A Note on the Effects of Income-Splitting under Dual Income Tax

Abstract

This paper reconsiders the income-splitting rules of the Nordic dual income tax system, introduced to address the incentives to shift income between labor and capital income tax bases. These rules impute a return on equity, categorized as capital income, and tax the residual roughly at the rates levied on labor income. There are broadly two ways to calculate the capital income part. One is to impute a return on the acquisition price of shares (Sweden and Norway) and the second is to calculate a return on the net book assets of the firm (Finland). This paper addresses the economic effects of the net asset-based splitting method, which has not been studied thoroughly in earlier literature. Using a dynamic investment model, we show that at appropriately chosen parameter values the net assets-based split exhibits the key properties of the reportedly neutral ACE corporation tax. Our analysis, therefore, implies that the incentive problems of Finnish taxation of closely held companies, found in some earlier studies, derive from wrong parameter values rather than from wrong principles.