New Developments in Small and Medium-sized Enterprise Income Tax Policy ?How to Address Income Shifting from Labor to Capital Income Tax Base?

Labor and capital incomes are usually taxed at different rates. These rate differentials are widening world over as countries cut corporate income taxes and effectively raise personal income taxes by levying higher social insurance premiums on their aging population. Therefore, owners of small and medium- sized enterprises (SMEs) can reduce their tax liability by restructuring their sole proprietorships as corporations. By doing so, they convert income from labor into lesser- taxed capital income and owe less tax burden. This tax - minimization strategy, so - called gincome shifting from labor to capital h, has become notable and been reported by many researches and government reports world over. The first half of this paper studies the recent problem in the US and UK. Thereafter, it takes up the case in Japan. The often - noted problem in Japan is rather unique. Point is that tax burden on salary income is alleviated because its tax code grants a special deduction for it. As its corporate tax rate was high until 2000s, Japanese small - business owners have incorporated and received all of their corporation fs earnings as salary and retained none. Because of this tax avoidance activities ( gincome shifting to salary h), many small corporations have seemingly gotten into red (Tajika and Yashio, 2005). This situation is changing. Like many countries, Japan has raised taxes on wage income by hiking social insurance premiums while reducing corporate tax rates. These reforms favor retaining corporate earnings over paying them as salaries. As a result, tax - minimizing efforts to convert wage income into capital income (retained earnings) by SME owners, that is, gincome shifting from labor to capital h can become a serious problem in Japan in the near future. This paper studies such recent situations and offers suggestions for future tax and social security reforms.