3. Fifteen Lessons from Tax Analysis
3.6 Avoid Taxing Income Differently when Earned Through Different Legal Forms Just as taxing different goods and services at different rates of GST creates tax-induced
‘density hole’ but this segment could be expected to have more ‘missing mass’ compared to a tax kink case (with correspondingly more individuals below the threshold). Kleven and Waseem (2013) provide examples of this for income tax paid by the self-employed in Pakistan.
Figure 8 Impact of Tax Kinks & Notches on Earnings Distribution
8A – Tax Kink 8B – Tax Notch
Source: 8A: Kleven (2016, p.439); 8B: Kleven and Waseem (2013, p.675)
3.6 Avoid Taxing Income Differently when Earned Through Different Legal Forms
A major problem in most OECD countries, however, is that while personal income tax rates typically demonstrate progression, company tax regimes often adopt one marginal ‘flat’ tax rate, or a small number set independently of the personal tax regime (usually combined with various deductions). Thus, in many OECD countries, with company tax rates set lower than the top rate of personal income tax, there is an incentive for top rate taxpayers to earn income through companies provided the difference is not subsequently taxed (for example, where it is passed on in dividends and taxed at personal rates).39 Conversely, low-rate personal income taxpayers may pay higher rates of tax if they earn income through a company – an especially relevant consideration for low- earning family members within small family businesses.
This ‘lesson’ therefore implies care is needed over the trade-off between setting higher personal income taxes to achieve redistribution, but lower corporate tax rates to encourage, for example, the location, or amount, of company investment. Many OECD countries have sought to live with this contradiction by maintaining a substantial personal-corporate tax rate difference, while setting up complex rules around the (re)characterisation of different forms of income that minimise
‘leakages’ to the company tax regime.
Example 1:
As part of the radical tax reforms in New Zealand in the early 1990s the government ‘aligned’
the top personal, corporate and trust tax rates at 33%, thus achieving a key efficiency objective that (largely) avoided different tax rates by legal form. However, subsequent decisions to raise the top rate of personal income tax (to 39% in 2001) and reduce the corporate tax rate (to 30% in 2007 and 28% in 2011) began to erode this alignment.
Nevertheless, as Figure 9 shows, after the top personal rate was reduced again to 33% in 2011, the personal-corporate rate difference in 2018 was just 5 percentage points. New Zealand therefore had the equal lowest difference in the OECD (along with Mexico). From April 2021, however, the top personal rate was again increased to 39% but with no change in the trust (33%) and company (28%) rates. The personal-corporate rate difference thus more than doubled to 11 percentage points. Such large differences in tax rates across legal forms, if they are not accompanied by carefully drafted, comprehensive anti-avoidance legislation, are likely to lead to a loss of integrity as taxpayers find ways to shift their incomes towards the lower taxed forms.
39 An ‘Imputation’ system is one mechanism used whereby, the difference between the corporate tax paid on dividends before distribution is ‘imputed’ (credited) to the personal taxpayer, with the difference between the corporate and personal tax liability paid on distribution.
Figure 9 Top Personal and Corporate Tax Rate Differences, 2018
Source: OECD.Stat
Other OECD countries, by contrast, typically have a 15-25 percentage point difference in those rates with some, such as Ireland, having a corporate rate almost forty percentage points below the top personal rate. It has been argued that the relatively low difference in New Zealand meant there was less need for ‘protective’ measures to prevent income shifting across legal forms facing different tax rates. However, even with the 5 percentage point difference between 2011 and 2021, evidence suggests New Zealand’s apparent lack of laws limiting income re-characterisation has given rise to easier income shifting than intended. NZTWG (2018b, section 4) and Gemmell (2020) show that, after the top personal tax rate and the trust rate were ‘re-aligned’ at 33% in 2010, but the corporate rate was not aligned, noticeably divergent trends occurred between income earned through trusts and income passing through small closely-held companies.
Example 2:
The removal of alignment in New Zealand in 2001, whereby the top personal rate was increased to 39% while the trust and company rates remained at 33% (the latter subsequently reduced to 30%
in 2008) created substantial opportunities for the legal form of income declaration to change for tax purposes – encouraging incorporation and the growth of trusts. NZ Treasury (2009) provides some evidence that this occurred. They note that ‘following the increase in the top personal rate in 2000, the number of company income tax returns grew at almost 10% p.a. over 2000-06 compared to only around 4% p.a. over 1993-2000. The increase in profit growth rates is much less … suggesting that it was small (low profit) companies that grew most after 2000’. (NZ Treasury, 2009, pp.16-17).
In addition, if this tax-motivated incorporation was encouraged by the 39% rate, compensating slower post-reform growth of unincorporated firms would be expected. The evidence also appears to support this – the numbers of unincorporated businesses grew more slowly, and their combined income actually fell, over 2000-06, whereas both had grown strongly before 2000. A similar reaction might be expected following the April 2021 reforms to the top personal rate.
Example 3:
Crawford and Freedman (chapter 11 in Mirrlees et al., 2010) provide interesting evidence for the UK on the effect of personal-corporate tax rate differences on small firms and the self-employed;
see especially section 11.3.3. Two changes in particular in the rules around corporate tax in the UK created strong incentives for the self-employed to incorporate: the adoption of a zero tax rate in 2002 for companies with less than £10,000 turnover, and changes in 2007 to tax rules to limit avoidance of social security taxes by ‘managed service companies’ (MSCs) in 2007. MSCs (which were unincorporated) were set up to provide ‘umbrella’ oversight/management services for groups of self-employed individuals rather than each being employed directly. Figure 10 shows the dramatic climb in numbers of firms incorporating from 2002 following the 0% corporate rate (which was soon abandoned), and the huge spike in incorporation in 2007 after the MSC legislation was announced, as the self-employed sought to avoid possible prosecution for tax evasion.
Figure 10 Incorporation Episodes in the UK
Sources: Mirrlees et al. (2010, p.1057)
3.7 Achieving Tax Efficiency Should Include Administrative and Compliance Costs