Study: Corporate tax reform aiming for tax neutrality would best improve productivity and economic growth
Finland’s tax policies on corporate and capital income distort companies’ financing and investment decisions by favouring debt-financed investments and influencing the type of investments made.
A report, released by the Research Institute of the Finnish Economy ETLA and VATT, proposes that the Government should aim for a corporate and capital income tax regime based on reasonable tax rates that would have a minimum distortive effect on the financial choices made by companies and their owners.
The objective of the study carried out as part of the implementation of the Government Plan for Analysis, Assessment and Research for 2015 was to analyse the problems of Finnish corporate and capital income taxation and the options for developing the system from the point of view of investments, productivity and economic growth.
Current system beset by problems that can be addressed in several ways
According to the study, the current corporate tax regime favours debt as a way of financing investments, increases the required return on equity on self-financed investments and distorts the allocation of investments by favouring massive investments in machinery and equipment.
The most obvious problem in dividend taxation is the variable tax rates applied to dividends from non-listed companies. The eight-percent limit for return specified in the current tax system is very high, providing, in some cases, an excessive incentive to increase the net asset value of the company. It may have an adverse effect on the optimum allocation of investments.
The report also assess several optional ways of alleviating the incentive problems associated with the existing regime. They can be divided into two categories:
- amendments that offer marginal improvements to the existing system (extension of the business loss relief system and reform of the depreciation and impairment system);
- reforms that affect the fundamental structure of the tax regime (allowance for corporate equity, abolition of interest relief, corporate tax on distributed profits and various provisions models).
ACE offers greater benefits than other optional approaches
The report analyses two approaches to a fundamental reform much discussed in the international context.
Under the Allowance for Corporate Equity (ACE) model, the company may deduct the imputed cost of corporate equity whereas the Comprehensive Business Income Tax (CBIT) model would do away with the right to deduct interest on debt. While both would eliminate discrimination against corporate equity, they are also perceived as involving a number of problematic incentives.
The adoption of the ACE model as part of a tax-neutral reform would require an increase of the corporate tax rate, which could reduce Finland’s appeal as a host country for multinational companies and repatriation of profits. While the CBIT model would make it possible to lower the tax rate, the abolition of interest relief would serve as a disincentive for investments.
The initiatives of the OECD and the EU Commission to reduce international tax planning diminish the importance of competition aspects in this analysis. If the ACE system is adopted in such a way that that the allowance only applies to new equity, the need for a tax increase and related disadvantages remain limited. For these reasons and if greater emphasis is placed on investments and financial efficiency, the ACE model appears more promising than CBIT.
Estonian model expensive, provisions no solution to the problems
The study also looked into the Estonian model of corporate tax on distributed profits and a range of provisions.
If the Estonian model were implemented in a cost-neutral manner, it would require a high corporate tax rate. Since the model provides an incentive for leaving the profits in the company, it would inhibit the reallocation of capital to more productive investments. The various provision models would reduce taxes to some extent but would fail to solve the incentive problems associated with the present system.
Recommendations for improving the efficiency of taxation
The report recommends that the return limit for tax on dividends from non-listed companies be reduced closer to market rates. The amendment would have a healthy effect on incentives. The tax rates for capital income should not be raised any further.
None of the options for developing corporate taxation is problem-free. The existing system also offers potential for further development. If so, it would advisable to reinforce the business loss relief system, and tax deductions could be made to reflect the actual depletion of equity.
If the trend of declining corporate tax rates continues, the distortive effects of the present system will gradually diminish. However, if the fall in corporate tax rates were to stop, it would be advisable to consider the adoption of the ACE model. If so, the reduced tax rate on dividends from non-listed companies should be eliminated or substantially lowered. Such a reform would stop the favouring of debt and reinforce the incentive to invest.
The report concludes that based on the negative experiences from the tax relief experiment for research and development activities in Finland, it would not appear advisable to adopt a permanent tax relief system. Instead, the efforts to develop innovation activities should focus on direct business support.
Report (in Finnish):
Yritysverotus, investoinnit ja tuottavuus
(Valtioneuvoston selvitys- ja tutkimustoiminnan julkaisuja 7/2016)
Seppo Kari, Research Leader, VATT, tel. +358 295 519 419
Niku Määttänen, Research Director, Etla, tel. +358 41 545 6721