TAX COMMITTEE RECOMMENDATIONS

The Tax Committee submits its reform proposal to the Minister of Finance today. The Committee emphasizes that the tax system must be underpinned by general principles in order to be stable and predictable. Neutrality, broad tax bases and low tax rates offer the best scope for effective use of resources as well as economic growth. These principles are becoming ever more important in light of increasing internationalisation and future pension obligations. In line with this, the Committee proposes to reduce the tax rates on labour income, keep the tax rate on ordinary income at its present low level of 28 pct., and to abolish a number of special income allowances and tax credits. Increased taxes on real property will finance a gradual phasing out of the net wealth tax. The so-called split model may be abolished for active owners of limited companies, as a result of the Committee’s proposed introduction of an extra tax on income from shares exceeding an opportunity rate of return.

The Tax Committee (chaired by Mr Arne Skauge) was appointed by the Government in order to evaluate the objectives of and principles applicable to the tax system, and to propose changes within the scope of a NOK 8 - 10 billion net tax reduction. The Committee was to pay particular attention to the need for reducing the tax rate differential between labour and capital income, and the scope for abolishing the split model in full or in part. The Committee has also been requested to assess the role of the net wealth tax.

The Appendix offers an overview of the specific proposals. The recommendations of the Committee are unanimous.

Income taxation principles

The Committee suggests that the principle from the 1992 reform be maintained, whereby the tax bases should reflect the underlying economic realities.

In terms of business taxation, this implies that one should not use tax schemes to attract individual industries or to stimulate particular investments. Equal tax treatment of all return on investment is normally necessary to ensure neutrality of investment decisions. Consequently, the tax rules should not be differentiated on the basis of how mobile various tax bases are. In the long run all capital and all businesses are mobile (with the exception of businesses that depend on non-mobile factors, such as real property or natural resources). To the extent that increased internationalisation and mobility of tax bases should affect the taxation of businesses and capital, this should be reflected in lower tax rates on profits, and not through favourable tax allowances or various special arrangements for certain investments.

Neither do any cluster effects suggest that one should deviate from the principle of tax neutrality. The favourable tax regime facing the shipping industry is motivated by alleged cluster effects and the potential emigration of the industry. Tax neutrality should in principle also apply to this sector. If other countries, including those within the EU, abolish their favourable tax regimes for the shipping industry, a quick phasing out of the current system could be unfortunate as it could lead to Norwegian shipping companies flagging out. Moreover, the need of the industry for a stable regulatory framework weighs against quick changes.

The Committee proposes certain changes to the determination of ordinary income for businesses, to ensure that taxable profits better reflect actual profits. In addition, it is proposed to abolish certain special tax rules applicable to primary industries (with the exception of the income allowance applicable to agricultural income).

In the taxation of personal income the principle of a broad tax base implies that one should curb allowances and tax credits for expenses that are not directly linked to the generation of income. Moreover, adding socially motivated subsidy schemes to the tax system will result in poor targeting, partly because such schemes only apply to persons who have a taxable income. The Committee proposes to abolish or curtail a number of tax allowance schemes and tax class 2 of the income and net wealth tax. These changes can partly be compensated by increasing basic deductions and/or the children’s allowance, or by introducing direct support measures.

Similarly, the Committee takes the view that all forms of remuneration should be taxed in the same manner, and that all benefits in kind should be taxed at market value. Deviations from such a principle is equivalent to subsidising certain forms of remuneration, leading to a waste of resources, increased administrative costs and often also to undesirable effects in terms of income distribution. The Committee is of the view that there is a need for reform in the taxation of benefits in kind, and recommends that the Ministry of Finance review the tax rules in this field shortly in order to achieve a more strict and simplified taxation of such benefits. Especially lenient provisions on the taxation of benefits in kind should be abolished as soon as possible.

The tax rate on ordinary income

The Committee recommends that the tax rate on ordinary income is kept at 28 pct. It is particularly unfortunate to increase the tax rate on business profits at a time when other countries tend to reduce it. A relatively low rate of company taxation will generate more acceptance of the principle of a broad tax base. Moreover, increasing the tax on ordinary income will not yield any considerable net tax income if one at the same time wants to avoid increasing the marginal tax rate on low and medium labour income. The Committee takes the view that it is important not to impair the work incentives for these groups.

Dual income tax and tax rate differentials

The current split model does not operate in a satisfactory manner. Both the incentives and the scope for having labour income taxed as capital income have accumulated, as the result of increased tax rate differentials and amendments to the tax rules of the split model. The resulting unequal treatment of the same type of income impairs the distribution effects as well as the legitimacy of the tax system.

The Committee’s proposed solution to the dual income tax problem is based on two main changes to the tax rules:

The marginal tax rates on personal income are reduced, by removing the extra employer´s social security contribution on labour income in excess of 16 times the basic amount of the National Insurance system, and by reducing the surtax within both tax brackets. The highest marginal tax rate on earned income, including the employer´s social security contribution, is reduced to 49.9 pct. in bracket 1 and to 54.3 pct. in bracket 2. Currently, the highest marginal tax rate is 64.7 pct., including the employer´s social security contribution.

Any returns on investments in shares that exceed a calculated opportunity rate of return, are to be taxed as ordinary income when paid out in the form of dividends or capital gains to persons (the shareholder model). This will result in the marginal tax rate on returns on investments in shares above this rate being increased from 28 pct. to 48.16 pct. It will no longer be particularly profitable to have labour income taxed as dividends, and the split model can be abolished for active owners of limited companies. It should be further considered whether a corresponding profit extraction model can be introduced for partnerships where taxation is effected at partner-level, and for sole proprietorships. Especially for businesses taxed at partner-level it would be desirable to find a solution that makes it possible to abolish the split model.

The proposal of the Committee eases the formal progressiveness of personal taxation. However, increased horizontal equality (equal taxation of persons with the same tax ability) and less adaptation will be likely to counter the immediate distribution effects. It is doubtful whether highly progressive taxation of labour income combined with a low, proportional tax on capital income will yield the intended distribution effects. This is due to the fact that high tax on high salaries is partly compensated by increased pre-tax salary, and that the actual distribution effects are jeopardised by adaptations. Furthermore, the persons with the highest total income also have the highest proportion of capital income. The Committee wishes to stress that distribution goals still should be achieved by a system of progressive personal taxation, and in this respect it proposes considerable tax reductions for low-income groups.

The Committee outlines necessary curtailments of the split model if it is to remain in effect for limited companies. The Committee believes, inter alia, that the distinction between trades and professions should be abolished, and that the scope for adaptation should be limited (by, inter alia, reducing the ownership threshold to 50 pct.). Certain basic weaknesses characterising the split model will nevertheless remain. A main problem is the distinction between active and passive ownership. Furthermore, the split model cannot sustain a substantial tax rate differential, which may be difficult to reconcile with distribution and revenue objectives. The Committee also fears that continued pressure for relief may make an improved split model unstable.

In addition to the shareholder model, the Committee considers the following alternatives:

Double taxation of dividends to persons (classical system).

Increased tax on the return on company investments, in excess of a calculated opportunity rate of return, with the rate of return being calculated with reference to the capital base of the company (CCB-models). The model may be designed as a profit source model or a profit extraction model.

Increased tax on the net capital income of persons.

A “Savings and investment”-model outlined by the Norwegian Investor Forum (the SI-model). A new surtax base comprises all income from work, business and capital, whilst investments in financial and business assets may be deducted.

Details on the shareholder model

The shareholder model implies increased tax on the return on shares exceeding the opportunity rate of return, when withdrawn in the form of dividends or capital gains to persons. The basis for the calculation of the rate of return is the cost price of the share. The opportunity cost allowance of the shareholder for each year is the cost price of the share multiplied with an opportunity rate of interest (risk-free rate of interest after tax). Only when the shareholder receives dividends or capital gains that exceed the calculated opportunity rate of return for the year, will the excess amount be subject to additional tax.

If dividends are less than the opportunity rate of return, unused opportunity cost allowances will be added to the cost price of the share for purposes of calculating next year’s opportunity cost allowances. Upon the investment in the share being liquidated, the taxable capital gains will be the selling price, less the sum of the original cost price of the share and accumulated, unused opportunity cost allowances. Unused opportunity cost allowances relating to the share investment being liquidated may be carried forward, and then deducted from future income from shares.

An objection to a tax on dividends has been that it may curtail the supply of domestic venture capital, which would, in particular, hurt small businesses and start-ups with limited access to international capital markets. A tax on dividends which is subject to an opportunity cost allowance will not have such effect. The symmetric treatment of income from shares implies that the State accepts a larger proportion of the investment risk than is currently the case, and the Committee assumes that this may increase willingness to invest in risky assets. Furthermore, the Committee’s proposals for increased tax on real property and reduced tax on wealth, may have a positive effect on the supply of equity as well .

The shareholder model differs from the CCB-models inasmuch as the opportunity cost is based on the cost price of the share, and not on the company’s return on investment. The Committee emphasises that the calculated opportunity cost to a larger extent will include intangible assets, since such assets will be reflected in the share price (upon liquidation). Moreover, the model differs from a CCB-profit source model inasmuch as the additional tax is levied on the person upon extraction, and not on the company upon accrual. The Committee rejects a CCB-profit source model because progressive corporation tax may affect the willingness of companies to be located in Norway.

The higher tax on dividends exceeding the opportunity rate of return will give incentives to granting loans rather than equity to the company, in order to extract profits in the form of interest rather than dividends. As the interest payments can be deducted from the taxable income of the company, they will only be taxed once as ordinary income. To avoid such adaptations, the Committee proposes that a tax similar to the proposed dividend tax is imposed on interest exceeding a certain level on loans granted from persons to limited companies,

The shareholder model poses administrative challenges in terms of tax assessment, because the cost price of shares and any unused opportunity cost allowances will have to be registered and controlled. On the other hand, the model simplifies the tax system in the sense that the split model can be abolished for active owners, together with the cost price adjustments (the so-called RISK-adjustments) required to calculate capital gains on shares made by personal tax payers.

Taxation of inheritance, property and net wealth

The favourable taxation of housing is an important part of the explanation why Norwegian households hold the main part of their wealth in the form of residential dwellings. This may restrict the supply of private venture capital. Furthermore, the Committee is of the opinion that it is unsound to have considerably higher tax rates on mobile tax bases than on less mobile ones, as is the case for the income tax as well as the wealth tax.

Taxation of real property is better targeted than the wealth tax in terms of taxing immobile capital. The Committee proposes to phase out the wealth tax . This is financed through tax increases on real property, and to some extent on inheritance as well. In the assessment of the Committee, such a reform would reduce the risk of undesired capital flight, and improve the use of overall resources. It would also bring Norway more in line with other OECD countries, which generally have materially higher tax on real property and inheritance than does Norway, whilst Norway is one of relatively few countries that still levies a wealth tax. In the short term the Committee proposes to reduce the wealth tax by about NOK 4.7 billion (more than half of the total revenue from the wealth tax).

The Committee takes the view that the most logical approach would be to step up the taxation of property by way of increased taxation of the imputed rent from housing, because, inter alia, this increases symmetry when compared to the interest allowance. In the absence of political commitment to stepping up the income taxation of imputed rents from housing, the Committee recommends that a mandatory (municipal or central government) property tax be introduced.

Sorting out basic allowances

The Committee also proposes changes that would in particular affect low income groups and pensioners. The objective is to reduce average and marginal tax rates on lower range labour income, to make it more profitable to receive wages as opposed to welfare payments, as well as to simplify the structure of allowances and the taxation of pensioners.

The structure of marginal tax rates on lower end labour income is complex, as the result of, inter alia, having both a personal allowance and a minimum allowance with a special lower limit for earned income. The Committee proposes that the special allowance for earned income be replaced by a dual rate structure applied to the minimum allowance, combined with the abolition of the lower limit on employee’s social security contributions for anyone over the age of 17.

Within a largely revenue neutral framework, the Committee proposes simplifications to the taxation of pensioners, including the abolition of special age and disability allowances, as well as the abolition of the wealth supplement aspect of the tax limitation provision.

Revenue neutral alternative

The Committee’s main proposal keeps within the scope of a NOK 10 billion net tax reduction. It will be very difficult to find satisfactory solutions to the challenges referred to in the mandate without accepting a certain reduction of the tax level. Within a revenue neutral framework one has to prioritise between the different objectives set out in the mandate. In the view of the Committee, this requires either that less weight be put on reduction of the wealth tax, or that one accepts a rate differential between labour income and capital income that is so large that adaptations will remain a problem. Furthermore, it would be necessary to broaden the tax bases more than under the Committee’s short term proposal, as well as to accelerate the increase in the taxation of housing and property.

Measures to ensure stable and predictable tax rules

The Committee was asked to assess possible measures to ensure more stable and predictable tax rules. The Committee wants to emphasise that a tax system founded on general and broadly accepted principles is a necessary condition for stability and predictability. In addition, the Committee proposes some measures regarding the decision-making procedure, amongst which are the following:

The Government presents its plan for changes to the tax rules the coming 3-year period to the Parliament, for example as a part of the revised National Budget.

An independent advisory committee of tax-experts is introduced

The principals and intensions behind the tax rules should be given more emphasis in the wording of the laws and in the tax resolutions, whereas the scope for increased delegation of the drafting of detailed tax rules should be considered.

Appendix

Main proposals of the Tax Committee