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The investment and financing decisions of closely held firms when there is a tax on the equity premium

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    Abstract

    This paper analyzes a tax system where personal share income in excess of the risk-free return on equity (the equity premium) is taxed. The rate of return allowance (RRA) in the Norwegian shareholder income tax system is, to the best of our knowledge, the first attempt of implementing such taxation in practice, and represents an innovation. This paper analyzes the effects of this form of taxation on the investment and financing decisions of closely held firms. Such firms typically have limited access to capital markets, but a high degree of financial flexibility that allows them to participate in tax planning. We show that even if the RRA reduces distortions compared to traditional dividend taxation, the tax system is not neutral if the shareowners' discount rate exceeds the risk-free interest rate used in the computation of the RRA. We find empirical support to the view that a tax on shareholder income without sufficient allowance for the opportunity cost of capital discourages investment in corporate equity. This finding is particularly relevant for entrepreneurship and investment in closely held firms.

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    File URL: http://www.ssb.no/a/publikasjoner/pdf/DP/dp594.pdf
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    Bibliographic Info

    Paper provided by Research Department of Statistics Norway in its series Discussion Papers with number 594.

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    Date of creation: Sep 2009
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    Handle: RePEc:ssb:dispap:594

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    Keywords: Dividend taxation; shareholder income tax; corporate financial policy;

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