The 2006 Tax Reform – Improved Re-distribution and Horizontal Equity

The Minister of Finance, Mr. Sigbjørn Johnsen, today submitted a White Paper on the evaluation of the 2006 tax reform to the Parliament. The evaluation is the result of a comprehensive work involving external contributors representing organizations and the business community, as well as national and international academics and tax experts.

English translation of chapter 1 is available here (pdf).

“I am pleased to say that the tax reform has significantly improved the re-distributional properties of the tax system. We have managed to eliminate the income shifting problem that characterized the former tax system. The reform is based on sound economic principles and was implemented at reasonable costs”, says Mr. Johnsen. 
 
The 2006 tax reform was implemented during the fiscal years 2004-2006 and was founded on a broad political consensus. The reform was based on the recommendations of the Skauge committee (NOU 2003: 9). The aim was to solve the income shifting problem without violating the economic principles of the dual income tax introduced in the fundamental tax reform of 1992.

The main element of the 2006 reform was to replace the split model and the imputation system with the shareholder model. The shareholder model involves a dividend and gains tax equipped with a cost of capital allowance to ensure neutral treatment of different sources of financing. The taxation of self-employed was also adjusted along these lines, saving higher tax rates than the basic rate of 28 percent for returns above a cost of capital. Corporate shareholders are exempt of dividend and gains tax after the reform.

The top marginal tax rates on labour income were reduced in order to narrow the discrepancy in marginal tax rates between share income and labour income, and to stimulate labour supply. A substantial base broadening combined with increased basic allowances has made the wealth tax more uniform and more re-distributive.

Solving the income shifting problem
The dual income tax introduced in 1992 was characterized by a low and flat tax rate on capital income and a progressive taxation of labour income. The basic idea was to imply a neutral taxation on capital income, and to ensure redistribution of income through the taxation of personal income and net wealth. The difference in marginal tax rates on capital and labour income (including employers’ social security contributions) started out at 28,1 percentage points in 1992, increasing to 36,7 percentage points in 2004. This large gap needed a mechanism to split the income from active owners and self employed into capital and labour income respectively. The split model used for this purpose became eroded during the nineties, and paved the way for increasing income shifting problems.

The challenge of the 2006 reform was to eliminate the gap in the marginal tax rates and abolish the split model without violating tax neutrality of financing decisions, and without increasing the corporate income tax. The only realistic way to reduce the gap in the marginal tax rates was to combine a reduction in the marginal tax rates on labour with an introduction of a dividend tax (by eliminating the former imputation system). To maintain neutrality, the dividend tax was equipped with an allowance for the cost of capital (as well as ordinary loss deductions), the so called shareholder model. The same principle was introduced in the taxation of sole proprietors and partnerships.

The evaluation supports the assumption that neutrality is especially important to small and newly founded businesses, which are often dependent upon new equity from Norwegian investors. Even though the statistics are still scarce, it supports the hypothesis that the shareholder tax is neutral, and that the cost of capital allowance is important to ensure this property.

The evaluation of the 2006 tax reform seems to confirm that the income shifting problem is solved. Although the tax rules for self-employed are somewhat different from those of shareholders, the evaluation also indicates a more even average and marginal taxation of different organisational forms after the reform. Before the reform there was a clear incentive to change organisational form by incorporating closely held entrepreneurships to avoid the split model.

Stronger re-distribution through the tax system
The introduction of the dividend tax and a strengthening of the re-distributional properties of the wealth tax have increased the progressivity of the tax system. An analysis performed by Statistics Norway suggests that the re-distributional properties of the tax system measured by the Reynold Smolensky index, have increased by 11 per cent from 2005 to 2008.

The main features of the tax reform have opposite re-distributional effects. The introduction of the dividend tax and a strengthening of the wealth tax have increased the progressivity of the tax system, while the reduction in tax rates for high income earners has decreased the progressivity.

The evaluation of the 2006 tax reform shows that the positive effects on re-distribution by the introduction of the dividend tax and the strengthening of the wealth tax are stronger than the negative effects of the decreased marginal tax rates. The 2006 tax reform has thus improved the tax re-distributional effect of the tax system.

Labour supply
The tax reform involved reductions in the top marginal tax rates and increases in the basic allowance in wage income. Overall, these adjustments implied a NOK 12 billion tax relief on labour income. Tax adjustments of this magnitude, corresponding to approximately 0,8 percent of Mainland GDP (2006), can be expected to affect labour supply and employment, and the tax revenue effect over time may differ from the initial tax reduction. Estimations by Statistics Norway indicate that 23 per cent of the initial reduction is returned over time due to labour supply adjustments.

Further work
The evaluation shows that the tax reform has improved the taxation of business income. However, there may still be some scope for further improvements, especially in the corporate income tax. The Ministry will look into certain possibilities for simplifications and measures to make the system more robust towards tax avoidance. These matters will be followed up in the regular work with the state budget. For further information on the Norwegian tax system we refer to the tax pages on the website of the Ministry of Finance.

Published April 1, 2011 - updated June 23, 2011