Dividend Taxes and Income Shifting

AuthorAnnette Alstadsæter,Martin Jacob
Date01 October 2016
Published date01 October 2016
DOIhttp://doi.org/10.1111/sjoe.12148
Scand. J. of Economics 118(4), 693–717, 2016
DOI: 10.1111/sjoe.12148
Dividend Taxes and Income Shifting
Annette Alstadsæter
Norwegian University of Life Sciences, NO-1432 Aas, Norway
annette.alstadsater@nmbu.no
Martin Jacob
WHU – Otto Beisheim School of Management, DE-56179 Vallendar, Germany
martin.jacob@whu.edu
Abstract
In this paper, we analyze whether a dividend tax cut for owner-managers of closely held
corporations encourages income shifting, income generation, or both. We use rich Swedish
administrative micro data from 2000 to 2011 comprising detailed firm- and individual-
level information. We find robust evidence of extensive income shifting across tax bases in
response to the 2006 Swedish dividend tax cut. Owner-managers of closely held corporations
reclassify earned income as dividend income but do not increase total income. The response
is more pronounced for owner-managers with tax incentives and with easier access to income
shifting through a high ownership share.
Keywords: Closely held corporations; dividend taxes; income generation; income shifting;
owner-managers
JEL classification:H21; H25; H3
I. Introduction
Governments often use tax incentives to stimulate entrepreneurship and
economic growth (e.g., Lee and Gordon, 2005). While some reforms target
specific industries or large multinational companies, other reforms target
small and medium-sized businesses. Cutting dividend taxes for small busi-
nesses can be seen as a way to increase investment, thereby stimulating
activity in firms and the economy. A lower dividend tax rate reduces the
required rate of return on investments financed by new share issues (Har-
berger, 1962, 1966; Feldstein, 1970; Sørensen, 1995). If dividend tax cuts
reduce the cost of capital, financially constrained firms might increase in-
vestments following a dividend tax cut (Becker et al., 2013; Alstadsæter
We thank Martin Fochmann, Jochen Hundsdoerfer, Martin Ruf, Altin Vejsiu, two anonymous
referees, and seminar participants at the Free University of Berlin and the 2012 Forum for
Tax Policy Research in Norway for comments and suggestions. Support from the Research
Council of Norway (grant 217139/H20) is gratefully acknowledged. Martin Jacob additionally
gratefully acknowledges financial support from the Fritz Thyssen Stiftung.
CThe editors of The Scandinavian Journal of Economics 2015.
694 Dividend taxes and income shifting
et al., 2016).1However, in addition to these intended investment effects,
beneficial tax rules for particular g roups create incentives and opportunities
for income shifting (Stiglitz, 1985; Slemrod, 1995; Gordon and Slemrod,
2000). Income shifting is the process of transferring income across time,
income categories, and tax brackets to reduce total tax payments. This
is legal tax avoidance and does not involve immediate real effects; it is a
purely tax-motivated relabeling of existing income. Very little is known em-
pirically about the income shifting of individuals. Pirttil¨
a and Selin (2011)
provide evidence of income shifting around the introduction of the dual
income tax system in Finland in 1993, which reduced the marginal tax
rates on capital income for some taxpayers. They find little or no response
from ordinary wage earners, but self-employed individuals seem to have
increased reported capital income.
We examine the income shifting behavior of individuals and exploit a
2006 Swedish tax reform that reduced the dividend tax rate for owner-
managers in closely held corporations (CHCs) by 10 percentage points,
while labor and corporate income tax rates remained constant. As a result,
incentives for owner-managers in CHCs to relabel labor income as dividend
income increased. We investigate whether a dividend tax cut encourages
owner-managers in CHCs to participate in income shifting, income gener-
ation, or both.2Using rich Swedish administrative panel data on all CHCs,
partnerships, self-employed businesses, and their owner-managers, we are
able to observe reported income across several tax bases from 2001 to
2011. Our data comprise 2.7 million observations, of which 44 percent are
owner-managers in CHCs and the remaining 56 percent are the owners of
partnerships or self-employed businesses. We use a difference-in-differences
(DD) estimator around the 2006 dividend tax reduction and compare the
income and income composition of owner-managers of CHCs (affected
by the tax reform) to the income of owners of unincorporated businesses
(unaffected by the tax reform).
We find robust evidence of income-shifting behavior. The owner-
managers of CHCs have substituted earned income with dividend income
since the reform. On average, CHC owners shifted about 6 percent, or about
1Further, the openness of the economy drives the effect of a dividend tax cut. A decrease in
the dividend tax rate for smaller corporations in an open economy can decrease the cost of
capital if these firms are owned by domestic investors (Apel and S¨
odersten, 1999; Lindhe
and S¨
odersten, 2012; Jacob and S¨
odersten, 2013).
2This isolated dividend tax change is advantageous as our results on income-shifting behavior
in this context are not affected by concerns about the macroeconomic effects that accompany
large tax reforms, such as around the introduction of the dual income tax. See Agell et al.
(1996) on the 1991 introduction of the Swedish dual income tax system. Our paper also
relates to theoretical papers on the dual income tax, such as those of Fjærli and Lund (2001),
Lindhe et al. (2002, 2004), and Sørensen (2005).
CThe editors of The Scandinavian Journal of Economics 2015.

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