As adviser to a small developing country that has traditionally used the classical system of corporate taxation, the writer has researched the feasibility of introducing a dividend imputation system to increase the equity in the tax system and to encourage investment in corporations. The writer has explored the advantages and disadvantages of the classical system of taxation in the country and whether introducing dividend imputation would improve it. The principles that shape taxation laws viz. Neutrality, Simplicity, Efficiency, and Equity are illustrated.
The key characteristic of the classical system of taxation is that it taxes corporate earnings twice. The double taxation of dividends results in a bias by companies to retain more earnings than they would if no corporate income tax was imposed. It also creates an economic distortion in favour of debt financing rather than equity financing.
The dividend imputation system makes provision for shareholders who have been paid a dividend to take a personal tax credit or franking credit since the company has already paid tax on the dividend. Although double taxation is avoided, neutrality is compromised when tax concessions in the form of income are passed on to shareholders and therefore subject to tax at a different rate.
Research however indicates that integrating corporate and personal income taxes can reduce corporate financial leverage and alleviate the tax-incentive for corporations to retain earnings. The same report advocates that the introduction of a dividend imputation system can:
Encourage capital and other resources to flow into the corporate sector to the extent of 2-8% or $125 billion to $500 billion increase in capital stock.
Encourage companies to use less debt and estimates a debt to asset ratios decrease of 1 to 7 percent.
Encourage corporations to increase the earnings distributed as dividends by 2 to 6 percent.
Improve economic by 0.73 percent of consumption.
This report culminates in a recommendation to the government to adopt an integrated system of corporate taxation to increase the equity in the tax system and to encourage investment in corporations. However, the proviso is that other taxes are adjusted to off-set the revenue effects of integration
Introduction
Terms of Reference
The assignment requires of the writer, as adviser to a small developing country that has traditionally used the classical system of corporate taxation, to research the feasibility of introducing a dividend imputation system to increase the equity in the tax system and to encourage investment in corporations. The writer is expected to explore the advantages and disadvantages of the classical system of taxation in the country and whether introducing dividend imputation would improve it.
Aim
The aim of the assignment is illustrate the writer’s understanding of the classical corporate taxation system and a fully integrated system of corporate taxation. Equally, the aim is to test the writer’s understanding of tax neutrality, efficiency, simplicity and equity under each system. The report culminates in a recommendation to the government to adopt an integrated system of corporate taxation to increase the equity in the tax system and to encourage investment in corporations.
Scope
The writer shall illustrate her understanding of the advantages and disadvantages of the classical system of corporate taxation and of an integrated system using dividend imputation. So too will she illustrate the principles that shape taxation laws viz. Neutrality, Simplicity, Efficiency, Equity.
Principals that Shape Taxation Laws
Sound tax systems are simple, neutral, and equitable. Sometimes, however, it does happen that in attempting to espouse a particular principle, the system can run afoul of another principle.
Tax Neutrality
The notion of a neutral tax provision implies that the tax system does not influence a taxpayer’s choices relating to investments or actions. A taxpayer should be treated in the same why regardless of the manner in which resources were invested. A biased provision that could influence a taxpayer to choose one investment or course of action over another is not considered to be neutral.
Tax Efficiency
The notion of an efficient tax system means that the impact of economic decisions is not negatively impacted and unnecessary declines in economic activity are not caused by the tax system inefficiencies. The costs of complying with the tax law and administrative requirements should be kept to a minimum.
Tax Simplicity
A tax system should make it easier for taxpayers to understand tax and equally make it easier for tax administrators to collect taxes fairly. The notion includes references not only to the simplicity of the legislation but also the simplicity of the tax system.
Tax Equity
Tax equity refers to the notion that taxes are imposed in a fair and equitable way. Two standards to evaluate the fairness and equity of a tax are the benefit principle and the ability to pay principle. A sound tax system applies the ability-to-pay principle in two ways viz. those with the same ability to pay should pay the same taxes and those with different abilities should pay different taxes. These terms are better known as horizontal equity and vertical equity.
Horizontal Equity
This tax equity principle states that people with the same ability to pay taxes should pay the same amount of taxes. The tax is imposed according to the person’s ability to pay the tax.
Vertical Equity
This tax equity principle states that people with a different ability to pay taxes should pay a different amount of taxes. Progressive tax rate scales would apply so that wealthier people pay both more gross tax but also more as a percentage of their income.
The Classical System of Taxation
The key characteristic of the classical system of taxation is that it taxes corporate earnings twice, once at the corporate level where profits are taxed, and again at the individual level where dividend income is taxed. The double taxation of dividends results in a bias by companies to retain more earnings than they would if no corporate income tax was imposed. It also creates an economic distortion in favour of debt financing rather than equity financing. Other economic distortions include the propensity to investing in non-corporate vs. corporate.
The Dividend Imputation System
The dividend imputation system or partially integrated corporate and personal income taxes provides provision for shareholders who have been paid a dividend to take a personal tax credit or franking credit since the company has already paid tax on the dividend.
Although double taxation is avoided, neutrality is compromised when tax concessions in the form of income are passed on to shareholders and therefore subject to tax at a different rate. If companies withhold earnings, shareholders will not receive the tax credit on the increased value of shares. Tax avoidance could be encouraged through the practice of dividend streaming.
Recommendations
The United States Treasury (UST) (Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once, 1992) found that integrating corporate and personal income taxes can reduce corporate financial leverage and alleviate the tax-incentive for corporations to retain earnings. The same report advocates that the introduction of a dividend imputation system can:
Encourage capital and other resources to flow into the corporate sector to the extent of 2-8% or $125 billion to $500 billion increase in capital stock.
Encourage companies to use less debt and estimates a debt to asset ratios decrease of 1 to 7 percent.
Encourage corporations to increase the earnings distributed as dividends by 2 to 6 percent.
Improve economic by 0.73 percent of consumption.
Therefore, based on these findings, to increase the equity in the tax system and to encourage investment in corporations, it is proposed that a dividend imputation system is adopted. However, the proviso is that other taxes are adjusted to off-set the revenue effects of integration (Cordes, Ebel and Gravelle, 2005, p.214).
