Some high tax countries concerned about outward flight of capital have reacted by imposing so called dual income tax systems. The idea is to keep high taxes on labour while holding low tax rates on capital income received by individual investors and entrepreneurs, matching those on corporations. A popular method is to state by law that capital income exceeding a certain level of return should be taxed as labour income. In specifying this level, cost of capital calculations have been used to determine what it should be to avoid serious distortions. This paper claims that such cost of capital comparisons across closely held companies and entrepreneurial ventures on the one hand and widely held companies on the other could easily be misleading. Contrary to current practice they should not be based on equal level assumptions regarding the investors’ required rates of return, net of taxes.
Theoretical considerations as well as empirical evidence show that the return requirements are much higher on investments by entrepreneurs in venture start-ups than on those by well diversified investors. Using earlier results based on the capital asset pricing model (CAPM), the paper shows that the difference can be as high as a factor three. Given this observation, the paper argues that by more or less neglecting it, dual income tax systems used in the Nordic countries are seriously discriminating against entrepreneurship and growth of small firms. The argument is supported by numerical illustrations for the case of Sweden. The conclusions send an important message to other countries in Europe and elsewhere considering the mitigation of effects of capital mobility by a dual income tax (i.e. by using standardized measures of the amount of capital income to be taxed at lower rates than labour).
