theentrepreneurwillonaverageobtainanincreaseinhistotalpre-taxreturnthatexactlycompensatesforthehighertaxonhisriskpremium;andatthesametime,thehighertaxrateonhismar-ginalearningswillensurethatthevariance(riskiness)ofhisoverallnetreturnisnogreaterthanbefore.

Taxation of the Self-Employed in the Nordic Countries

TheNordicDITcountriesallprovideanoptionfortheself-employedtohavetheirin-comesplitintoacapitalincomecomponentandalabourincomecomponent.Norwayusesavariantofthegrossassetsmethod,whileFinlandandswedenpractisevari-antsofthenetassetsmethod.Apartfromdistinguishingbetweenlabourandcapitalincome,theswedishschemealsoallowsimputedlabourincomeretainedinthefirmtobetaxedatthelowcorporateincometaxrate,postponingimpositionofthepro-gressivelabourincometaxuntilprofitsaredistributed.

AlthoughDenmarkdoesnotapplyapureDIT,havingmaintainedsomedegreeofprogressivityinthetaxationofcapitalincome,itdoestaxlabourincomemoreheavilyatthemargin.Denmarkthereforeallowstheself-employedtooptforasplit-tingoftheirbusinessincomeintocapitalincomeandlabourincome.Entrepreneursoptingforincomesplittingmaychoosebetweenthesimplergrossassetsmethodandamorecomplicatednetassetsmethodsimilartotheswedishscheme.

Some Final Observations on Income Tax Design for the Self-Employed

Indesigningtaxrulesfortheself-employedundertheDIT,thefollowingconsider-ationsshouldbekeptinmind:

1. If the tax rate in the lowest bracket of the labour income tax schedule isalignedwiththetaxrateoncapital income,entrepreneurswhosebusinessincomefallswithinthelowesttaxbracketwillhavenoneedforincomesplit-ting,sincetheywillfacethesamemarginaltaxrateoncapitalincomeandlabourincome.Iftheupperthresholdforthelowesttaxbracketissetatafairlyhighincomelevel,manyself-employedwillneverneedtohavetheirincomesplit,resultinginconsiderableadministrativesimplification.

2. Incomesplittingshouldbeanoptionbutnotarequirementforthetaxpayer,sinceitoffersanopportunityforentrepreneurstoavoidovertaxationofthecapitalincomecomponentoftheirbusinessincome.Ifanentrepreneurdoesnotoptforincomesplitting,hisbusinessincomewillautomaticallybetaxed


aslabourincome.sinceincomesplittingrequiresthattaxpayerskeepproperaccountsoftheirassetsandliabilities,taxpayerswishingtobenefitfromthelowtaxrateoncapitalincomewillhaveanincentivetokeepproperbooksratherthanrelyingonsimplifiedaccounting.switchingtoaDITmaythere-forehelptopromotemodernbusinessrecordkeepinginsmallenterprises—aresultthatmaybedesirableinitself.

3. The gross assets method is administratively simpler than the net assetsmethod,fortherevenueauthoritiesaswellasfortaxpayers,inpartbecauseitrequiresfeweranti-avoidancemeasures.Ifsimplicityandlowcompliancecostsareapriority,thereisastrongargumentforchoosingthismethodofincomesplitting.

tA x Atio n o f income from closely held co rP o r Atio ns

The Income-Shifting Problem

Thetaxationofsmallcorporationswithactiveownersworkingintheirownbusi-nessraisesasimilarissueasthetaxationoftheself-employed:partoftheowner’sincomefromthebusinessmustbeseenasareturntothecapitalinvestedinthefirm,andpartistherewardfortheworkeffortandskillsoftheowner.Intheabsenceofspecialrulesforthesecloselyheldcompanies,dividendsandcapitalgainsonsharesrealizedbyanownerwouldbetreatedascapital incomeundertheDIT(perhapswithsomeformofrelief fortheunderlyingcorporationtax),whilemanagementsalarypaidtotheownerwouldbetreatedaslabourincome.Ifthesumofthecor-porationtaxandthepersonaltaxondividendsand/orcapitalgainsislessthanthemarginaltaxrateonlabourincome,theownerhasanobviousincentivetopayhim-selfdividendsortorealizeacapitalgainon(partof )hissharesratherthanpayhimselfarealisticsalary.

One Solution: Treating Small Companies like Proprietorships

Apossiblesolutiontothisproblemwouldbetotaxtheincomefromsmallcom-paniesaccruingtoactivecontrollingshareholdersinthesamewayasincomefromself-employment.Thisimpliesthatafractionofcorporateprofitsequaltothefractionofsharesownedbyactiveshareholdersworkingintheirowncompanywouldbesplitintoanimputedreturnoncorporateassets,whichwouldbetaxedascapitalincome,andaresidualprofitthatwouldbetaxedaslabourincome.Thisincomesplittingwouldapplyregardlessoftheactualamountofdividendsorcapitalgainsrealizedbytheowners,sothattheownerswouldbeunabletotransformlabourincomeintocapitalincomebypayingthemselveslowersalariesandinsteadtakingouthigherdividendsorcapitalgains.Thecorporationtaxwouldserveasawithholdingtaxoncorporateprofits,butitwouldbecreditedagainsttheshareholder’spersonaltaxbilltopreventdoubletaxationofcorporateequityincome.

Themainproblemwith this scheme is thedifficultyof identifying theactivecontrollingshareholderswhoshouldbesubjecttomandatoryincomesplitting.It


wouldseemnaturaltorequiremandatoryincomesplittingonlyincaseswheretheshareholder carries out a certain minimum amount of work in the business andwhere,inaddition,hehasacertainminimum(controlling)ownershipshareinthecompany,possiblyinconjunctionwithhisclosestrelatives.Itisinsuchcasesthattheshareholderwillmostlikelybeabletotransformmanagementsalaryorotherlabourincomefromthecompanyintodividendsorcapitalgainsinordertoreducehistaxbill.

However,onecaneasilyimagineseveralwaysinwhichsuchrulescouldbecircum-vented.Forexample,acontrollingshareholdermightinviterelativesorfriendstostepinasminorityshareholderssothathewouldnolongerbesubjecttotheincome-splittingrules,evenifhemaintainedeffectivecontroloverthecompany’sdividendpolicy.Onecanalsoimaginethatdominantshareholdersmightexchangesharesineachother’scompaniesinordertoavoidmandatoryincomesplittingwithoutgivingupcontroloftheirrespectivecompanies.

TheNorwegianexperiencesuggeststhatsuchtaxavoidanceisnotjustatheor-eticalpossibility.AspartofthetransitiontotheDITin1992,Norwayintroducedmandatoryincome-splittingrulesforactiveshareholdersalongthelinesdescribedabove.Yet,between1992and2000,theproportionofcorporationssubjecttoin-comesplittingfellfrom55percentto32percent,indicatingthatagrowingnumberoftaxpayerswereabletochangestatusfromactivetopassiveshareholders.

Morefundamentally,thedividinglinebetween“active”and“passive”shareholdersisessentiallyarbitraryandmayleadtounequaltaxtreatmentofshareholderswhoare,forpracticalpurposes,inequalpositions.

An Alternative Solution: A Shareholder Income Tax with a Rate-of-Return Allowance

Becauseofthedifficultiesdiscussedabove,itseemsdesirabletoavoidhavingtodis-tinguishbetweenactiveandpassiveshareholders.Thissectiondescribesanalternativeschemethatdoesnotrequirethisdistinction.Aversionofthisschemehasbeenim-plementedinNorwaysinceJanuary1,2006,followingrecommendationsfromanexpertcommittee.11

Thebasicprincipleoftheschemeissimple:shareholderincomebelowanim-puted“normal”returnistax-exemptattheshareholderlevel,sincesuchincomehasalreadybeensubjecttocorporationtaxataratecorrespondingtothecapitalincometaxrate,butdividendsandcapitalgainsinexcessoftheimputednormalreturnaresubjecttoapersonalshareholderincometax.Byanappropriatechoiceoftaxrates,thesumofthecorporationtaxandthepersonalshareholderincometaxcorrespondstothetopmarginaltaxrateonlabourincome.sincecontrollingshareholderscan

11 skatteutvalget,Forslagtilendringeriskattesystemet,Norgesoffentligeutredninger2003:9.Iwasamemberofthiscommittee.Foramoreformalanalysisoftheschemedescribedhere,seePeterBirchsørensen,“NeutralTaxationofshareholderIncome”(2005)vol.12,no.6International Tax and Public Finance777-801.


gainnothingbytransforminglabourincomeintoshareholderincome,thereisnoneedtosplittheincomeof“active”shareholders.

Theshareholderincometaxisimposedonlywhenincomefromthecompanyisdistributedasadividendorisrealizedasacapitalgainonshares.Inotherwords,thetaxbaseistherealizedincomefromthesharesminusarate-of-returnallowance(RRA).Therealizedincomeisthesumofdividendsandanyrealizednetcapitalgainonthesharesinthecompany.Dividendsandcapitalgainsarethustreatedsymmetric-ally.IftherealizedincomefallsshortoftheRRA,theunutilizedRRAmaybecarriedforwardanddeductedinalateryear.

TheRRAiscalculatedasanimputedrateofreturntimesthebasisoftheshare.ThebasisforthecurrentyearisthesumoftheoriginalbasisandallunutilizedRRAsfrompreviousyears;thatis,theoriginalbasisissteppedupyearbyyearbyanyun-utilizedRRAs.Thisstep-upisnecessarytoensurethatonlycapitalgainsinexcessofthenormalreturnaresubjecttoshareholderincometax.

Theimputedrateofreturnshouldcorrespondtoanormalafter-taxrateofre-turnfrominvestmentinthecapitalmarket,sincethisisthetaxpayer’sopportunitycostofinvestingin,say,bondsratherthanshares.12Atthesametime,sincethecor-poratetaxratecorrespondstothecapitalincometaxrateunderaconsistentDIT,shareholderincomenotexceedingtheimputedreturnshouldbeleftfreeofpersonalincometaxsoastoavoiddoubletaxationofthenormalreturntoinvestment.13

Asimplenumericalexample(example1below)illustrateshowthebasefortheshareholderincometaxiscalculated.Assumethatashareholderinjectsequityintoacompanyatthestartofyear1,receivesadividendattheendofyear1,andrealizesacapitalgainontheshares(scenario1)orreceivesadividend(scenario2)attheendofyear2.Theimputedreturnonshares,theafter-taxinterestrate,andthereturntothecompany’sinvestmentaftercorporationtaxareallassumedtobe5percent.Itisalsoassumed,plausibly,that$1.00ofretainedprofitwillgeneratea$1.00in-creaseinthemarketvalueofsharesinthecompany,aslongastheretainedprofitdoesnotexceedtheshareholder’stax-freeimputedreturn.

Example 1

Year 1

1. Injectionofequityatthestartoftheyear . . . . . . . . . . . . . . . . . . . . . . . . 1,000 2. Profitaftercorporationtax(5%ofline1) . . . . . . . . . . . . . . . . . . . . . . . . 50 3. Dividend. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 4. Retainedprofit(line2−line3). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 5. RRA(5%ofline1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 6. UnutilizedRRA(line5−line3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

12 Iwilldiscussinalatersectionwhethertheimputed“normal”returnshouldincludeariskpremium.see“TheImputedReturnandtheTreatmentofLosses.”

13 Companiescouldberequiredtokeepataxedprofitsaccounttoensurethatonly“normal”dividendspaidoutoftaxedprofitsareexemptfrompersonaltax.


Year 2

7. stepped-upbasisofshares(line1+line6) . . . . . . . . . . . . . . . . . . . . . . . 1,020 8. Profitaftercorporationtax(5%of(line1+line4)) . . . . . . . . . . . . . . . . 51 9. RRA(5%ofline7) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Scenario 1: Shares are realized at the end of year 2

10. Revenuefromsaleofsharesattheendofyear2(line1+line4+line8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,071

11. stepped-upbasisofsharesatthestartofyear2(line7) . . . . . . . . . . . . . 1,02012. RRAforyear2(line9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5113. Taxablecapitalgain(line10−line11−line12) . . . . . . . . . . . . . . . . . . . 0

Scenario 2: All profits are distributed at the end of year 2

14. Dividendattheendofyear2(line4+line8). . . . . . . . . . . . . . . . . . . . . 7115. TotalRRA(line6+line9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7116. Taxabledividend(line14−line15). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

Under the foregoing assumptions, we see that regardless of the form of theshareholder’sreturn(whetherdividendsorcapitalgains),hewillendupwithzerotaxableincomeinbothscenarios.Theexampleillustratestheimportantpointthattheshareholderincometaxisneutralwithrespecttoinvestmentandfinancingdeci-sions.Intheabsenceoftheshareholderincometax,theinvestmentconsideredintheexampleisbarelyworthundertakingforthecompanysinceityieldsareturnthatonlyjustmatchesthemarketinterestrate.Theexampleshowsthattheshare-holderincometaxwillnotaffecttheprofitabilityofsucha“marginal”investment,whetherprofitsaredistributedorretainedinthecompany.

Theneutralityoftheshareholderincometaxreflectsitsequivalencetoacashflowtaxthatisknowntobeneutral.Thisequivalenceresult(whichassumesfulllossoffsets)isdemonstratedformallyinmyearlieranalysis,14anditmaybeexplainedintuitivelyasfollows.Acashflowtaxisneutralbecauseiteffectivelymakesthegov-ernment a silent partner in all investment projects, sharing symmetrically in allgainsandlosses.Thus,acashflowtaxallowsfullexpensingofinvestment,gener-atinganimmediatetaxreductionequaltothetaxratettimestheinvestmentoutlayk.Alternatively,onemightallowinvestorstodeductinallfutureperiodsarateofreturn,RRA,ontheinitialinvestmentoutlay,astheshareholderincometaxactuallydoes.WhenthefuturetaxsavingsfromtheRRAarediscountedatthemarketinter-estratei,theirnetpresentvaluewillbeNPv=t RRA k /i.IfwesetRRA=i,asinournumericalexample,wegetNPv=t k,indicatingthatashareholderincometaxwithanRRAequaltothemarketinterestratewillensureequivalencewiththeneutralcashflowtax,generatingexactlythesametaxliabilityinpresentvalueterms.

14 sørensen,supranote11.


Holding Period Neutrality Under the Shareholder Income Tax

Anotherattractiveaspectoftheneutralityoftheshareholderincometaxisthatitdoesnotinduceshareholderstopostponerealizationoftheirsharesinordertodefercapitalgainstax,eventhoughthetaxisleviedonlyuponrealization.ThereasonisthatthebasisoftheshareiswrittenupeveryyearbytheamountofanyunutilizedRRA.Asshowninthefollowinganalysis,thiseffectivelymeansthatanypostponedcapitalgainstaxliabilityiscarriedforwardwithinterest,thuseliminatingthegainfromdeferralofrealization.15

Analysis 2 Holding period neutrality under a realization-based capital gains tax with an RRA

Considerasharewithamarketvalueattimetofmtandabasisvalueofbtatthattime.Iftheshareholderrealizeshisaccumulatedcapitalgainmt–btattimet,andifthetaxrateis,histaxliabilityTtwillbe

Tt= (mt−bt). (4)

Iftherealizationispostponeduntiltimet+1,andassumingforsimplicitythatnodividendsarepaidinthemeantime,thetaxliabilitywillbe

Tt + 1= [mt + 1−(1+r)bt]. (5)

Thatis,thebasisofthesharewillbesteppedupbytheamountrbtbetweentimetandtimet+1,whereristheimputedrateofreturnandrbtistheunutilizedRRAduringperiodt.Fromequations4and5,wefindthat

T Tm m

mm bt t

t t

tt tr+

+− =−

−

1

1τ

=−

−

+ ( )

+ −τ

m m

mm m bt t

tt t tr r1

=−

−

+ ⇔+τ

m m

mmt t

tt tr rT1

T Tm m

mmt t

t t

ttr r+

+= +( ) + −−

1

11 τ . (6)

Equation6isthetaxliabilityinperiodt+1expressedasthesumofthetaxliabilityinperiodt,carriedforwardwithinterest,andthetaxonthegain(inexcessofthenormal

15 TheshareholderincometaxisaspecialcaseofthegeneralizedcashflowtaxdescribedinAlanJ.AuerbachandDavidF.Bradford,“GeneralizedCash-FlowTaxation”(2004)vol.88,no.5Journal of Public Economics957-80.TheAuerbach-Bradfordschemeensuresholdingperiodneutralityeventhoughtaxisdueonlywhenassetsarerealized.


rateofreturn)fromperiod t toperiod t+1.Equation6showsthatthetaxsystemleavesnoadvantagefromdeferringthecapitalgainstaxbypostponingtherealizationfromoneperiodtothenext.Thereasonisthatthepostponedtaxliabilityiscarriedforwardwithinterest,asreflectedinthepresenceoftheterm(1+r)Ttontheright-handside.

Theneutralityoftheshareholderincometaxwithrespecttorealizationdeci-sionsmayalsobeillustratedbyexample2below,wheretheshareholderattheendofyear0holdsshareswithacurrentmarketvalueabovethestepped-upbasis,re-flectinglargecapitalgainsaccruedinthepast.Theshareholdermaypostponetherealizationofhisgainuntiltheendofyear1(scenario1),orhemayrealizethegainimmediatelyandinvesthisfundsinthecapitalmarket(scenario2).Inbothcases,heisassumedtoearnanormalrateofreturnequalto5percentofhiswealthbeforeshareholdertax.Intheabsenceofthetax,hewillthusbeindifferentinchoosingbetweenimmediateandpostponedrealizationofhisaccruedcapitalgain.Theex-ampleshowsthathewillalsobeequallywelloffinthetwoscenariosaftertheintro-ductionoftheshareholderincometax(assumedheretobe30percent).

Example 2

Shareholder’s status at the end of year 0

1. stepped-upbasisofshares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 2. Marketvalueofshares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Scenario 1: The shares are held until the end of year 1

3. Revenuefromsaleofsharesattheendofyear1(105%ofline2). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,100

4. RRAforyear1(5%ofline1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 5. Taxablecapitalgainattheendofyear1(line3−line1−line4). . . . . . 1,050 6. Taxoncapitalgain(30%ofline5). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315 7. shareholder’swealthattheendofyear1(line3−line6) . . . . . . . . . . . . 1,785

Scenario 2: The shares are sold at the end of year 0 and the revenue is invested in the capital market

8. Revenuefromsaleofshareattheendofyear0(line2) . . . . . . . . . . . . . 2,000 9. Taxablecapitalgainattheendofyear0(line8−line1). . . . . . . . . . . . . 1,00010. Taxoncapitalgainattheendofyear0(30%ofline9) . . . . . . . . . . . . . 30011. Fundsavailableforinvestmentinbondsatthestartofyear1

(line8−line10) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,70012. shareholder’swealthattheendofyear1(105%ofline11) . . . . . . . . . . 1,785

Weseethattheshareholderincometaxwillneitherencouragenordiscouragetherealizationofshares.Inasimilarway,onecanshowthatthetaxwillnotdistortthedecisiontorealizealoss.Asshownbyanalysis2above,theRRAiscrucialforthisneutralityproperty.


The Imputed Return and the Treatment of Losses

Inasettingwithuncertaintyandrisk,theneutralityoftheshareholderincometaxreliesonthesymmetryofthetax:whenevertherealizedrateofreturnrfallsshortoftherate-of-returnallowanceRRA,theshareholdershouldideallybegrantedataxreduction equal to t (RRA − r) in present value terms, where t is the (marginal)shareholderincometaxrate.Thismaybeachievedbyallowingthetaxpayertooff-setanyrealizedlossonashareagainstanytaxableincomefromothersharesduringthesameyear,andbyallowinganyremaininglosstobecarriedforwardindefinitelywithinteresttobeoffsetagainstfutureshareholderincome.Aslongasthetaxpayerearnssufficienttaxableshareholderincomeinthefuture,suchacarryforwardrulewillensureafulllossoffsetinpresentvalueterms.Incaseswherethetaxpayerdoesnotreceive(sufficient)futureincomefromshares,fullneutralitywouldrequirethathebegrantedataxcreditequaltotheshareholderincometaxratetimeshisremain-ingloss,tobeoffsetagainsthistaxliabilityonotherincome.Notethattopreservesymmetryandneutrality,the“loss”onasharemustbedefinedasRRA−r;thatis,itmustincludethetaxpayer’sRRA.Inotherwords,fortaxpurposes,thetaxpayerisdeemedtoincuralosswheneverhisrealizedcapitalgainfallsshortofhisRRAforthecurrentyearplusanyunutilizedRRAscarriedoverfrompreviousyears.

Withsuchfullysymmetrictaxrules,onecanshowthattheimputedRRAdoesnothavetoincludeariskpremiumtoensureneutralityoftheshareholderincometax.16Tounderstandthis,notethatifthefuturetaxreductionsattributabletotheRRAaccruewith certainty,aswillinprinciplebethecasewithfulllossoffsets,thefuturetaxbreaksshouldbediscountedattherisk-free(after-tax)interestratei,eveniftheothercashflowsassociatedwiththestockinvestmentareuncertain.Hence,thepresentvalueofthetaxsavingsfromanextradollarofstockinvestmentwillbeNPv=t RRA/i.IftheRRAissetequaltotherisk-freeinterestratei,wethereforegetNPv=t,showingthatthegovernmenteffectivelyfinancesafractionoftheinvestmentoutlaycorres-pondingtothefractionofthecashreceiptsfromtheinvestmentthatmustbepaidintax.Essentially,thegovernmentparticipatesintheinvestmentasasilentpartner,andaddinganotherpartner sharing symmetrically ingains and losses cannotbedistortionary.

NotethatwhentheRRAdoesnotincludeariskpremium,theshareholderincometaxbecomesataxontheequitypremium—thatis,ataxonthedifferencebetweenthereturnonsharesandtherisk-freeinterestrate.sincetheequitypremiumisonaveragepositiveandquitesubstantial,theshareholderincometaxwillonaveragecollectanon-negligibleamountofrevenue,evenwithfulllossoffsets.

InNorway,whereaversionoftheshareholderincometaxwasintroducedeffect-iveJanuary1,2006,theimputedrateofreturnissetequaltothe(after-tax)interestrateonthree-monthgovernmentbonds.Thesearepracticallyrisk-free,butdespitethefactthattheRRAdoesnotincludeariskpremium,Norwegianpolicymakers

16 seesørensen,supranote11.


decidedtoimposecertainlimitationsonlossoffsetsinordertopreventabuse.spe-cifically,anunutilizedRRAforonesharecannotbeusedtoreducetaxablecapitalgainsonothersharesortoreduceothertaxableincome.Theconcernwasthatun-lesssuchalimitationwasintroduced,taxpayerswouldengageinso-calledyear-endtransactionssimplyforthepurposeofreducingtaxliability.

IntheNorwegiancontext,thispotentialtax-avoidanceproblemarisesbecausetheRRAonashareisassignedtothetaxpayerwhoownstheshareattheendoftheyear.IfanunutilizedRRAfromarealizedsharewerefullydeductibleagainstotherincome,aNorwegianpersonaltaxpayercouldpurchaseasharefromatax-exemptcorporateorinstitutionalinvestororfromaforeigninvestor(forwhomtheRRAhasnovalue)justbeforethestartofthenewyearandsell it immediatelyafter.ThiswouldleavethetaxpayerwithanunutilizedRRAthatcouldbeusedtoshieldothertaxableincome.

Theproblemwithyear-endtradescouldbeavoidediftheamountofataxpayer’sRRAforanygivenyearcorrespondedtothefractionoftheyearinwhichthetaxpay-erownedtheshare;indeed,thisappearstobethemostaccurateandconsistentwayofcalculatingtheRRA.However,itwouldalsoincreasetheburdenofadministeringtheshareholderincometaxbyrequiringtheauthoritiestokeeptrackoftradesinsharesoccurringduringthefiscalyear.17Foradministrativereasons,theNorwegianauthoritiesthereforedecidedtoassignRRAstotaxpayerswhoownedsharesattheendoftheyear,relyingonlimitationsonlossoffsetstodealwiththeproblemoftax-motivatedyear-endtransactions.

Asindicatedbytheseobservations,therulesforlossoffsetsandfortheassign-mentofRRAsunderashareholderincometaxrequirecarefulconsiderationandmayinvolve difficult tradeoffs between the goals of tax neutrality and administrativesimplicity.

The Treatment of Debt Versus Equity

Theshareholderincometaximpliesthatreturnstosharesabovethegoing(risk-free)marketinterestratewillbesubjecttodoubletaxation,whereasinterestondebtwillbetaxedonlyonceattheordinarycapitalincometaxrate.Thisasymmetrymightinducecompaniestodistributetheirearningsintheformofinterestondebtratherthanintheformofequityincome.subordinateddebtisoftenaclosesubstituteforequity, and interest on such debt typically includes a substantial risk premium.Hence,itmaybepossibletoavoidtheshareholderincometaxbypayingoutabove-normalratesofreturn intheformof intereston loans fromshareholders tothecompany.Thismaybepreventedbyananti-avoidanceclausestatingthatwhenevertheinterestrateonaloanfromapersonaltaxpayertoanunlistedcompanyexceeds

17 sinceunquotedsharesarerarelytraded,theproblemwouldrelatemainlytoquotedshares.Becausetradesinsuchsharesarecomputerized,itshould,inprinciple,bepossibletorequirefinancialintermediariesandprofessionaltraderstoreportinvestorholdingperiodstothetaxauthorities.


theimputedrateofreturnonshares, thedifferencewillbesubjecttotheshare-holderincometax.18

The Treatment of Cross-Border Shareholdings

Theshareholderincometaxisaresidence-basedpersonaltaxontheincomefromforeignaswellasdomesticshares.Inprinciple,thetaxthusensuresequaltreatmentofforeignanddomesticinvestment.Inpractice,residence-basedtaxationmaybehardtoenforce,sinceitisdifficultfordomestictaxauthoritiestomonitorforeign-sourceincome,buttheincentivetoevadetheshareholderincometaxisreducedbythe existence of the RRA combined with a credit for foreign withholding taxesagainstdomesticpersonaltax.Giventhesetwoelementsofthetaxcode,thegainfromevasionwilloftenbelimited.

AcountryadoptingtheshareholderincometaxmustdecidewhetheritwantstoallowadeductionfortheRRAbeforeimposinganywithholdingtaxondividendspaidouttonon-residentindividualshareholdersindomesticcompanies.NorwayhaschosentodosofordividendspaidtoindividualshareholdersresidentwithintheEuropeanEconomicArea(EEA),inordertoavoidchargesofdiscriminationagainstnon-resident investors intheEEA.However,acountrythat isnotboundbyEEAtreatyobligationswouldprobablywanttoallownon-residentstodeducttheRRAonlywhereabilateraltaxtreatywiththeforeignjurisdictionlikewiseofferssomekindofdoubletaxrelieftonon-residents.

The Treatment of Corporate Shareholders

Inprinciple,ashareholderincometaxcouldbeappliedtocorporateaswellastoin-dividualshareholders.However,thiswouldimplythatdividendsdistributedthrougha chainof subsidiaries ina corporategroupwouldattractmultiple layersof tax,sinceeachdistributionwouldbesubjecttoshareholderincometax.Realizationsofcapitalgainsstemmingfromimprovedearnings(prospects)inasubsidiaryofacon-glomeratecouldlikewiseattractmultiplelayersoftax.Theshareholderincometaxmightthereforedistortthestructureofcorporateorganizationsifitwereimposedoncorporateaswellasindividualshareholders.Forthisreason,itseemsdesirableto exempt corporate shareholders from the shareholder income tax. As an anti-avoidancemeasure,theexemptionmightbemodifiedbyarulestipulatingthatadomestic(resident)corporationissubjecttoshareholderincometaxwhenthein-comeoriginatesfromsubsidiariesincertainforeignlow-taxcountries.

Ifcorporateshareholdersareexempt,theshareholderincometaxwillbeleviedonlywhencorporateearningsaredistributedfromthecorporatesectorto(orwhencapitalgainsonsharesarerealizedby)adomesticpersonaltaxpayer.Thisprovidesanincentivefordomesticindividualshareholderstoaccumulateearningswithina

18 Forinvestorsinlistedcompanies,thereislittleneedforsuchananti-avoidancerule,sinceinterestpaymentsfrompubliccorporationsareunlikelytoincludeanelementof“hidden”labourincomegeneratedbythecompany’sshareholders.


domesticcorporationfreeofshareholder incometaxandthenmoveabroadtoalow-taxcountrybeforesellingtheshares,therebyrealizingacapitalgainthatwillescapedomestictax.Topreventsuchavoidance,thetaxcodecouldtreatthetermin-ationofdomesticresidencyasarealizationofsharesthattriggersdomesticcapitalgainstax.

Small Versus Large Companies

Theshareholderincometaxissupposedtobeleviedontheequitypremiumonallsharesownedbydomesticindividualshareholders.Itmightbearguedthatquotedsharescouldbeexemptfromthetax,sincetheproblemofincomeshiftingthattheshareholderincometaxissupposedtoaddressmainlyexistsinsmallercompanieswhosesharesaretypicallyunquoted.Leavingincomefromquotedsharesoutofthebasefortheshareholderincometaxwouldclearlyfacilitatetheadministrationofthetax.However,suchasymmetryinthetaxrulesmightdistortthedecisionofcompaniestogopublic.Moreimportantly,theattractionoftheshareholderincometaxisthat,becausetheequitypremiumisonaveragepositive,thetaxraisesrevenueinanon-distortionarymanner.Anexemptionforquotedshareswouldimplyarev-enuelossthatwouldnecessitateheavierrelianceondistortionarytaxes.

ApopularviewintheNordictaxpolicydebateisthatdoubletaxationofcorpor-ateequityincomedrivesupthecostofcapitalforsmallcompaniesbutnotforlargecorporationswithaccesstotheinternationalstockmarket,becausedomesticpersonaltaxesonshareholderincomedonotaffectthereturnsrequiredbyinternationalin-vestors.TolimittherevenuelossfromtheRRAundertheshareholderincometax,itmightthereforeseemnaturaltooffertheRRAonlytoshareholdersofsmalldomesticcompanies.Motivatedbythislineofreasoning,theswedishgovernmentpreviouslyallowedadeductionforanimputedrisk-freereturnforholdersofswedishsharesthatarenotlistedonastockexchange.19AsIhavedemonstratedinapreviousarticle,20byreducingtherelativeattractivenessofinvestmentinquotedshares,aselectiveRRAavailableonlytoholdersofunquotedshareswilltendtolowerthecostofcapitalforunquotedcompanies,sinceitwillinducedomesticinvestorstosubstituteunquotedforquotedshares.Forthesamereason,aselectiveRRAwillalsotendtoincreasethedegreeofforeignownershipofdomesticquotedcompaniesasdomesticinvestorsselloff(someof )theirsharesinthesecompanies.Inalatersectionofthisarticle,IwilldiscusswhetheraselectiveRRAapplyingonlytoinvestorsinsmallcompaniescould,infact,beadesirablepolicy.

19 Underthesetaxrules,theRRAwasonlydeductibleagainstdividendincomeandcapitalgainsonsharesweresubjecttoseparatespecialtaxrules.Hence,theswedishregimewasnota“clean”shareholderincometaxthatfullyintegratedthetaxationofdividendswiththetaxationofcapitalgains.

20 P.B.sørensen,“TaxationofshareholderIncomeandtheCostofCapitalinanOpenEconomy:TheoryandApplicationstotheNordicCountries”(2005)vol.143,no.3Danish Journal of Economics433-47.


The Tax Schedule for Shareholder Income: Full Integration of the Corporate and the Personal Income Tax?

Toensurethatactiveshareholderscannottransformlabourincomeintolightlytaxedcapital incomeundertheDIT,thesumofthecorporationtaxandthe(marginal)personaltaxonshareholderincomemustberoughlyequaltothetopmarginaltaxrateonlabourincome.UnderthenewNorwegiantaxsystem,thisisachievedbytaxingshareholderincomeinexcessoftheRRAattheordinarycapitalincometaxrateof28percent.sincethecorporatetaxrateisalso28percent,thetotalmarginaltaxrateoncorporateequityincomeis28+(1−0.28)×28=48.16percent,whichisclosetoNorway’stopmarginaltaxrateonlabourincome,currently47.8percent.

Taxingshareholder incomeat theflatcapital incometaxratehaspedagogicaladvantages,sincedividendsandcapitalgainsonsharesarenormallyperceivedasincomefromcapital.However,undertheNorwegiantaxregime,theneedtokeepthetotalmarginaltaxrateoncorporateequityincomeinlinewiththemarginaltaxburden on labour obviously constrains the choice of tax rate structure, since it(roughly)requiresthat +t(1−)=m,whereisthecorporateincometaxrate,tisthecapitalincometaxrateleviedonthemarginalreturntoshares,andmisthetopmarginaltaxrateonlabourincome.Thisconstraintimpliesalossofflexibility.Inparticular,iffutureincreasesininternationalcapitalmobilityforceareductioninthetaxratesoncorporateincomeandcapitalincome,themarginaltaxrateonlabourincomewillalsohavetocomedown.Hence,itappearsthatamajoradvantageoftheDIT—thatitallowsaspreadbetweenthemarginaltaxratesoncapitalandlabourtoaccountfordifferencesinfactormobility—couldbelost.

Thisproblemmaybeavoidedbytaxingshareholderincomeabovetheimputedreturn as labour income.shareholder incomeexceeding the RRAwould thenbe“grossedup”bytheunderlyingcorporationtax(bydividingtheexcessofthedividendorcapitalgainovertheRRAby1minusthecorporatetaxrate),andtheprogressivetaxonlabourincomewouldbecalculatedonthisgrossed-upbasis,withacreditbeinggivenforthecorporationtaxalreadypaid.Inthisway,themarginaltaxrateonshare-holderincomewouldalwayscorrespondtothetaxpayer’smarginaltaxrateonlabourincome,whetherornotthetaxpayerwasinthetoptaxbracket,andthelabourincometaxschedulecouldbechosenindependentlyofthetaxrateoncorporateandcapitalincome.ThedisadvantageofthissolutionisthattheproposedcreditingmechanismismorecomplexthanthecurrentNorwegiantaxregime.

Introducing and Administering the Shareholder Income Tax

Inprinciple,theshareholderincometaxutilizesthesameinformationondividends,acquisitionprices,andrealizedsellingpricesthatisneededtoimplementaconven-tionalincometaxondividendsandonrealizedcapitalgainsonshares.However,underaconventionalcapitalgainstax,thetaxauthoritiesdonotneedtoverifythebasisvalueoftheshareuntilthetimeitisrealized.sincemanyunquotedsharesarenevertraded,thisreducestheneedforcheckingthebasisvalueofshares.Undertheshareholderincometax,thebasisvalueofthesharemustalreadybedeterminedwhen


theshareisacquired,andthebasismustbesteppedupeveryyearinwhichthereisanyunutilizedRRA.Therefore,inpractice,taxadministratorswillhavetoprocessmoreinformationundertheshareholderincometaxthanunderaconventionalcapitalgainstax.Ontheotherhand,itwilloftenbeeasiertodocumentandverifytheacqui-sitionpriceofashareatthetimeofpurchasethanwhenitissubsequentlyrealized.

Theshareholderincometaxrequiresinformationoneachtaxpayer’ssharesineachcompany.Theadministrationandenforcementofthetaxwillbefacilitatedifitcanbebasedonacentralshareholderregisterthatrecordstheacquisitionandsaleofshares,withcorrespondingvalues,andthepaymentofdividendsbycompanies.Withsucharegister,thetaxliabilityoneachsharemaybecalculatedonacomputerizedbasis.Infact,sincethebeginningof2004,NorwayhasmaintainedashareholderregisterrecordingshareholdingsandsharevaluesbasedoninformationreportedbyNor-wegiancompaniesandshareholders.

Ifacentralshareholderregisterisnotavailable,theadministrationoftheshare-holderincometaxwillhavetorelyonself-assessmentcombinedwithrandomaudits.IftheRRAisgrantedonlytoshareholdersinsmalldomesticcompanies(asdiscussedaboveandsubsequently),suchasystemshouldnotimposeunreasonableadminis-trationandcompliancecosts.

Totheextentthatthetaxauthoritieshavenotalreadyrecordedabasis(acquisi-tionprice)forexistingshares,thesebasisvalueshavetobedeterminedatthetimeofintroductionoftheshareholderincometax.Avaluationofsharesmaybeneededincaseswherethetaxpayercannotdocumentthehistoricalcostprice.Ifanimputa-tionsystemorsomeothersystemofdoubletaxreliefisinplacebeforethereform,considerations of fairness suggest that the RRA should be granted to all existingshareholdingsfordeductionagainstdividendsaswellascapitalgains,sincetheRRAisjustanewformofdoubletaxrelief.However,ifthestartingpointisaclassicalcorporatetaxsystemwithfulldoubletaxationofcorporateincome,itseemsnaturalnottoofferanRRAfordeductionagainstdividendsonexistingshares,sincedoingsowouldonlygenerateawindfallgaintocurrentshareholdersandacorrespondingtaxrevenueloss,withoutimprovingcorporateinvestmentincentives.Tostrengthenincentivesfornewcorporateinvestments,itwouldbesufficienttoallowanRRAfordividendsonnewequityissuedafterthetimeofreform.similarly,whencalculatingtaxablecapitalgains,only(unutilized)RRAsaccumulatedafterthereformwouldbedeductible,ensuringanimprovedincentivefornewinvestmentfinancedbyretainedearnings.

Double Tax Relief for Companies or for Shareholders?

Asanalternativetoalleviatingthedoubletaxationofcorporateincomeattheindivid-ualshareholderlevel,doubletaxreliefcould,inprinciple,begrantedatthecorporatelevel.Forexample,inlinewiththe“allowanceforcorporateequity”(ACE)proposaloftheBritishInstituteforFiscalstudies,21companiescouldbeallowedtodeductan

21 InstituteforFiscalstudies,CapitalTaxesGroup,Equity for Companies: A Corporation Tax for the 1990s,IFsCommentaryC026(London:InstituteforFiscalstudies,April1991).


imputednormalreturnontheirequity(oronnewequityissuedafterthereform),justastheyareallowedtodeductinterestondebt.

Atleasttwoargumentscanbemadeinfavourofdoubletaxreliefatthecompanylevelratherthanattheshareholderlevel.First,forcompanieswithaccesstotheinter-nationalequitymarket,taxreliefatthelevelofdomesticshareholdersmaynotbeveryeffectiveinreducingthecostofcapital(asexplainedabove).Bycontrast,reliefatthelevelofdomestic(resident)companieswouldsignificantlystrengthenthein-centivefordomesticinvestment,includingdirectinvestmentbyforeigncompanies.second,doubletaxreliefatthecorporatelevelwouldpresumablybesimplertoad-ministerthanashareholderincometaxwithanRRA,sincetheshareholdertaxinvolveslargenumbersoftaxpayersandtransactions.

However,thepricetobepaidforthesebenefitswouldbereducedtaxrevenues:whiletheRRAundertheshareholderincometaxwouldbegrantedonlytoresidentindividualshareholders,reliefatthecorporatelevelwouldaccruetoallholdersofsharesindomesticcompanies,includingforeigninvestorsandtax-exemptinstitu-tionalinvestors.Hence,taxreliefwouldbegrantedwhetherornotdomestictaxwaspaidontheimputedreturn.Moreover,incaseswherethehomecountriesofforeigninvestorswouldhavegrantedaforeigntaxcreditforcorporationtaxpaidtothedo-mesticsourcecountry,exemptingtheimputedreturnfromdomesticcompanytaxwouldsimplybeagiveawaytotheforeignfiscthatwoulddonothingtoimprovetheincentivetoinvestinthedomesticeconomy.

Forthesereasons,alleviationofdoubletaxationatthedomesticindividualshare-holderlevelmaybepreferableafterall,asNorwegianpolicymakershavedecided.

Discrimination in Treatment of Proprietorships and Small Companies?

Underthepersonalshareholderincometax,theshareholderisnottaxableuntilhisincomeisrealizedintheformofdividendsorcapitalgains.Bycontrast,theincome-splittingsystemfortheself-employeddescribedearlierimpliesthattheincomeofproprietorsistaxedonacurrentbasis,whetherornotitisretainedinthefirm.Onemightthinkthattheabilityofownersofcorporationstopostponetaxationuntilthetimeofdistribution/realizationwouldimplyanunfairtaxadvantagecomparedwiththe tax treatmentof the self-employed.The following simplifiedexample showsthatinprinciplethisisnotthecase.

Consideranentrepreneurwhoestablishesaproprietorshipandinvestsoneunitofcapitalinhisfirmatthestartofyear1.Thiscapitalyieldsapre-taxreturn,r,thatisequaltothepre-taxmarketinterestrate.Inaddition,theentrepreneur’sworkef-fortgeneratesbusinessincomew.Alloftheafter-taxbusinessincomegeneratedinyear1isretainedinthefirm,andattheendofyear2,theentrepreneursellsthefirm.Ifheorganizesthefirmasaproprietorship,hisimputedcapitalincomeundertheincome-splittingsystemwillbertimesthestockofbusinesscapitalatthestartofeachyear.This imputedincomewillbetaxedatthecapital incometaxratet,whiletheremainingbusinessincomewillbetaxedaslabourincomeattheratem.Theafter-taxinterestrateisdenotedbyir (1−t).Example3asummarizesthe


proprietor’ssituation,assumingthatthevalueofthefirmattheendofyear2equalsthevalueofitsaccumulatedassetsatthattime.

Example 3a Scenario 1: The firm is organized as a proprietorship

Year 1

1. Initialcapitalstock:1 2. Incomebeforetax:r+w 3. Taxbill:tr+mw 4. Retainedafter-taxbusinessincome(line2−line3):i+w(1−m)

Year 2

5. Initialcapitalstock(line1+line4):1+i+w(1−m) 6. Incomebeforetax(r×line5+w):r[1+i+w(1−m)]+w 7. Taxbill:tr[1+i+w(1−m)]+mw 8. Retainedafter-taxbusinessincome(line6−line7):(1+i)[i+w(1−m)] 9. Revenuefromsaleoffirm(line5+line8):(1+i)2+(2+i)w(1−m)

Asanalternative,theentrepreneurmayorganizehisfirmasacorporation.UndertheDIT,thecorporateincometaxrateequalsthecapitalincometaxratet.Thisistherateatwhichbusinessincomeistaxed,providedthatitisretainedinthefirm.Whentheentrepreneursellshissharesinthefirmattheendofyear2,theexcessofhissalesrevenueoverhisRRAistaxedattheshareholderincometaxrate,whichisas-sumed tobeequal to t.Example3b illustrates the situation foranentrepreneurchoosingthecorporateorganizationalform,assumingthattheRRAimputedtohissharesequalstheafter-taxinterestratei.

Example 3b Scenario 2: The firm is organized as a corporation

Year 1

10. Initialcapitalstock=initialbasisofshares:111. Businessincomebeforetax:r+w12. Corporateincometaxbill:t(r+w)13. Retainedafter-taxbusinessincome(line11−line12):i+w(1−t)

Year 2

14. Initialcapitalstock(line10+line13):1+i+w(1−t)15. Basisofsharesatthestartoftheyear:1+i16. Businessincomebeforetax(r×line14+w):r[1+i+w(1−t)]+w17. Corporateincometax:t{r[1+i+w(1−t)]+w}18. Retainedafter-taxbusinessincome(line16−line17):(1+i)[i+w(1−t)]19. Capitalstockattheendoftheyear=revenuefromsaleofshares

(line14+line18):(1+i)2+(2+i)w(1−t)20. BasisofsharesplusRRAforyear2:1+i+i(1+i)=(1+i)2

21. shareholderincometax[t×(line19−line20)]:t(2+i)w(1−t)22. Netrevenuefromsaleofshares(line19−line21):(1+i)2+(2+i)w(1−t)2


Comparingrows9and22,weseethattheentrepreneurwillbeequallywelloffunderthetwoorganizationalformsif(1−t)2=1−m.Asthereadermayeasilyverify,thiswillbethecasewhen

t+t(1−t)=m. (A)

Themagnitudeontheleft-handsideofequationAisthesumofthecorporatetaxandtheshareholderincometaxonlabourincomeearnedwithinthecorporation.Ifthisisequaltothetaxratemontheimputedlabourincomeofproprietors,thetaxsystemwill,inprinciple,beneutraltowardthechoiceoforganizationalform.Asexplainedabove,thisneutralityis(roughly)achievedundertheNorwegianshareholderincometax.

Thereasonwhythecorporateorganizationalformdoesnotnecessarilyimplyanyadvantagefromtaxdeferralisthatwhenashareholderretainsandreinvestsin-comeinhiscompany,andwhentheconditioninequationAismet,theaccumulatedreturnstothisreinvestedincomewillbetaxedatthesametotalrateaslabourin-comewhenthereturnsareultimatelydistributed(sincetheretentiondoesnotaddtothebasisvalueoftheshares).Thus,theinitialliquiditygainfrompostponementofthe(high)labourincometaxisoffsetbythefactthatthepostponedtaxliabilityiseffectivelycarriedforwardwithanormalreturn,providedthatthereinvestedin-comegeneratesanormalreturn.

Thus,inprinciple,thereisnoinherenttaxdiscriminationbetweentheself-employedandtheownersofcloselyheldcompaniesundertheshareholderincometax.How-ever,inpractice,manysmallenterprisesmaybesubjecttocreditconstraintsandmaythereforehavetorelyonretainedearningsastheonlyrealisticsourceofinvestmentfinance.Insuchcases,theentrepreneur’ssubjectivediscountratewillexceedthemarketinterestrate,andhewillprefertobeabletopostponetheprogressivetaxonlabour incomebyretaining income in thefirm.Under the tax regimedescribedabove,thecorporateformoforganizationwouldthenbefavoured.Furthermore,byorganizingthefirmasacompany,theentrepreneurwouldbeabletoengageinin-comeaveragingbyappropriatetimingoftherealizationofhisshareholderincome,andtherebyminimizetheimpactoftheprogressivelabourincometaxbyexploitingtheRRAtothegreatestpossibleextent.Theself-employedwillhavenosimilarop-portunityforincomeaveraging.

Toeliminatethesesourcesofunequaltaxtreatment,onecouldallowtheself-employedtopostponetheprogressivetaxontheirimputedlabourincomeuntilthetimetheincomeisdistributedfromthefirmtotheowner,inlinewithcurrentprac-ticeinDenmarkandsweden,forexample.Fortaxaccountingpurposes,thisrequiresthattheincomeandwealthoftheself-employedbesplitintoa“business”sphereanda“private”sphere.However,thisisadministrativelycomplexforthisgroupofnon-corporatetaxpayers.

Taxation of Closely Held Corporations in the Nordic Countries

ThediscussionabovehasdescribedalternativewaysoftaxingincomefromcloselyheldcorporationsunderaDIT,assumingthatpolicymakersgivehighprioritytothe


goaloftaxneutrality.ThissectionbrieflysummarizesactualtaxpracticesinFinland,Norway,andsweden,eachofwhichhasenactedspecialtaxrulesfortheownersofcloselyheldcompanies.22

Until2005,Finnishtaxlawrequiredthatthegrossed-updividendsfromsharesinunlistedcompaniesexceedinganimputedreturntothecompany’snetassetsbetaxedaslabourincome,withacreditbeinggrantedfortheunderlyingcorporationtax.Dividendsbelowtheimputedreturnwereeffectivelyexemptfromtaxattheshareholderlevel,asaconsequenceoftheFinnishimputationsystemandthecor-respondencebetweenthetaxratesoncorporateandcapitalincome.Realizedcapitalgainsonshareswerefullytaxedascapitalincome.Toreducethetaxincentiveforownersofsmallcompaniestotransformlabourincomeintocapitalgains,Finlandhasthusaccepteddoubletaxationofretainedcorporateearnings.

In2005,Finlandabolisheditsimputationsystem.Tomaintainsomealleviationofdoubletaxation,only70percentofdividendsfromquotedcompaniesareincludedintheshareholder’scapitalincome.Forunquotedcompanies,anydividendbelowtheimputedreturnistax-exemptinsofarasitdoesnotexceedE90,000fortheindivid-ualshareholder.Aslongasthedividendremainsbelowtheimputedreturn,70percentofanydividendaboveE90,000isincludedintaxablecapitalincome,while70per-centofanydividendabovetheimputedreturnisincludedintaxablelabourincome.Essentially,Finnishtaxlawthusincludesaschematicversionoftheshareholderin-cometaxforunquotedcompanies,combinedwithpartialdoubletaxreliefforquotedcompanies.

Untilrecently,swedenalsoallowedanimputedreturntobedeductedfromthetaxableincomefromsharesinunquotedcompanies.However,in2006,thisRRAwasreplacedbyareducedtaxrateondividendsandcapitalgainsonunquotedshares.23Toaddresstheincome-shiftingproblem,swedishtaxlawimposesprogressivelabourincometaxondividendsandrealizedcapitalgainsaboveanimputedreturntothebasisvalueofsharesincloselyheldcompanies.However,thisisonlydoneforshare-holderincomerealizedbyactiveshareholderscarryingoutacertainamountofworkintheirowncompanies.Ifthedividendorrealizedcapitalgainfallsshortoftheim-putedreturninanyyear,theresidualamountiscarriedforwardwithinterestandisaddedtothebasisforcalculatingfutureimputedreturns,aswellastotheamountofshareholderincomethatmaybetaxedascapitalincomeinthefuture.

Asdiscussedearlier,fromtheintroductionoftheDITin1992untiltheendof2005,Norwaytreatedactiveshareholdersinmuchthesamemannerastheself-employed,applyinga(complex)versionoftheDITincome-splittingscheme.However,becauseofthedifficultiesofdistinguishingbetweenactiveandpassiveshareholders,in2006,

22 Denmarkdoesnothavespecialtaxrulesforcloselyheldcompanies.Instead,thegovernmentreliesonaseparateschedularprogressivetaxondividendsandcapitalgainsonsharestoensurethatthetotalcorporateandpersonaltaxburdenoncorporateequityincomeisroughlyinlinewiththemarginaltaxrateonlabourincome.

23 seenotesdandfintable1above.


Norwayintroducedavariantoftheshareholderincometax.VariousaspectsofthisnewNorwegiantaxregimehavebeenanalyzedinthepreviousdiscussion.

A duA l income tA x fo r c A n A dA?

Thisfinalsectionofthearticleconsidersthecaseforintroducing(elementsof )dualincometaxationinCanadaandhowaDITmightbeimplementedintheCanadianfederalcontext.Inthefirstpartofthediscussion,Iwillleaveasidetheissueoftheintegrationofthecorporateandthepersonalincometax,andinsteadfocusonotheraspectsoftheDIT.Then,addressingtheneedforcorporate-personaltaxintegration,IwilldiscusswhetheraNorwegian-typeshareholderincometaxcouldbeamodelforsuchintegration,evenifCanadianpolicymakersdonotwishtoadoptotherele-mentsoftheDIT.Finally,Iwillconsiderwhetherabroader-basedRRAcombinedwithprogressivetaxationofabove-normalreturnscouldbeanattractivealternativetoaconventionalDIT.

The Canadian Income Tax System: Current Situation

Althoughcertainformsofsavingforretirementaresubjecttoexpendituretaxtreat-ment,thecurrentCanadiansystemofpersonalincometaxationisinspiredbytheidealofcomprehensiveincometaxation.UndercurrentCanadiantaxlaw,taxableincomefromallthedifferentsourcesisaddeduptoarriveattotaltaxableincome,whichissubjecttoacommonprogressivetaxscheduleatthefederalaswellastheprovinciallevels.Thus,(taxable)capitalincomeissubjecttothesamemarginaltaxrateaslabourincome.

Thepersonalandthecorporateincometaxarecurrentlypartiallyintegratedviaanotionalimputationsystemforthetaxationofdividends.However,increasesinfederalandprovincialdividendtaxcreditrates,aswellasagradualreductionofthefederalcorporateincometaxrate,willfurtherimprovetheintegrationofthein-cometaxregimes.Thesechangesareexpectedtobefullyphasedinby2011.

Asof2006,atthefederallevel,dividendsreceivedbypersonalshareholdersaregrossedupto145percentoftheamountreceivedandincludedintaxableincome,andadividendtaxcreditof19percentofthegrossed-updividendisthensubtractedfromtheshareholder’staxbill.Thefederalcorporateincometaxrateis22.1percentandthetoppersonalincometaxrateis29percent.Attheprovinciallevel,thesamegross-uprateof145percentandadividendtaxcreditrateaveraging9.5percentalsoapply.By2010,however,thefederalcorporateincometaxratewillbereducedto19percent24andcertainprovincialdividendtaxcreditrateswillbe increased,raisingtheaverageprovincialcreditratefrom9.5percentto10.8percent.Thesefiguresaresummarizedintable2.

24 Afurtherreductionto18.5percenteffectiveJanuary1,2011wasproposedinthefallof2006aspartofthegovernment’sTaxFairnessPlan:Canada,DepartmentofFinance,“Canada’sNewGovernmentAnnouncesTaxFairnessPlan,”News Release2006-061,October31,2006.sinceParliamenthadnotyetapprovedthatproposalatthetimeIpreparedthisarticle,thecalculationsthatfollowusethe19percentratethatistotakeeffectin2010.


Realizedcapitalgainsaresubjecttopersonalincometax,butingeneral,only50per-centofthegainisincludedintaxableincome.Thisrulealsoappliestocapitalgainsonshares.Moreover,aso-calledlifetimecapitalgainstaxexemptionforgainsuptoCdn $500,000appliestosharesinCanadian-controlledprivatecorporationsandtofarmandfishingproperty.

Should Canada Move Toward a Dual Income Tax?

ThemarginaltaxratesonlabourincomeinCanadaaresomewhatlowerthantheratesintheNordiccountriesthatcurrentlyhaveaDIT.IntheCanadiancontext,thecaseforseparatingthetaxationofcapitalincomefromthetaxationoflabourincomebyadoptingalowflattaxrateoncapitalincomemightthusseemtobeweaker.

However,thereturnonordinarysavingthatdoesnotbenefitfromexpendituretaxtreatmentisineffecttaxedmuchmoreheavilythanlabourincomeinCanada.Forexample,assuminganominalinterestrateof4percent,aninflationrateof2percent,andatopcombinedmarginaltaxrateof45.6percentonnominalinterestincome,theeffectivemarginaltaxrateonrealinterestincomeis45.6%×4/(4−2)%=91%(sincetherealpre-taxrateofreturntosavingequalsthenominalinterestrateminustherateofinflation).Foranyrealisticcombinationsofnominalinterestandinfla-tion,thereturnstoordinarysavingarethustaxedmuchmoreheavilythanlabourincomeundercurrentCanadiantaxlaw,owingtothelackofinflationadjustmentofnominalcapitalincome.

tAble 2 Selected Statutory Tax Rates in the Canadian Tax System, 2006 and 2010

2006 2010

percent

ToppersonalincometaxrateFederal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29.0 29.0Provinciala. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.6 16.6Combined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45.6 45.6

DividendtaxcreditrateFederal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19.0 19.0Provinciala. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9.5 10.8Combined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28.5 29.8

ToppersonaltaxrateondividendincomeFederal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14.5 14.5Provinciala. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.3 8.4Combined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24.8 22.9

CorporateincometaxrateFederal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22.1 19.0Provincialb . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.4 12.8Combined . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34.5 31.8

a Weightedonthebasisoftotalpersonaltaxableincomereportedineachprovince.bWeightedonthebasisoftotalcorporatetaxableincomereportedineachprovince.


DistributedcorporateprofitsarealsotaxedmoreheavilyinCanadathanlabourincome.Withanaveragecombinedcorporatetaxrateof34.5percentin2006andaneffectivetoppersonaltaxrateondividendincomeof24.8percent,thetotalcor-porateandpersonaltaxburdenondistributedprofitsis34.5%+(1−0.345)×24.8%=50.7%(comparedwith45.6percentfor labourincome).By2010,however,thecombined tax rate on dividend income will fall to 47.4 percent, 1.8 percentagepointsabovethetoprateonlabourincome,assumingthatpersonaltaxratesremainconstant.

Moreover,althoughCanada’sstatutorycorporatetaxrateislowerthanthecor-poratetaxrateintheUnitedstates,itisrelativelyhighcomparedwiththeratesinmost OECD countries. Even with the planned reduction in the federal rate, thecombinedcorporatetaxrateinCanadaisstilllikelytoremainconsiderablyabovetheratesprevailinginmostsmalldevelopedeconomies.

Moregenerally,thegrowinginternationalmobilityofcapitalislikelytocontinuetoputdownwardpressureoncapitalincometaxratesandcorporatetaxratesaroundtheworldandtomakeitincreasinglydifficulttoenforcehighresidence-basedtaxesoncapitalincome.Againstthisbackground,andifCanadianpolicymakerswishtostrengthenincentivesforsavingandinvestment,itmightbeworthwhileforCanadatoconsiderintroducingelementsofdualincometaxation,asalsosuggestedbyMintz.25

Outline of a Dual Income Tax for Canada

ApossiblemovetowarddualincometaxationinCanadacouldproceedinseveralsteps.GiventhehighdegreeoffiscalautonomyenjoyedbytheCanadianprovinces,itseemsmostlikelythataDITwouldinitiallybeintroducedonlyatthefederallevel(assumingthattheintroductionofafederalDITwouldbeincompliancewiththecur-renttaxcollectionagreementswiththeprovinces).Ifthefederalexperiencewiththenewtaxsystemprovedtobepositive,theprovincesmightthenwanttovoluntarilyadoptadualtaxratestructure,relyingonthefederalsplitbetweencapitalincomeandotherincome.

AsIhaveexplained,onecomplicationassociatedwithapureDITistheneedtosplittheincomefromself-employmentintocapitalincomeandlabourincome.InseveralEuropeancountriesoutsidetheNordicregion,policymakershavewantedtoavoidthiscomplicationbuthaveneverthelessintroducedalowflattaxrateoncertainformsofcapitalincome,suchasinterestanddividends.similarly,afirststeptowarddualincometaxationinCanadacouldbetointroduceaseparatelowflattaxrateonpersonalcapitalincome,butwithoutincludingimputedreturnstobusinessassetsinthecapitalincometaxbase.Thecapitalincometaxbasecouldincludethosesourcesofincomethatarecurrentlycategorizedasincomefromproperty(mainlyinterest,dividends,royalties,andrentalincome)aswellasrealizedcapitalgains.

25 JackM.Mintz,The 2006 Tax Competitiveness Report: Proposals for Pro-Growth Tax Reform,C.D.HoweInstituteCommentaryno.239(Toronto:C.D.HoweInstitute,september2006).


UndersucharudimentaryDIT,non-corporatebusinessincomewouldcontinuetobetaxedaccordingtotheprogressiverateschedulethatisappliedtolabourincome.AsIhavepointedout,thiswouldimplysometaxdiscriminationagainstsavingsin-vestedinunincorporatedfirms.Therefore,asasecondsteptowardafull-fledgedDIT,afterconsideringthealternativemethodsofincomesplittingdescribedearlier,Canadianpolicymakersmightwanttointroduceanoption(butnotanobligation)fortheself-employedtoincludeanimputedreturntotheirbusinessassetsinthecapitalincometaxbase.Iflowadministrationandcompliancecostsareapriority,there is a strong case for choosing the gross assets method of income splitting,whichhasworkedquitewellinNorway.

Thefederalcapital incometaxratecouldbesetat15percent,corresponding(roughly)tothemarginalpersonalincometaxrateinthefirsttaxbracket.Assuminganominalinterestrateof4percentandaninflationrateof2percent,asinourpreviousexample,a15percenttaxrateonnominalinterestincomewouldimplyaneffectivefederaltaxrateonrealinterestincomeequalto30percent,whichisclosetothetopmarginalfederaltaxrateonlabourincome(29percent).Assumingthattheaveragetopprovincialtaxrateoninterestincomewouldmatchthe2006personaltaxrateof16.6percent,theeffectivetopcombinedmarginaltaxrateonrealinterestincomewouldthenbeequalto63percent.Thisisstillconsiderablyhigherthanthetopcombinedmarginalpersonaltaxrateonlabourincomeof45.6percent,butitwouldimplyasubstantialreductionfromthe91percentrateimpliedbythecurrenttaxrules(giventhenominalinterestandinflationratesassumedabove).

AsIhavearguedinthisarticle,thereisacaseforaligningtheflattaxrateoncap-italincomewiththecorporateincometaxrate,forreasonsoftaxneutrality.Further,thereisacaseforloweringCanada’scorporatetaxrate,inordertomakethecoun-tryamoreattractive location for international investment.Theseconsiderationssuggestthatthefederalcorporateincometaxrateshouldbefurtherreducedfromthe19percentrateplannedfor2010(or18.5percentfor2011)to15percent,inlinewiththesuggestedfederalcapitalincometaxrate.

Animportantjustificationforloweringthestatutorytaxratesoncapitalincomeandcorporateincomeisthatlowerratesshouldfacilitatebasebroadeningtoachievemoreuniformandconsistenttaxationofallreturnstocapital.Apartfromcontributingtogreatertaxneutrality,basebroadeningwouldhelptocompensatefortherevenuelossfromthereductionofstatutorytaxrates.Inparticular,withsignificantlylowertaxratesoncapitalincomeandcorporateincome,itwouldbenaturaltoabolishthecurrenttaxpreferenceforcapitalgainsbyincludingall(andnotjusthalf )ofrealizedcapitalgainsintaxablecapitalincome.Indeed,sinceonejustificationforaseparatelowtaxrateoncapitalincomeisthatthetaxisleviedonallofthenominalreturn(andnotjustontherealreturn),thecapitalincometaxbaseshouldincludetheentirenominal capital gain. The case for imposing full tax on capital gains is furtherstrengthenedbythefactthatthecapitalincometaxisflatundertheDIT,sothatrealizationoflargegainsinasingleyeardoesnotpushthetaxpayerintoahighertaxbracket.Thiswillhelptoreducethewell-knownlock-ineffectofarealization-basedcapitalgainstax.


Bysimilarreasoning,themovetowardaDITwouldprovideacaseforeliminat-ingthecurrentCanadianlifetimecapitalgainstaxexemption.Inlinewiththegoalofgreatertaxneutrality,theproposedcut inthecorporatetaxratealsomakesitnaturaltoconsiderremovingthesmallbusinessdeductionsothatallcorporationsaretaxedatthesame15percentrateatthefederal level.smallcorporationsarecurrentlytaxedat13.1percent(11percentby2009)ontheirfirst$400,000oftax-ableincome.IthasbeensuggestedintheCanadiantaxpolicydebate(althoughnostrongevidenceexiststosupporttheclaim)thatthesteepincreaseinthemarginaltaxratebeyondthesmallbusinessthresholdcreatesadisincentivetogrow,andpo-tentiallyaffectsCanada’sproductivityperformance.Furthermore,theproposedcutinthecorporateincometaxrateprovidesagoodcaseforbroadeningthecorporatetaxbasebyeliminatingspecialprovisionsthattendtodistortcorporateinvestment.Mintzpresentsseveralconcreteproposalsforsuchbasebroadening.26

TheaboveproposalforaCanadianDITassumesthatthecurrentCanadianim-putationsystemfordividendtaxationwouldbeabolishedatthesametimeasthetaxratesoncapitalincomeandcorporateincomearelowered.Thediscussionthatfol-lowsexaminestheimplicationsofsuchareformandconsiderswhetherthereisaneedtointroducesomeotherformofcorporate-personaltaxintegration,suchasashareholderincometaxwithanRRA.

The Income-Shifting Problem Under a Canadian Dual Income Tax

Despitetheabolitionoftheimputationsystemfordividendtaxation,theproposedfederalDITwouldstillimplyacutinthetaxburdenondistributedcorporateprofits.Underthe2010Canadiantaxsystem,withafederalcorporatetaxrateof19percent,anaverageprovincialcorporatetaxrateof12.8percent,andfederalandprovincialtaxcreditratesof19.0percentand10.8percent,respectively(asshownintable2),thetotalcorporateandpersonaltaxburdenonCdn$100ofdistributedcorporateprofitswouldbecalculatedassetoutinexample4a.

Example 4a Total tax burden on Cdn$100 of distributed corporate profits under the 2010 tax system

Dividendaftercorporationtax:$100×(1−0.19−0.128)=$68.20Federalpersonaldividendtax:1.45×(0.29−0.19)×$68.20=$9.89Provincialpersonaldividendtax:1.45×(0.166−0.108)×$68.20=$5.74Effectivetotalpersonaldividendtaxrate:($9.89+$5.74)/$68.20=22.9%Totaltaxrateondistributedprofits:($19.00+$12.80+$9.89+$5.74)/$100=47.4%

UndertheproposedfederalDIT,thefederalcorporateincometaxratewouldbecutto15percent,dividendswouldbetaxedattheflat15percentcapitalincometaxrate, and the current imputation system would be abolished. Assuming that theprovinceswouldstillwanttocollectthesameamountofcorporateandpersonaltax

26 Ibid.,at26.


ondistributedprofitsafterthereform,thetotaltaxburdenondividendsmaybecalculatedasshowninexample4b.

Example 4b Total tax burden on Cdn$100 of distributed corporate profits after the federal tax reform

Dividendaftercorporationtax:$100×(1−0.15−0.128)=$72.20Federalpersonaldividendtax:0.15×$72.20=$10.83Provincialpersonaldividendtax:$5.74(sameasbefore)Effectivetotalpersonaldividendtaxrate:($10.83+$5.74)/$72.20=23.0%Totaltaxrateondistributedprofits:($15.00+$12.80+$10.83+$5.74)/$100=44.4%

Example4showsthatundertheproposedDIT,thetotaltaxburdenondistributedprofitswouldbereducedbyanaverageof3percentagepoints,from47.4percentto44.4percent.

TheexamplealsoshowsthattheswitchtotheproposedfederalDITwouldimplyatotaltaxburdenondistributedprofitsslightlybelowtheaveragetopcombinedmarginalpersonaltaxrateonearnedincome(assumed,intable2,toremainat45.6percent).Hence,theownersofcloselyheldcompanieswouldhavealimitedincen-tivetoreducetheirtaxbillbytransformingmanagementsalariesintodividends,andtherewouldbenoneed for special anti-avoidance rules toprevent such incomeshifting.

Whenprofitsareretainedbythecompany,thereturntotheshareholderaccruesasacapitalgain.Realizedcapitalgainsarecurrentlytaxedatonlyhalftheordinarytaxrate(sinceonlyhalfofthegainisincludedintaxableincome)—thatis,atanaveragerateof0.5×(0.29+0.166)=22.8%forataxpayerinthetopbracket.Assumingforsimplicitythat$1.00ofretainedprofitgeneratesa$1.00increaseinthevalueofthecompany’ssharesandthatthiscapitalgainisrealizedimmediately,thetotalcorpor-ateandpersonaltaxburdenonadollarofpre-taxretainedprofitunderthe2010Canadiantaxsystemwouldthusbe19.0+12.8+(1−0.19−0.128)×22.8=47.3%.Theprovincialpersonaltaxcontributes0.5×16.6×(1−0.19−0.128)=5.7percent-agepointstothisoveralltaxwedge.

UndertheproposedfederalDIT,realizedcapitalgainswouldbefullytaxedattheflat15percentfederalcapitalincometaxrate.Assumingthattheprovinceswouldwanttomaintainanunchangedprovincialtaxburdenoncapitalgains,thetotaltaxrateonretainedprofitsundertheproposedfederalDITwouldbecome15+12.8+(1−0.15−0.128)×15+5.7=43.8%.Again,thiswouldbeclosetothetopmarginaltaxrateonlabourincome,thusminimizingthescopefortaxavoidancethroughthetransformationofmanagementsalaryintocapitalgains.27Atthesametime,thisex-ampleshowsthatthefederaltaxreformwouldreducethetaxburdenonretainedprofitsbyabout3.5percentagepoints(from47.3percentto43.8percent).

27 Inpractice,acontrollingshareholdercould,ofcourse,reducetheeffectivetaxburdenonaccruedcapitalgainsbydeferringrealizationofthegain,butthiswouldinvolvesacrificingsomecurrentconsumption,unlesshechose(andwasable)toborrowagainsttheaccruedgain.


Is There a Need for Integration of the Corporate and the Personal Income Tax?

AlthoughtheproposedfederalDITimpliesaslightreductionofthetotaltaxburdenoncorporateequityincome,evenwhenoneaccountsfortheabolitionoftheimputa-tionsystemandforthetighteningofcapitalgainstaxation,corporate-sourceequityincomewouldstillbesubjecttodoubletaxation,incontrasttootherformsofin-comefromcapital.Inparticular,whilenominalinterestincomewouldbetaxedatacombinedfederalandaverageprovincialrateof15+16.6=31.6%,thetotalcorporateandpersonaltaxburdenoncorporateprofitswouldbearound44percent,asillus-tratedbyexample4babove.Thisraisesthequestionwhethersomeformofrelieffromthedoubletaxationofcorporateincomeiscalledfor.

Indiscussingthisissue,it isusefultodistinguishbetween“large”and“small”corporations. shares in large public corporations listed on a stock exchange aretraded(oratleastaretradable)intheinternationalequitymarket,andhencetheymustofferanexpectedrateofreturnequaltothereturnrequiredbyinternationalinvestors.ThismeansthatinCanada—asmallopeneconomywithanopenstockmarket—themarginalholderofsharesinadomesticpubliccorporationislikelytobeaforeigninvestorwhoserequiredreturnisunaffectedbyCanadianpersonaltaxes.ThesetaxesarethereforeunlikelytohaveanysignificantimpactonthecostofequityfinanceforCanadianpubliccorporations.Forexample,ifaresidence-basedpersonaltaxonequityincomemakesshareholdinglessattractivetoCanadianindividualinvest-ors,thoseinvestorswillselloff(someof )theirdomesticsharestoforeigninvestorswhostandreadytobuythesharesatpricesdeterminedfromtheworldstockmarket.Thus,althoughCanadianpersonaltaxesonequityincomewillinfluencethepatternofcorporateownershipandthelevelofdomesticsavings,theyshouldhavenono-ticeable effect on the cost of equity finance for Canadian public corporations.28similarly,totheextentthatunlistedsharesinlargeprivatecorporationsaretradableintheinternationalequitymarket,therequiredreturnonsuchsharesmaybecloselylinkedtothereturnrequiredintheinternationalmarket.

The situation is different for small corporations sincenormally the shares inthesecompaniesarenottradedinternationally.Becausetheytypicallyhavedifferentrisk characteristics, and are less liquid, shares in small private corporations (andperhapsalsosharesinsmalllistedcompanies)areimperfectsubstitutesforsharesinlargepubliccorporations;asaresult,therequiredreturnonsharesinsmallcompan-iescannotsimplybetakenasgivenbyreferencetotheworldequitymarket.sinceinvestorshavetheoptionofinvestingininterest-bearingassetsinsteadofshares,onemayexpectthatapersonaltaxonequityincome(dividendsand/orcapitalgains)willtendtodriveuptherequiredreturnonsharesinsmalldomesticcompanies,

28 seeRobinBoadwayandNeilBruce,“ProblemswithIntegratingCorporateandPersonalIncomeTaxesinanOpenEconomy”(1992)vol.48,no.1Journal of Public Economics39-66;andPeterBirchsørensen,“ChangingViewsoftheCorporateIncomeTax”(1995)vol.48,no.2National Tax Journal279-94,foranelaborationofthispoint.


therebyincreasingthecostofequityfinanceforthiscategoryoffirms.Inprinciple,theremaybecaseswheretheinsurancepropertiesofacapitalgainstaxwithfulllossoffsetscouldmakeinvestmentincertainhigh-risksharesmoreattractive;butevenifapersonaltaxonequityincomemaynotalwaysdriveupthecostofequityfinanceforsmallcorporations,itwilldosoinmanysituations.Inanycase,asIhavedem-onstrated in a previous article,29 it will tend to distort the pattern of risk takingwithinthesectorofsmallcompanies.

Theforegoingdiscussionsuggeststhattheremaybeacaseforsomeformofre-lief fromthedouble taxationofcorporate incomeevenwhenoneallows for theopennessoftheCanadianeconomy.Togainfurtherinsightintothisproblem,itisusefultoconsiderasimplenumericalexample.Accordingtothecalculationsinex-ample4aabove,undertheexistingtaxsystem,thetotalcorporateandpersonaltaxburden on corporate equity income is estimated at 47.4 percent in 2010 (whenprofitsaredistributed),whereastheaveragetopcombinedmarginalpersonaltaxrateoninterestincomeisaround29+16.6=45.6%.Foraninvestorwhoconsidersthealternativeofinvestingininterest-bearingassetsyieldingapre-taxinterestratei,therequiredpre-tax(risk-adjusted)returnoncorporateinvestmentristhereforegivenbythearbitragecondition30

r(1−0.474)=i(1−0.456)⇔r=1.03i.

Underaneutraltaxsystemthatneitherfavourednordiscriminatedagainstcor-porateinvestment,onewouldhaver=iinthenotationabove,aswouldbethecaseintheabsenceoftaxation.WeseethattheCanadiantaxsystemplannedfor2010comesclosetobeingneutralinthisdimension.Bycomparison,undertheproposedfederalDIT,theestimatedtotaltaxburdenondistributedcorporateprofitsisaround44percent,andtheaveragecombinedpersonaltaxrateoninterestincomeisroughly15+16.6=31.6%.Thus,therequiredpre-taxreturnoncorporateinvestmentisgivenby

r (1−0.44)=i(1−0.316)⇔r=1.22i.

Comparedwiththepresentsituation,thereformwouldthusraisethecostofcorporatecapitalbyabout(1.22−1.03)/1.03=18%.Thisisaconsiderableincrease.However,oursimplifiedexampleprobablyoverstatesthetaxdiscriminationagainstequity-financedinvestment.Thereasonisthat,whereastheinflationcomponentofthenominalinterestrateisalwayssubjecttocurrenttaxation,shareholdersmaydefertaxontheinflationcomponentoftheirnominalincomebyreceivingthatincomeintheformofanunrealizednominalcapitalgainontheirshares,thusreceivingonlytherealrateofreturnintheformofadividendsubjecttocurrenttaxation.

29 sørensen,supranote20.

30 Forsimplicity,thisanalysisassumesthattaxablecorporateincomecorrespondstothetrueeconomicincomeofthecompany.


still,itseemsclearthattheproposedfederalDITcombinedwiththeabolitionofthefederaldividendtaxcreditimpliessomebiasagainstcorporateequityfinance.Thenextsectiondiscusseshowthisbiascouldbeeliminated.

A Shareholder Income Tax for Canada?

Onewayofensuringfulltaxneutralitybetweenthecorporateandthenon-corporatesectorswouldbetoadoptafullimputationsystemfordividendtaxation(grantingfullcreditagainstthepersonaldividendtaxforalloftheunderlyingcorporationtax)andtoallowthebasisofsharestobesteppedupbytheamountofretainedcorpor-ateprofitswhencalculatingtaxablecapitalgainsonshares.ThiswouldcorrespondtoNorwegiantaxpracticefrom1992until2006.Whilesuchataxsystemhasdesir-ableneutralityproperties,ittendstobeadministrativelycomplex.Inparticular,thestep-upofthebasisofsharesbytheamountofretainedcorporateprofitposessomeadministrativechallenges,althoughtheNorwegianexperienceshowsthat imple-mentingsuchasystem—originallyproposedbyCanada’sCartercommissionbackinthe1960s31—isindeedfeasible.

Furthermore,combiningtheDITwithafullimputationsystemfordividendsandsomeformofdoubletaxreliefforcapitalgainsonshareswouldopenthedoortoincomeshiftingbytheownersofcloselyheldcorporations,bygivingthesetaxpay-ersanincentivetotransformmanagementsalariesintolightlytaxeddividendsorcapitalgains.AstheNorwegianexperiencesuggests,anyattempttopreventsuchincomeshiftingthroughmandatoryincomesplittingforactiveshareholdersislikelytobeadministrativelydemandingandratherineffective.

Finally,asystemoffullimputationandacapitalgainstaxregimelikethepreviousNorwegianregimeimpliesfulldoubletaxreliefforallreturnstocorporateinvest-ment,including“pure”profits.ButasIhavepointedoutinthisarticle,investmentneutralityrequiresdoubletaxreliefonlyforthenormalreturntocapital;indeed,providedthatthetaxcodeallowsfulllossoffsets,itisevenpossibletotaxthe“normal”equitypremiumonshareswithoutdiscouragingcorporateinvestment.Byavoidingdouble taxationofpureprofits andof thenormal equitypremium, thepreviousNorwegiantaxregimethussacrificedsometaxrevenuethatcouldhavebeencol-lectedwithoutdistortingcorporateinvestment.ThisinsightwasthemotivationfortheintroductionofthenewNorwegianshareholderincometax,whichgrantsdoubletaxreliefonlyforarisk-freereturnonthevalueofshares.

Theshareholderincometaxdescribedaboveisinprincipleneutraltowardinvest-ment,financing,andrealizationdecisions,eventhough,onaverage,itwillgeneratepositiverevenues.Hence,itseemsanattractiveblueprintforalleviatingthedoubletaxationofcorporateincome.UndertheproposedtaxratestructureforaCanadianfederalDIT,therewouldbenoneedforaseparatetaxrateonshareholderincome.Instead,dividendsandrealizedcapitalgainsonsharesexceedingtheimputedrisk-freerateofreturnonthesharescouldsimplybetaxedascapitalincomeatarateof

31 supranote2.


15percentatthefederallevel.Assumingthattheprovinceswouldwanttomaintainthesamerevenuefrompersonaltaxesondividends(say,throughanappropriatead-justmentoftheprovincialdividendtaxcredit),thecombinedfederalandprovincialtaxrateondividendsinexcessoftheimputedreturnwouldthencorrespondrough-lytothetopmarginaltaxrateonlabourincome,asillustratedbythecalculationsinexample4.Thisroughcorrespondencewouldpreventanysignificantgainfromincomeshifting;andatthesametime,theRRAwould,inprinciple,eliminateanydistortionsfromthedoubletaxationofcorporateequityincome.

Indeed,evenifCanadianpolicymakersdidnotwishtoadoptaDIT,theycouldstillchoosetoreplacethecurrent imputationsystemandthecurrentregimefortaxingcapitalgainsonshareswithashareholderincometax,asanalternativewayofcoordinatingthecorporateandthepersonalincometax.suchareformwouldachieveneutraltaxtreatmentofretainedanddistributedprofitsandaneutralre-gimefortaxingcapitalgainsonshares(againassumingfulllossoffsetsandcarefuldesignoftheRRA,asdescribedbelow).

Thediscussionofequityfinancingabovesuggeststhat,ifpolicymakersarepri-marilyconcernedaboutavoidinganincreaseinthecostofcorporatecapital,theyshouldfocusondoubletaxreliefforsmallcorporations,sincedomesticpersonaltaxes areunlikely to affect the costof capital for large corporations inCanada’ssmallopeneconomy.Thiswouldhave significant administrative advantages,be-cause itwouldeliminate theneedtokeeptrackof (changes in) shareholdings inlargecorporations,andbecausesharesinsmallcorporationsaretypicallyconcen-tratedinthehandsofrelativelyfewpeopleandarerarelytraded.Whensharesweretradedduringthefiscalyear,itwouldnotrequiretoomanyadministrativeresourcestosplittheannualRRAbetweenthepreviousandthecurrentshareholdersinpro-portiontothefractionoftheyearinwhicheachshareholderownedtheshares.ThisapproachdiffersfromthecurrentNorwegianpracticeofassigningalloftheRRAtothetaxpayerholdingtheshareattheendofthefiscalyear.Asdiscussedearlier,theallocationoftheRRAinthismannerwouldeliminatepotentialabuseofthelossoff-setrulesthroughyear-endtrades,32andwouldallowliberallossoffsetstoensurethegreatestpossibledegreeoftaxneutrality.

Alsoasdiscussedearlier,introducinganRRAonlyforshareholdersofsmallcom-panies would increase the attractiveness of investing in such shares rather thansharesinlargecorporationsorbonds.Thisshouldtendtoreducethecostofequityfinanceforsmallcompanies.Inprinciple,suchadifferenceinthetaxtreatmentoflargeandsmallcorporationsimpliesataxdistortioninfavourofthelatter.However,introducingthisdistortioncouldbedefensiblebecauseitwouldtendtocompensateforaninefficientallocationofrisk.specifically,theownersofsmallcorporationsofteninvestalargefractionoftheirwealthintheirowncompany,thusfailingtofullydiversifytheirriskbyholdingabroad“marketportfolio”ofshares.Totheex-tentofthisunder-diversification,theownersofsmallcompaniesmaybeperceived

32 seethediscussionundertheheading“TheImputedReturnandtheTreatmentofLosses.”


totaketoolittleriskfromasocialperspective.Ifthatisthecase,theoveralllevelofinvestmentinthesecorporationswilltendtobesuboptimal.IntroducinganRRAforshareholdersofsmallcompanieswouldtendtooffsetthiseffectandcouldtherebyenhanceeconomicefficiency.

Inaddition,grantinganRRAonlytoholdersofsharesinsmallcompanieswouldreducetherevenuelossfromdoubletaxrelief.Itwouldalsostrengthenthecasefor removing the current small businessdeduction inCanada and subjecting allcorporationstothesame15percentcorporateincometaxrate.ThiscouldhelptocompensatefortherevenuelossfromtheRRA.

AnRRAforshareholdersofsmallcompanieswouldobviouslyrequireadistinctionbetween“small”and“large”corporationsfortaxpurposes.Giventhatthecurrentsmallbusinessdeductionalreadyrequiresasimilardistinction,thiswouldnotlikelycause(additional)administrativeproblems.However,thedistinctioncouldcreatesome distortions: shareholders in a company that crossed the borderline from a“small”toa“large”corporationwouldlosetheirRRA,implyingadisincentiveforbusinessexpansionbeyondtheborderline.Itisdifficulttoevaluatetheseriousnessofthisdistortion.Inanycase,asimilartypeofbarriertobusinessexpansionexistsinallcountriesofferingspecialtaxprovisionstosmallenterprises.ThedistortionmightbereducediftheRRAwerephasedoutgraduallyasthecompanymovedoutofthe“smallbusiness”category.

Anotherissueisthetaxtreatmentofdebtversusequity.AshareholderincometaxwithanRRAdoesnoteliminatethedoubletaxationofabove-normalreturnstoequity.Asexplainedearlier,thismaygivecontrollingshareholdersanincentivetotakeoutincomefromthecompanyintheformofinterestondebtratherthanequityincome.Hence,itisadvisabletointroduceananti-avoidanceprovisionstatingthatwhentheinterestrateonaloanfromapersonaltaxpayertoasmallcompanyexceedsacertainthreshold,thedifferencewillbetaxedaslabourincome.

Insummary,grantingtheRRAonlytoshareholdersofsmallcompanieshasad-ministrativeadvantagesandimpliesalowerrevenuecost.Ontheotherhand,itmayimplysomebarriertobusinessexpansion.Moreover,fulldoubletaxationofincomefromlargecorporationsmayincreasethedegreeofforeignownershipoflargedo-mesticcompanies(sincesomedomesticpersonaltaxpayersmaybeinducedtoselltheirshares).Thismaybeseenaspoliticallyundesirable.Choosingbetweenagen-eralRRAforallshareholdersandaselectiveRRAforshareholdersofsmallcompaniesinvolvesatradeoffbetweenthesedifferentconsiderations.InNorway,policymakersdecidedinfavourofageneralRRA,whereasFinnishpolicymakershavedecidedtograntanRRAonlytoholdersofsharesinunquotedcompanies(asdidswedenuntilrecently).

Double Tax Relief at the Corporate Level?

ThepurposeofgrantinganRRAwhencalculatingthetaxableshareholderincomeofindividualtaxpayersistoreducethecostofequityfinanceforsmallcompaniesthatlackaccesstotheinternationalstockmarket.AsIhaveexplained,eveniftheRRAweregrantedtoholdersofquotedaswellasunquotedshares,itwouldhavelittle,if


any,noticeable impactonthecostofcapital forpubliccorporations,although itmightcausesomesharesinthesecompaniestochangehandsfromdomestictofor-eigninvestors.

ImplementingdoubletaxreliefthroughashareholderincometaxwithanRRAisthusapolicyaimedmainlyatavoidingthenegativeimplicationsofdoubletaxationforsmallcompanies,includingstartupfirms.However,ifthepolicygoalistostimu-latedomesticinvestmentmorebroadly,amoreeffectivepolicywouldbetograntdoubletaxreliefatthecorporateratherthantheindividualshareholderlevel.Thiswould involve full taxation of dividends and realized capital gains for individualshareholders,butsomeformoftaxreliefforallcompaniesinvestinginCanada.

Inpractice,suchreliefatthecorporatelevelcouldbeimplementedthroughanallowanceforcorporateequity(ACE)ofthetypeproposedbytheBritishInstituteforFiscalstudies33andrecentlyintroducedinBelgium.Underthissystem,companiesoperatinginCanadawouldbeallowedtodeductanimputednormalreturntotheequity(assetsminusliabilities)recordedintheirtaxaccounts,justastheyarecur-rentlyallowedtodeductinterestondebt.AnACEwouldstrengthentheincentiveofallcompaniestoinvestinCanada,andsincethenumberofcorporatetaxpayersissmallerthanthenumberofpersonalshareholders,itshouldbeeasiertoadministerthanabroad-basedshareholderincometaxwithanRRAforallshareholders.

AnACEwouldalsohavetheadvantageofoffsettingthedistortionstoinvestmentcausedbyaccelerateddepreciation:ifcompanieswritedowntheirassetsatanac-celeratedpace,thecurrenttaxsavingfromaccelerateddepreciationwillbeoffsetbyareductioninfutureRRAsofequalpresentvalue,sinceaccelerateddepreciationreducesthebookvalueoftheassetstowhichfuturedeductibleratesofreturnareimputed.34Moregenerally,anACEreducesinvestmentdistortionsbyexemptingthenormalreturntodomesticinvestment,recognizingthatinasmallopeneconomywithhighcapitalmobility, a taxon thenormal returnwill, to a largeextent,beshifted(viaanoutflowofcapital)ontolessmobiledomesticfactorsofproduction,suchaslabourandland.Thus,althoughataxexemptionforthenormalreturntodomesticcorporateinvestmentmaycauseasignificantlossofrevenue,onecanarguethatitwouldbemoreefficienttoraisethisrevenuevialessdistortionarytaxesondomesticlabourandland,giventhatthesefactorsareinanyeventlikelytobearmostoftheburdenofasource-basedtaxonthenormalreturn.

However,intheCanadiancontext,thislineofreasoningmayneedtobemodi-fied:alargepartofdirectinvestmentinCanadabyforeigninvestorsisundertakenbyUsmultinationalsthatreceiveaforeigntaxcredit forCanadiantaxespaidonprofitsrepatriatedtotheUnitedstates.Totheextentthatprofitsarerepatriated,a

33 seesupranote21.

34 seeRobinBoadwayandNeilBruce,“AGeneralPropositionontheDesignofaNeutralBusinessTax”(1984)vol.24,no.2Journal of Public Economics231-39.


CanadianACEforUsinvestorswouldlikelyamounttoagiveawaytotheUsTreas-urythatwouldnotincreasetheincentiveforUscompaniestoinvestinCanada.Inotherwords,aCanadianACEwouldincreasetheincentiveforUsmultinationalstoinvestinCanadaonlytotheextentthatsuchinvestmentwasfinancedbytheretainedprofitsoftheirCanadiansubsidiaries.Hence,thecaseforintroducingaCanadianACEmaynotbepersuasive as long as theUnitedstatesmaintains a foreign taxcreditsystem.

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