samlet årgang - Økonomisk Institut - Københavns Universitet

TAXATION OF SHAREHOLDER INCOME AND THE COST OF CAPITAL IN AN OPEN ECONOMY 435
a residence-based personal tax on dividends and capital gains on shares may actually
reduce the required rate of return on shares in small unquoted companies, because of
the risk-reducing insurance effect of a tax with full loss offsets. This might seem to
suggest that policy concern over the double taxation of corporate equity income is
indeed unwarranted.
In this paper I extend the Apel-Södersten model to include an additional risky asset.
Within this extended model I show that although personal taxes on shareholder income
may well, on average, reduce the cost of capital for small companies, they will also
distort the pattern of risk-taking and investment within the group of small companies
by favouring investment in unquoted shares whose returns are highly correlated with
the return on the market portfolio. Presumably this distortion is undesirable, so there is
a case for designing tax rules that will be neutral towards the allocation of risk and investment.
This paper shows that if shareholders are allowed a deduction for a risk-free
rate of return on their shares so that tax is only levied on the equity premium, the tax
system will be neutral provided investors are well-diversified. If shareholders in small
companies are not well diversified, I show that a symmetric tax on the equity premium
will tend to reduce the required rate of return on unquoted shares, and I argue that this
non-neutrality is likely to be socially desirable. Finally, I demonstrate the non-neutrality
of a tax system that allows a deduction for a risk-free rate of return only to holders
of shares in unquoted companies. These results are relevant for the current Nordic tax
policy debate, since Norway is about to introduce a rate-of-return allowance for all resident
personal shareholders, while Sweden has already introduced such an allowance
for holders of unquoted shares.
The next section sets up a model of portfolio choice in a small open economy. Section
3 uses the model to derive and discuss the distortionary effect of a personal tax on
the full return to equity. Section 4 demonstrates the neutrality of an equity income tax
which allows a deduction for a risk-free rate of return, assuming well-diversified investors.
Section 5 analyzes the effect of a tax on the equity premium under incomplete
diversification, and section 6 studies the effect of a selective rate-of-return allowance
targeted at the holders of unquoted shares. The final section 7 discusses some limitations
of the model.
2. A model of portfolio choice in a small open economy
Like Apel and Södersten (1999), I distinguish between shares that are traded in the
international stock market (»quoted shares«) and shares that are only traded domestically
(»unquoted shares«). However, in order to study the effects of taxation on the
allocation of risk within the sector of small companies, I extend the Apel-Södersten
framework to include two types of unquoted shares. Thus the representative investor invests
a fraction v 1 of his initial wealth V 0 in unquoted shares of type 1, yielding an