Wednesday, June 1, 2011

Risk-free rate tax deductions

The Norwegian shareholder tax is rather peculiar in that it allows the deduction of risk-free interest income, thus only taxing the risky portion of capital income. This is rather counter-intuitive, as one usually wants to encourage risk-taking in the form of venture capital or plain entrepreneurship. But the idea in Norway was that this would make financing of firms neutral with respect to the source of funds.

Jan Södersten and Tobias Lindhe argue this line of reasoning is not appropriate for an open economy like Norway and 56% foreign ownership. Indeed, one needs to understand as well who is investing. Indeed, taxes are capitalized differently by different people. Indeed, for an economy that is so open, returns are largely determined on international markets, What is then determinant for Norway is the after-tax return, and this is where new distortion enter the picture: large firms are financed on international markets, and the after-tax rate is set abroad. Small firms that finance themselves domestically have provide similar after-tax returns, but domestic investors face different tax rules than their foreign counterparts. This is where new distortions can enter, and severe under-investment in domestic firms could be the consequence. But for a rather closed economy, this seems a good idea, especially as it is a neat way to prevent under-reporting of income.

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