The adoption of Dual Income Taxes in the Nordic countries during the 1990s and more recent moves in this direction in other European countries have elicited a sizeable number of academic contributions. Among them, the article by Nielsen and Sørensen(1997) stands out as a comprehensive attempt to buttress the case for the Dual Income Tax (DIT). The theoretical idea expounded in their contribution states that the traditional taxation of labor income on the basis of cash-flows and the taxation of returns from physical capital on an accrual basis may lead to distortions in investment behavior which in turn harm economic efficiency. As a traditional income tax lumps together these two streams of payoffs and applies a common tax schedule to the resulting sum, the fundamental distinction between them – the difference in the determination of their respective tax bases – is blurred. The DIT, on the other hand, separates the two income types and typically applies a constant marginal tax rate to capital income while labor income is taxed progressively.
This setup inevitably prompts one to investigate the “correct” spread between the two tax rates. Empirically, this difference varies from country to country, as recently shown inGenser and Reutter(2007, table 2), a part of which is reproduced in table 1.1 for convenience.
TABLE1.1: Tax Rates in the Nordic Countries (in %)
Country Norway Finland Sweden Denmark
Implementation of DIT 1992 1993 1991 1987 Income Tax Rate for
Capital Income 28 28 30 28/43
Earned Income 28-40 26.5-50 31.6-56.6 38.8-47.9
Source:Genser and Reutter(2007), Table 2
Table 1.1 highlights the fact that the approach towards the relationship between capital and labor ("Earned") income tax rates is nonuniform across the four Nordic countries. While the Norwegian tax system lets "labor income taxation begin where capital income taxation ends", the Finnish system sets the lowest labor income tax rate below the rate for capital income while the Swedish legislator reverses this re-lationship. With regard to the highest applicable marginal rate on labor income, the degree of the spread between the rates for top earners differs widely as well. While these observations are certainly incomplete in the sense that the determination of the
Contribution 1 Higher Tax Rates on Labor?
respective tax bases exerts a strong influence on the effective tax burden weighing on the economic activities of the taxpayer, they do show a rather surprising degree of variation even though the Nordic countries are relatively homogeneous in other economic aspects1.
In Germany, the introduction of a final withholding tax for capital income in the year 2009, coupled with the continuing progressive taxation of labor income, can be viewed as a step toward the Dual Income Tax in all but name. The German capital income tax rate has been set at 25%, while labor income is taxed at marginal rates ranging from 15% to 45%. German tax law also allows taxpayers to elect to have their capital income taxed at their individual marginal tax rate if it is lower than 25%.
The goal of this contribution is the investigation of the "correct" spread between labor and capital income tax rates under a Dual Income Tax under the premises of the Nielsen and Sørensen (1997)-Model. This agenda is thus fairly narrowly fo-cused on an empirical investigation and does not seek to provide a new reasoning for the results established byNielsen and Sørensen(op. cit.).Nielsen and Sørensen build an "overlapping generations model where consumers face a trade-off between investment in human capital and investment in non-human capital" (p. 311, op.
cit.). Set in a small open economy, with perfect foresight and perfect competition, the legislator has already committed himself to tax capital income at a constant marginal rate and now has to determine the appropriate taxation of labor income2. The "cash-flow treatment of human capital investment" is responsible for a distor-tion under a convendistor-tional income tax that slaps equal marginal tax rates on labor and capital income. Nielsen and Sørensen (op. cit.) argue that a justification for differential tax treatment of labor and capital income lies in the fact that the social and private after-tax rates of return coincide in the case of labor income while the taxation of capital income drives the private rate of return below the social rate of re-turn. As their equation (5) shows3, agents’ optimization behavior leads to the usual prescription of equal marginal after-tax returns on human and non-human capital investment, which in turn must equal the rate of time preference. As taxation does
1 Cf. Elschner and Schwager(2007) who classify the Scandinavian countries as uniformly high tax with regard to labor taxation.
2 TheNielsen and Sørensen-Model thus conveys a “... typical second-best argument” (Nielsen and Sørensen, 1997, p. 313) in that the commitment to tax capital income is taken as given. I thank an anonymous referee for stressing this point.
3 Nielsen and Sørensen(1997, p. 317).
Higher Tax Rates on Labor? Contribution 1
not take a bite out of the return on human capital investment, overinvestment in hu-man capital results and a surcharge is applied to the labor income tax rate above a certain threshold to counteract this effect.
Applying this model to real world data necessitates adaptions that may be open to criticism:
• Workers are not as homogeneous with regard to their ability to accumulate human capital as the Nielsen and Sørensen-Model envisions. The human capital production functiong(E)(Nielsen and Sørensen, 1997, p. 316) should be indexedgi(E), withirepresenting differently gifted brackets of society.
• The model is set in an OLG context, i.e. lives off the contrast between a young and old generation. The dividing line in the data between these generations is drawn at the time individuals enter the labor market after their formal ed-ucation ends. In practice, the dividing line is blurred by the fact that lifelong learning is commonplace so that a formal end to education cannot be reliably determined4.
• Costs of education in the Nielsen and Sørensen-Model come exclusively as opportunity costs during the education phase. Estimating these for differently gifted workers is challenging. It requires the specification of a counterfactual which constitutes another source of uncertainty.
The rest of the paper is organized as follows: In section 1.2, I describe my dataset and discuss the estimation strategy. The eight waves from 2000 to 2007 of the Ger-man Socio-Economic Panel are employed to estimate a Mincer-type wage equation.
From the estimation results, the empirical age-earnings profiles for different educa-tion brackets of the German populaeduca-tion are deduced. In seceduca-tion 1.3, the necessary surcharges to the labor income tax rate are computed under different constellations of parameters for the simple tax system envisioned byNielsen and Sørensen(1997).
Section 1.4 concludes.
4 In the Mincer earnings equation, labor market experience and its square as well as tenure account for the effects of general and firm-specific human capital investments. I thank an anonymous referee for alerting me to this point.
Contribution 1 Higher Tax Rates on Labor?