Peter Birch Sørensen: alieving the problem of double dividends – University of Copenhagen

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Peter Birch Sørensen: Tackling the problem of double taxation

Over the years there have been many attempts to solve the problem of double taxation of corporate income. The problem is that the return to the equity capital invested in the corporate sector of the economy is taxed at two levels. At the corporate level, corporate net profits after deduction of interest payments are subject to the corporate income tax. At the shareholder level, investors are subject to personal taxes on dividends and on capital gains on shares. This double taxation tends to hamper business investment and it encourages companies to use too much debt finance since interest payments can be deducted from the corporate tax base. It might seem that the problem could be solved by exempting dividends and capital gains on shares from personal income tax so that corporate income is only taxed at the company level. But this would also create problems.

Peter Birch Sørensen explains: "Think of small companies where the dominant shareholder is often also the manager. He can more or less decide for himself whether to take out income from the company in the form of dividends or in the form of management salary. If there is no tax on the dividend and the corporate income tax is lower than the top marginal tax rate on personal income, it will be profitable for the  manager to pay himself a dividend rather than a salary. He is then only paying the corporate tax on the income and thus escaping the higher marginal tax rates on personal income such as wages."

Apparently, then, tax policy makers are faced with an unpleasant dilemma: Either you accept double taxation of corporate income which will depress investment and make companies dangerously dependent on debt, or you open a loophole in the tax system to the advantage of corporate owner-managers. Back in 2002-2003 when Peter was a member of a Norwegian government tax reform committee, he proposed a way out of the dilemma in the form of a new way of dealing with the problem of double taxation. This new system of taxing income from the corporate sector was described by Peter in a research article published in 2005. It became an important part of the Norwegian tax reform of 2006 and a variant of the system was also included in the blueprint for tax policy in the 21st century proposed in 2011 by a committee of international tax experts led by Nobel Prize Winner James Mirrlees.

Peter sketches the tax principles he suggested: "At the shareholder level dividends and capital gains are tax-free as long as they do not exceed a normal rate of return on the shares. However, if the dividend or the capital gain exceeds the normal return, the shareholder must pay tax on the excess return. That way you make sure that as long as the shareholder only gets a normal return to investment, the income from the investment is only subject to the corporate income tax rate which is equal to the tax rate on interest income according to my proposal. But if the shareholder gets a return above normal, the excess return is taxed at a rate ensuring that the total corporate and personal tax on the excess return corresponds to the tax rate on labor income. In this way there will be no gain for the small company manager if he pays himself dividends  instead of salary. Also, there is no excess tax on the normal return to equity-financed investment compared to debt-financed investment. So the system avoids creating loopholes and it puts debt and equity on equal footing."