Abolished Company Tax
English Summary of the book
ABOLISHED COMPANY TAXATION - ANALYSIS AND CONSEQUENSES
Swedish title Slopad Bolagsbeskattning - analys och konsekvenser, Norstedts juridik, Stockholm 2007.
In recent years, there has been an international trend to reduce corporate taxation. Within the course of ten years, the average tax rate in the 15 older member states of the EU has fallen from 39 to 29 percent. Looking at all member states, the average rate of corporate taxation in 2006 was 25 percent.
Even though the reduction in tax rates was accompanied by some broadening of the tax base, there has also been a general move towards tax relief and tax exemption for certain types of company establishments. An intensive international discussion is under way on what has come to be called harmful tax competition, i.e. methods of using tax relief by certain countries to attract foreign investment with conditions to employ only local staff, carry on operations only in certain free zones, not to carry on competitive operations within the country etc.
What has largely been overlooked in this discussion is whether taxation on business - or at least corporate income tax - can be dispensed with completely. This book examines the practical, legal, accounting and business economics problems generated by the taxation of business. It then analyses and describes the economic consequences of the taxation of business and the macroeconomic effects of the abolition or substantial reduction of the corporate income tax.
A starting point for the book is the role of taxation on business in a schematically-described economic cycle. In a simple model such as this, the subject of taxation of business, i.e. corporate profits, are studied as part of the flows between the household and the business sector in the form of payment for work and capital which runs parallel to payments for goods and services. Corporate profits can then be described as a temporary collection of the results of production. This connection between corporate profits, salaries and dividends means that the taxation of these different bases also is closely linked. The scope for salaries and dividends, for example, is reduced when corporate profits are taxed.
The historical background to business taxation is described in more detail in Chapter 3, which concludes that there is no evidence that any in-depth analysis was made on the introduction of taxation on corporate profits during the 19th century. With the appearance of companies with limited liability, it became practicable to raise capital from people not directly involved in the business. This form of taxation subsequently became internationally accepted and generally implemented. Today, the arguments for corporate taxation would probably be purely fiscal and political. The conception that this form of taxation is to be based on good reasons or is systematically essential has probably been sustained by the discussion being carried on in various international bodies with the aim of eliminating 'harmful' tax competition and tax evasion through tax havens etc.
The review in Chapter 4 of various problem areas caused by the taxation of business reveals both theoretical and practical difficulties. The relationship between the taxation of business and accounting law means that a high degree of complexity is unavoidable. The general tax law issues include problems in determining taxable and non-taxable income, deductible and non-deductible expense, profit transfers through transfer pricing, profit/loss equalisation over time and within groups etc. If an international perspective is introduced, the problems are exacerbated, and, for example, the principles for handling countries' overlapping tax claims (international double taxation) add further layers of complexity.
The extensive theoretical analyses required to establish the tax base can verge on the unreasonable, as can be seen, for example, in questions of how income and expenditure are to be allocated over time. If, in addition, cross-border business transactions and a number of national tax systems are involved, differing allocation rules may lead both to double taxation and to complete tax exemption, and may also complicate or render impossible the deduction of or credit for foreign taxes. Furthermore, fiscal requirements can often conflict with commercial interests, both national and international. This becomes particularly serious when states' interest in preserving their tax bases - i.e. what in reality is a dispute between nations - has a negative impact on companies through double tax demands, litigation costs, uncertainty and wasted time.
The costs of implementing corporate taxation are investigated in Chapter 5. The compliance costs to companies have been examined by NUTEK, among others, and are reported at SEK 2 billion per year. The EU Commission investigated the division of costs by size of company, and reported that the costs to small and medium-sized companies amount to over 30% of the tax paid. The tax authorities' costs in respect of notices, forms, audit procedures etc. have been estimated at SEK 1.9 billion. To this can be added what is probably an even larger sum for legislative work in committees, government departments and Parliament, as well as the court costs of hearing cases involving taxation of business. On top of this, corporate taxation may also be deemed to give rise to costs of several billion SEK through unprofitable investment and lost time in the national economy as well as legal uncertainty, creating a negative attitude towards tax and perhaps even inducing criminal behaviour.
The effect of corporate taxation on investors' yield requirements in making investment decisions on the basis of traditional theoretical structures is examined in Chapter 6. According to these theories, the effect of corporate taxation on yield requirements depends on whether equity is used to finance marginal investment. The assumption that marginal investments are wholly or partly financed through equity implies that a reduction - or the abolition - of corporate taxation would lead to a reduction in the gross yield requirements of foreign shareholders, with a consequent increase in investment in Sweden (provided that foreign parent companies' business in Sweden are not taxed, which neither is the case for most countries). In certain cases, however, the abolition of corporate taxation would lead to the tax base moving from Sweden abroad. The reactions of other countries to unilateral Swedish action are impossible to predict. Countermeasures could mean that the yield requirement would actually rise, despite the fact that corporate taxation had been abolished in Sweden and the tax base exported to other countries as a result.
In Chapter 7, the analysis is broadened to include the macroeconomic effects of corporate taxation. It is established that the underlying assumptions of the theoretical model for an open economy can be questioned on empirical grounds. In practice saving and investment are not mutually independent. This means that the taxation of Swedish shareholders may have greater significance for the size of the capital stock than the strict theoretical version of the open economy model would indicate. This is partly explained by "home bias", i.e. investors' preference to invest in their own country; a feature well supported by a number of empirical studies. Another contributory explanation is that, in practice, all investors - especially foreign investors - lack perfect and detailed information on available investment opportunities.
Accordingly, the analysis of the macroeconomic effects of the abolition of corporate taxation indicates that foreign investors would be very interested in investing in Sweden, whether or not a reform of this type is combined with other Swedish fiscal measures. In the short run, the existence of agglomeration, i.e. establishments within the same area (clusters), and the cost of establishing in other countries are responsible for a certain amount of inertia which means that adaptation takes time.
As far as Swedish investors are concerned, the effect of the abolition of corporate taxation would very much depend on what specific Swedish fiscal measures accompany the move. Swedes would also invest and increase their shareholdings in companies provided that the reform was financed other than through taxes on shareholders. Both Swedish and foreign investment leads to higher salaries. Obviously, the abolition of corporate taxation also involves a reduction in administration for companies, which generates efficiency gains and tends to make enterprise more attractive. If the reform were to be linked to increased taxes on Swedish shareholders, one of the main effects would be a rise in foreign ownership of existing major companies. This would also be accompanied by increased salaries.
An unambiguous conclusion is that the foreign investors are the winners from a reform in which corporate taxation is abolished through the removal of the "tax export" currently charged to them. Swedish wage earners would probably gain from the abolition of corporate taxation, at least if it took place in combination with other fiscal measures to increase the tax on shareholders. If, on the other hand, the accompanying fiscal measures took a different approach, there is some uncertainty as to whether increased gross salaries would outweigh the negative effects of, for example, tax rises and reductions in expenditure that may affect wage-earners. The theory also suggests that whether Swedish investors gain or lose from the reform is largely a matter of how the different generations are affected. An interesting question is the extent to which a reform involving the abolition of corporate taxation would need to be combined with other fiscal measures, and this would be determined in part by the expected effects from the abolition of corporate taxation.
The effects of the abolition of corporate taxation are analysed in detail in Chapter 8, starting from the available empirical studies of investor response among Swedish and foreign investors. From these, effects on shareholder structure and central government finances are estimated. Even if foreign investors are not more sensitive to changes in the corporate income tax than Swedish investors, their large volume still implies that the effects for Swedish economy will be powerful, when they become more interested in investing in Sweden. The response to lowered corporate income tax from foreign investors therefore result in significantly larger effects on the Swedish stock of capital, compared to domestic actors. This implies that total investment in small, open economies such as Sweden's is strongly affected by reductions in corporate taxation.
The analysis shows that the abolition of corporate taxation could be largely self-financing in the long term. It is not, therefore, definite that other fiscal measures would be required. The conditions for this appear to be particularly good when the analysis considers the situation for small and medium-sized companies and large companies respectively. The condition is that profits and salaries rise sufficiently so that taxes on shareholders and wage earners can compensate for the tax shortfall from corporate taxation.
In the short term, it is almost always the case that the public finances are negatively affected by tax reductions. In the longer term, however, new investment takes place, and this means that total salaries rise. Since the tax on earned income is relatively high, an increase in total salaries generates a strong contribution to the financing of a reform of this type. When both profits and salaries rise, not least through increased employment, it appears that a significantly lower elasticity on the part of foreign investors is sufficient for the reform to be self-financing than the available empirical studies suggest. When the analysis is carried out on the assumption that small and medium-sized companies are more salary-intensive than large companies, an even lower elasticity is enough to fulfil the condition that the central government budget balance must not change. This result must be considered in relation to the general insight that the elasticity normally is higher in the long term and not lower. If the elasticity is higher than the level sufficient to maintain the balance in central government finances - as the available studies indicate - then the abolition of corporate taxation would create scope for other taxes to be cut as well.
It is, however, a necessary condition for the analysis that it involves only an isolated reduction of corporate taxation in Sweden, and that other countries do not take any countermeasures when Sweden unilaterally abolishes corporate taxation. Should other countries reduce their corporate taxation rates before Sweden, it can be expected that the effects of a reduction in Swedish corporate taxation at a later date would be more modest.
In Chapter 9, possible problems with abolishing corporate taxation are examined. These include the ability to save through deferral offered by companies (the piggy-bank effect) and the question of the conversion from earned income to investment income. Existing tax laws already include methods of handling these questions. It should, therefore, be possible to deal with the problems, even though the tensions within the existing system may increase if corporate taxation is abolished. The reaction of other states to unilateral action by Sweden is less certain. With the rules currently applied in tax treaties between Sweden and its most important trading partners, the effects of an abolition of corporate taxation would not automatically be neutralised. Nor does it appear that the current CFC rules in other countries would be an immediate threat. However, an assessment of what changes in this respect may come in the future is difficult.
The conclusions from the analysis are given in Chapter 10. The traditional macroeconomic, legal and political arguments for corporate taxation are considered to rest on fragile grounds. The tax can be seen in a context where it affects and is affected by the taxation of salaries and dividends. How the tax burden will finally be allocated among these bases - the incidence - is difficult to assess. In the short term, there are clear indications that investors bear corporate taxation, while in the longer term there is no reason that corporate taxation on the whole should affect the allocation of the results of production between investors and wage earners. The analyses of the economic effects of the abolition of corporate taxation suggest considerable gains for investment, for government finances etc., as was shown in the preceding chapter.
To some extent the abolition would mean that Sweden would lose the corporate tax revenue presently collected from the profits accruing to foreigners. The untaxed profits would, therefore, be distributed tax-free (or at a low rate) to foreign shareholders who are then taxed in their own countries. Since Sweden would not deduct any tax, there would be no tax to set off against tax in the recipient counEnglish try. This loss of Swedish tax revenue to the benefit of the recipient country would, however, appear to be very limited. Among the countries of major economic significance to Sweden, it is only the USA that taxes dividends from Swedish companies. EU countries do not tax dividends from associated companies in other EU countries.
One effect of Sweden completely abolishing corporate taxation would be that Swedish companies would not be able to benefit from Sweden's tax treaties. This would be answered by Sweden introducing a very low rate of tax. The risk of other countries taking countermeasures is assessed to be low, partly because the climate in favour and the understanding of very low corporate taxes or the complete abolition of corporate taxation has increased in recent times.
The crucial question in connection with the abolition of corporate taxation in Sweden is how other countries would react. Historical experience shows that it is likely that a substantial reduction in corporate taxation in one country is seen as an aggressive act aimed at attracting capital from other countries. In the worst case, other countries could introduce special rules aimed at penalising companies investing in Sweden. If a number of countries abolish corporate taxation, however, the effects in terms of inflows of foreign capital would be significantly less for any individual country. The contribution of foreign investors to capital formation in Sweden, and so to the financing of such a reform though taxation of earned income would therefore, shrink. This in turn would place greater pressure on public finance measures such as reductions in expenditure or rises in other taxes. For a country that is left behind, i.e. is left isolated with high corporate taxation, there is a substantial risk of being left in a seriously worse situation. The investment stimulus from an inflow of foreign business capital would disappear.
Provided that the above-mentioned problems can be dealt with, the abolition of corporate taxation would in general hardly give rise to any negative effects that could not be overcome. The positive effects, on the other hand, would be many and almost overwhelming.
• Former Head of Department,
• Former Senior Vice President,
• Former Member of Tax Law Committee
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