Tax treatment of dividends and capital gains and the dividend decision under dual income tax

Abstract

The paper analyses efficiency aspects of a dual income tax system with a higher tax on capital gains than dividends. It argues that apart from the distortions to investments claimed in earlier literature, the system puts even more emphasis in creating incentives for entrepreneurs to participate in tax planning. The paper suggests that the owner of a closely held company can avoid all personal taxes on entrepreneurial income by two tax-planning strategies. The first is the avoidance of distributions, which would be taxed at the tax rate on labour income. These funds would instead be invested in the financial markets. The second strategy is a distribute and call-back policy, converting retained profits into new equity capital. Interestingly, the outcome is that investment in real capital is not distorted in the long-run equilibrium. Empirical evidence using microdata is also provided. Copyright Springer Science+Business Media, LLC 2007Dual income tax, Small business taxation, Income shifting, H24, H25,

Dividends and tax avoidance as drivers of earnings management: Evidence from dividend-paying private SMEs in Finland

“…Our current sample covers practically all dividend-paying private SMEs in Finland between 2006 and 2010 for which financial statement data needed in the study were available. In line with the empirical findings in related prior studies of our institutional setting (Harju & Matikka, 2016;Kari & Karikallio, 2007, among others), we document that during this period, the dividend tax rule creates a strong financial incentive to pay a tax-exempt target dividend of 9 percent of net worth, as anything less leaves money on the table and anything 1 From 2005 to 2014, these maxima were 90,000 euros per shareholder, or 9 percent of a firm's net worth, depending on which of the two was lower. Thus, the total amount of annual tax-exempt dividends that private companies could distribute to their shareholders was defined by the following upper limit: min (90,000 × number of shareholders; 9 percent × firm's net worth).…”

Anticipating Tax Changes: Evidence from the Finnish Corporate Income Tax Reform of 2005*

“…As discussed above, the old system seems to have created incentives for non-listed companies to distribute as dividends the maximum amount of normal dividends. Kari and Karikallio (2007) present evidence that a significant proportion of dividend-distributing non-listed corporations closely followed this rule in their payout policies.…”

“…Lindhe, Södersten and Öberg (2004) and Hietala and Kari (2006) show that the split affects investment incentives and may reduce the cost of capital to a low level. Kari and Karikallio (2007) discuss the implications of the splitting system for dividend distributions. They show that a non-listed corporation's optimal payout policy may well be to distribute exactly the maximum amount of normal dividends.…”

Nonlinear Dividend Tax and the Dynamics of the Firm

“…Our analysis predicts that without carry-forward, a nonlinear tax induces firms to bunch around the dividend tax threshold. There is indeed some evidence of bunching below the exemption limit in Finland (Kari and Karikallio, 2007;Harju and Matikka, 2013). Similarly, in line with our predictions, Alstadsaeter and Jacob (2013) report no bunching around the Swedish exemption limits.…”

“…In some others, such as Denmark, Spain, and the United States, dividends are taxed using a separate progressive rate schedule (OECD, 2014). While a smaller body of literature considers the investment and efficiency implications of a specific progressive tax -the so-called split model of the Nordic dual income tax (Lindhe et al, 2004;Kari and Karikallio, 2007;Sørensen, 2005) -we are not aware of any study focusing on the effects of a generic nonlinear tax rate schedule on the decisions of firms.…”