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Tax Treatment of Dividends and Capital Gains and the Dividend Decision Under Dual Income Tax

  • Seppo Kari
  • Hanna Karikallio

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 micro data is also provided.

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Paper provided by Government Institute for Economic Research Finland (VATT) in its series Discussion Papers with number 416.

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Date of creation: 05 Apr 2007
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Handle: RePEc:fer:dpaper:416
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  1. Sinn, Hans-Werner, 1991. "The vanishing harberger triangle," Journal of Public Economics, Elsevier, vol. 45(3), pages 271-300, August.
  2. Erik Fjaerli & Diderik Lund, 2001. "The choice between owner's wages and dividends under the dual income tax," Finnish Economic Papers, Finnish Economic Association, vol. 14(2), pages 104-119, Autumn.
  3. Alan J. Auerbach, 1980. "Wealth Maximization and the Cost of Capital," NBER Working Papers 0254, National Bureau of Economic Research, Inc.
  4. Seppo Kari, 1999. "Dynamic Behaviour of the Firm Under Dual Income Taxation," Research Reports 51, Government Institute for Economic Research Finland (VATT).
  5. Peter Sørensen, 2005. "Neutral Taxation of Shareholder Income," International Tax and Public Finance, Springer, vol. 12(6), pages 777-801, November.
  6. repec:cup:cbooks:9780521331586 is not listed on IDEAS
  7. Lindhe, T. & Sodersten, J. & Oberg, A., 2001. "Economic Effects of Taxing Closed Corporations under a Dual Income Tax," Papers 2001:16, Uppsala - Working Paper Series.
  8. Raj Chetty & Emmanuel Saez, 2005. "Dividend Taxes and Corporate Behavior: Evidence from the 2003 Dividend Tax Cut," The Quarterly Journal of Economics, MIT Press, vol. 120(3), pages 791-833, August.
  9. Seppo Kari & Vesa Kanniainen & Jouko Ylä-Liedenpohja, 2007. "Nordic Dual Income Taxation of Entrepreneurs," Discussion Papers 415, Government Institute for Economic Research Finland (VATT).
  10. Roger H. Gordon & Joel Slemrod, 1998. "Are "Real" Responses to Taxes Simply Income Shifting Between Corporate and Personal Tax Bases?," NBER Working Papers 6576, National Bureau of Economic Research, Inc.
  11. Arellano, Manuel & Bond, Stephen, 1991. "Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations," Review of Economic Studies, Wiley Blackwell, vol. 58(2), pages 277-97, April.
  12. Vidar Christiansen, 2004. "Norwegian Income Tax Reforms," CESifo DICE Report, Ifo Institute for Economic Research at the University of Munich, vol. 2(3), pages 09-14, October.
  13. Cnossen, Sijbren (ed.), 2000. "Taxing Capital Income in the European Union: Issues and Options for Reform," OUP Catalogue, Oxford University Press, number 9780198297833, March.
  14. Annette Alstadsæter, 2003. "The Dual Income Tax and Firms' Income Shifting through the Choice of Organizational Form and Real Capital Investments," CESifo Working Paper Series 1018, CESifo Group Munich.
  15. Tobias Lindhe & Jan Södersten & Ann �berg, 2004. "Economic Effects of Taxing Different Organizational Forms under the Nordic Dual Income Tax," International Tax and Public Finance, Springer, vol. 11(4), pages 469-485, 08.
  16. Roger Gordon & Martin Dietz, 2006. "Dividends and Taxes," NBER Working Papers 12292, National Bureau of Economic Research, Inc.
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