Studies and research papers

ALESSANDRA TACCONE
Taxation of the income of small businesses

Taxation of the income of small businesses

Alessandra Taccone
Professor of Finance, LUISS University, Rome

1. The taxation of income and the characteristics of small firms

The traditional theory of public finance founded taxation on horizontal equity, i.e. the principle that taxpayers in the same economic situation equal ability to pay must pay an equal amount of tax. This principle corresponds to one of the cornerstones of democracy, namely equality before the law. In industrial societies, income has come to be seen as the best direct indicator of ability to pay, and this view corresponds to way market participants gauge the economic results of firms and individuals, which are evaluated mainly in terms of income. At aggregate level, national income (product) is the principal international indicator of an economys performance. The theory of the taxation of business income developed on these principles, and the size or legal form of a business offered no grounds for tempering the uniform taxation of economic results (net income) as long as flat-rate income taxes prevailed. Uniform taxation was assisted by the development of common rules on accounting and financial statements and reports, which were incorporated into civil law in order to give the markets accurate and transparent information on firms operations (and prospects).1

1 Tax laws essentially transposed the civil law provisions to determine taxable net business income, but with specific variations to counter underreporting of net income by taxpayers using the margins of discretion allowed them by civil law with regard to the calculation of some financial items (amortization and depreciation, inventory values, risk provisions) that are subject to an estimation of uncertain future values.

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However, the economic importance (and political influence) of large corporations has led to a bias in tax laws, with some rules for determining taxable income tailored to their operational realities. The question of the uniform tax treatment of firms but of its possibly unequal effects became a matter of theoretical debate following the introduction of the progressive personal income tax, which bears on the taxpayers total income regardless of source (vertical equity). Comprehensive income tax with progressive rates raises the problem of how to treat firms retained profits and the resulting capital gains (identifying those attributable to the accumulation of profits). The conceptual and administrative difficulties entailed in imputing the retained profits of widely-held companies to their shareholders also gave substance to the size factor in the taxation of businesses. The concrete response of tax policies was to introduce the corporate income tax, which is also levied on retained earnings but at a flat rate, violating the principle of equity,2 while capital gains are taxed when realized3 and have generally enjoyed significant concessions. The introduction of the corporate income tax violated the uniform taxation model, differentiating the taxation of business income according to legal form. In practice, corporate tax also differentiates, indirectly, between the larger enterprises, which for reasons of governance and financial and business credibility must adopt the legal form of the corporation, and small businesses, which can effectively choose whether or not to take independent legal personality and which factor corporate taxation (and its coordination with personal income
The corporate tax was also advocated on the grounds that companies have an independent ability to pay inasmuch as they exercise an economic power that transcends the sum of the incomes attributed pro rata to the shareholders, and that there is often a separation between ownership and management in large corporations. This view, challenged by theorists who maintain that economic power is in any case expressed in the production of income, does offer a justification for the classic model of double taxation of distributed profits. Currently, the United States and many European countries provide for at least partial double taxation of distributed profits. 3 With the exception of an experiment in taxing accrued capital gains, implemented in Italy (1997-2001). In Norway, the recent (2006) reform that introduced the personal shareholder income tax neutralizes the taxs effect on the decision whether or not to realize capital gains: SRENSEN (2006).
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taxation) into this decision. Some analysts hold that the corporate and personal taxation of income can distort the choice of legal form, with significant repercussions on efficiency, and accordingly praise some models of taxation for their neutrality in this regard.4 However, the theoretical discussion of the effects of the taxation of business income has generally, if often implicitly, taken the mediumsized or large corporation as the model. In fact, the long-running debate on the advisability of taxing the normal rate of return to capital and that on the effects of differing tax treatment of equity and debt capital are based on the notion of the opportunity cost of capital, which supposedly guides firms investment and financing decisions.5 In Section 3 I argue that the notion of the opportunity cost of equity capital (the normal rate of return obtainable on an alternative financial investment, taking into account the risk premium) is a valid instrument for interpreting the choices of large corporations and of savers, but not for the decision-making processes of the small entrepreneur who is sole owner (or shares ownership with relatives or a few partners). The small entrepreneur-owner identifies himself with the firm, which enables him to determine the quality of his work and gives him decision-making power and social status; the capital invested is one of the conditions for achieving these objectives. The conceptual distinction between the normal return to invested capital, returns to risk, rents and income imputable to his labour is unlikely to have much bearing on such a mans investment and financing decisions. The marginalist comparison between the cost (including taxes) of the alternative sources of financing from the market, equity versus debt, is outweighed by the decision on ownership and control. Since the 1980s, the theory of business taxation has adapted to take account of international economic integration and the attendant high mobility of capital. It is argued that international integration makes source-based capital income taxes unsustainable in the long run, while
See SRENSEN (2006). The decision-making model underlying many analyses is the neo-classical one of JORGENSON (1963). For an application of that conceptual apparatus to the effects of taxation on firms investment and financing decisions, see SINN (1991).
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residence-based taxation depends on effective international agreements, where little progress has been made, even with the EU, despite the interest of policymakers. But differences in the taxation of capital income play a fundamentally different role in multinational corporations decisions on location of investments, business activities and tax base than in the decisions of smaller enterprises (SMEs), which have fewer opportunities either to transfer business activities and investment to lowtax countries or to arrange for their taxable profits to arise there. A significant implication of recent developments in the theory of the incidence of income tax in open and relatively small economies6 is that the relative immobility of SMEs business activity makes it harder for them to shift the economic burden of taxation from capital to the factors that are not internationally mobile (unskilled labour, land and buildings). Thus the theory is better applicable to large companies that already operate or are in a position to operate in more than one country. Accordingly, source-based taxes on business income can be levied effectively on SMEs. Further, the great mobility of capital with international economic integration has induced theory to specify the effects of taxation on firms decisions concerning forms of financing. The differences between the national tax rates on personal incomes (of shareholders and financiers) are not relevant for the (marginal) financial decisions of companies that can access the international capital market.7 But at present unlisted companies (i.e. most SMEs) mostly lack access to the international capital markets. The concern that without international agreements, capital and taxable profits could be moved to low-tax jurisdictions has led many countries to reduce their corporate and capital income tax rates and prompted three Nordic countries (Norway, Sweden and Finland) to introduce a dual income tax (DIT). In application, the Achilles heel of the dual income tax has been small firms whose owners are active in

For this theory of incidence, see GORDON (1986); RAZIN and SADKA (1991);TANZI (2002); SRENSEN(2006). 7 See SRENSEN (2005); FUEST, HUBER (2001); DEVEREUX (2004).
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management8; for them a conventional imputation of business income to capital and, on a residual basis, to labour is necessary, as real information is not available. For that matter, the application of the traditional uniform income taxation to SMEs has also encountered serious difficulty. In many countries information on the income they actually earn is lacking, as it is impossible to effectively to audit a vast population of small firms. In some (such as France and Italy) the authorities have sought a solution by estimating presumptive incomes of small and medium-sized firms depending on sector and specific characteristics.9 Firms are induced to align their declared income with the presumptive minimum, in order to avoid audits. Consequently, in these countries a particular duality, presumptive versus actual, separates the taxation of small and large firms. In the sections that follow I shall examine some aspects of the situation of small firms that appear to demand specific attention with respect to the prevailing tax policy reference to larger companies. First, as a preliminary, we review some methodological questions.

2. Evaluation of income tax models: efficiency and equity

The prevailing theory evaluates the individual models of taxation according to their efficiency and their equity, i.e. their effects on
8 SRENSEN (1994; 2005; 2006; 2007; 2008); CHRISTIANSEN (2004); LINDHE, SDERSTEN, BERG (2004). The difficulty of reconciling income tax rules generally designed for large corporations with the operational reality of small and medium-sized enterprises is encountered in all the countries that have both corporate and personal income tax. A particularly significant experience is that of the Nordic DIT, the most up-to-date model for the taxation of income, which was introduced in the early 1990s and soon gained a broad consensus among experts, many of whom have recommended it as a model for taxation in the European Union (see, for example, CNOSSEN, 2000, 2003). Section 4 below describes the weaknesses of applying that model to SMEs, weaknesses that induced Norway to amend the DIT substantially in 2006. See the works cited above and also CRAWFORD and FREEMAN (2008), who refer to the UK tax system but also take ample account of the structural question of the treatment of selfemployment labour income with respect to capital income as part of entrepreneurial activity, essentially using arguments that emerged from the Nordic DIT experience. 9 In Italy, the presumptive estimates of incomes resulting from sector studies are applied to businesses with annual revenues of up to million. See REY (2008). 7.5

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resource allocation and income distribution. These analyses leave some questions of method and economic logic open. One is the moment to which the analysis refers when the law imposes the legal liability on the taxpayer or when the tax actually modifies agents income or decisions (incidence). Many studies do not make this distinction explicit and thus implicitly assume that the two effects coincide, an assumption often contradicted by reality. Unfortunately, the theory of incidence, which succeeded in reaching predetermined conclusions in the analysis of the partial equilibria of the pure forms of market (competition and monopoly), has not reached determined results for imperfect or externally open markets, and it has had to be acknowledged that uncertainty on the incidence of taxes renders evaluations of their distributive effects (on equity) problematic.10 In part for this reason and in part because of the weakening sociopolitical and cultural drive to use taxation for income redistribution, the recent literature pays more attention to the effects of the taxation of capital income in terms of efficiency. The models of the taxation of income are examined and compared for their relative balance between distortionary effects and neutrality.11 In my opinion, however, this approach too is open to doubt over the significance of its conclusions. For instance, it may be found that a given tax modifies the economic values of the market on the basis of which economic agents make their choices and can therefore be said to not be neutral. But this does not justify the statement that a non-neutral (distortionary) tax causes inefficiency, which implicitly assumes that without the tax, agents choices would have been efficient, or less inefficient. This thesis may be justified, theoretically, for Pareto efficiency (a property of perfect competitive markets in equilibrium) and making a number of assumptions (agents utilitarian and rational choices, well-behaved
On the criteria of corporate taxation in an international context DEVEREUX (2004) observes: With regard to taxpayers, equity is only meaningful with respect to effective incidence; and effective incidence is in most cases extremely difficult to assess (p. 80). MINTZ (1995) states: There is little economic evidence that can be used to answer who pays the corporate tax? (p. 62). 11 See the recent critical review by SRENSEN (2006).
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economic functions, no causes of market failure). But there is little correspondence between real, observable markets and these ideal perfect markets. Since tax policy acts in real markets as they actually work, the proposition that a non-neutral tax causes inefficiency remains to be proven. A conceptually different question is the causal relation between a given tax and taxpayers incentives to work, save, invest, take risks, and so on. In examining this question, analysts compare the effects of the tax with the objectives of economic policy (labour supply, productivity, capital accumulation, etc.) in real economic systems (again, not easily reduced to the model of Pareto efficiency). Nor does the standard distinction between the two aspects of taxation (equity and efficiency) seem unquestionable, considering the well-known critiques by some schools of the neoclassical model in which the profit rate and the wage rate are equal to the marginal productivity of capital and labour respectively. The price system that guides economic agents towards efficient allocation of resources is the same one that produces the distribution of income, so it is hard to see the logical foundation for separating the effect on allocation from that on distribution.12 Nor is it clear on the plane of economic logic how, even assuming a trade-off, the objectives of Pareto efficiency, which for internal consistency can and must be rigorously utilitarian, can be compared with redistributive objectives, which generally reflect nonutilitarian motivations.13
The second fundamental theorem of welfare economics has been demonstrated in its specific normative theory, but it rests on assumptions and has implications that render it inapplicable to todays reality. Neo-classical normative theory has been challenged by schools of thought that reject the assumption that the rate of profit is determined by the marginal productivity of capital and hence rejects the neo-classical theory of distribution. 13 On this subject, see SEN (1970; 1979). In truth, the definition of equity in public finance is inevitably subject to value judgment, as MUSGRAVE (1959) himself admits in his explicitly neoclassical theory. In a recent essay, PEDONE (2009) highlights the complexity of notion of the equity in taxation, since it has multiple aspects (tax rates, the definition of the tax base, assessment procedures and, I would add, the actual incidence of the tax, which often determines a different economic distribution of tax burdens than that implied by the legislated tax rates.
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I therefore consider it preferable to limit the analysis to the effects of taxation on economic agents incentives in making their decisions, leaving judgments on allocative efficiency and how it relates to the distribution of income between factors to future developments in economic theory.

3. The effects of taxation on firms financing decisions

One of the most debated issues in the taxation of business income is the non-neutrality of the conventional income tax for firms financing decisions, because interest payments are deductible but not the normal profit ascribable to capital. The different tax treatment of the remuneration of equity and debt implies a tax-induced distortion in firms financial decisions, because the financier, whether shareholder or creditor, demands a risk-adjusted after-tax return at least as high as on alternative investments.14 This marginalist model of the investor who wants to equalize (at the margin) the after-tax returns on alternative assets (factoring different risk premiums into his calculations) can be suitably applied to analyze the effects of the taxation of income on the financial decisions of large, widelyheld companies, which can rationally bring the tax cost of the alternative forms of financing (equity, self-financing, borrowing) to bear on such decisions. Further, as we have seen, economic internationalization permits listed firms that are sufficiently large (size is not irrelevant) to access the international capital market, with the attendant system of taxation. For unlisted and small firms, the domestic conditions of corporate and personal taxation of financing remain relevant. The problem I take up here, however, is the explanatory power of this model when it is applied to SMEs, including those set up as closely-held (and mainly family-controlled) corporations. Small and
The analysis is formalized using the marginalist neoclassical model of investment decisions (the most frequently used version is that of JORGENSON, 1963), which shows that in the case of debt financing there is, at the margin, no taxation of the return on capital invested (as the interest payments to service the debt are deductible), whereas for equity financing the conventional tax on income increases the gross return needed to pay the normal net return that the investor demands.
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medium-sized enterprises form a significant part of the productive system and in some EU countries, Italy among them, they play a major role in overall output and a decisive one in some niche sectors (in Italy, SMEs also predominate in the typical export-oriented sectors).15 SMEs rarely address the choice of whether to finance themselves in the market for new equity or debt or through self-financing by comparing the total costs (including tax costs) of each course. For the multitude of unlisted SMEs, raising equity capital in the market is precluded in any case, and the momentous decision to seek listing depends on the strategic design of the owners, which generally transcends calculations of relative tax advantages. For listed SMEs that maintain a family-controlled ownership structure (the majority in Italy), a capital increase financed by the market represents the risk of loss of control. In any case, capital increases are typically discontinuous and do not readily lend themselves to marginalist analysis. An important option for SMEs is not going to the market but raising fresh capital from the existing owners, because it does not dilute control or require going public. The Italian experience shows that SMEs have taken this route, though in many cases not as an alternative but as a supplement to borrowing, as banks sometimes make such a capital increase the condition for additional lending (because it enhances the firms creditworthiness). As an alternative to this option, which has often been a vehicle for accessing additional bank credit, Italian SMEs have made abundant use of bank loans secured by personal guarantees from shareholders (or third parties, possibly relatives or other stakeholders). Such hybrid financing, combining elements of equity and debt, is hard to fit into theoretical models in which these two forms are strictly alternative. Such theoretical models assign importance to the choice between equity and debt capital mainly because an unduly low ratio of

15 Among EU countries, SMEs account for particularly large shares of employment and value added in Italy, Spain, Portugal and Greece. See European Commission, Observatory of European SMEs, various years, and European Central Bank, Monthly Bulletin, August 2007.

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equity to debt is considered to be a sign of financial weakness and rigidity and greater risk of insolvency and is so interpreted by the market. But from the perspective of economic (and legal) guarantees of a firms solvency, it makes no substantial difference whether the owners inject a part of their personal assets into the firm by subscribing the capital increase or instead pledge those assets as collateral for the firms debt. True, one reason why Italian SMEs commonly resort to debt financing backed by owners personal assets is the scope for tax avoidance inherent in the complete deductibility of interest expense and the low rate of taxation of interest income, while dividends are subject to higher overall (corporate and personal) tax rates. To deter such avoidance, like other European countries Italy has enacted a tax measure especially designed to combat over-borrowing by reducing the deductibility of interest expense when the ratio of debt to equity capital is too high.16 But the aim is not to remove the tax distortion of market choices between alternative forms of financing but to simply to combat tax avoidance. An instructive example of the way tax policy decisions have been influenced in practice by theoretical propositions concerning the taxbased distortion of financing decisions is the particular form of dual income tax introduced in Italy in 1997. Briefly, it was decided that firms carrying out a capital increase would benefit from the exclusion from income tax of the normal return on the new capital.17
16 The rule against thin capitalization for purposes of tax avoidance, introduced in 2004, excludes non-deductibility of interest expense on loans provided or secured by shareholders or related parties, in the case of qualified shareholders (holders of at least 25 per cent of the companys share capital). In addition, such loans must be of substantial amount. However, companies have the possibility to demonstrate that such loans are justified by their borrowing capacity (and thus may not be presumed to have been taken out for purposes of tax avoidance). It is important to note that the rule against thin capitalization does not apply to small firms with sales of 7.5 million or less, which are subject to tax assessment on the basis of sector studies. This indirectly confirms the difference between SMEs and large companies in terms of the choice of forms of financing. 17 Profits corresponding to the normal remuneration of the new capital invested in the firm were taxed at a lower rate than ordinary corporate income tax or (for unincorporated firms) personal tax. Italys dual income tax was applied on a fullyphased-in basis, i.e. applying the lower rate to the normal profits on all the capital invested (and not just the fresh capital) in favour of sole proprietorships and partnerships not subject to corporate tax.

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The declared objective was greater neutrality of taxation with respect to the choice between equity and debt financing.18 The idea was that eliminating the tax penalization of equity financing would stimulate capital increases and thus improve firms financial structure, which was believed to be over-weighted towards debt. Short-lived though it was (1997-2003), the Italian experience with the DIT confirms the important differences of attitude between large, widely-held corporations and small, closely-held and familycontrolled firms. Large companies, which made share issues during the period, clearly welcomed the new tax benefit, but we do not have sufficient evidence to be sure that the decision to issue fresh capital was actually influenced by the new tax rules or whether other factors in play that would have led them to raise new equity in any case. On the other hand, it is more certain that most small firms, including some listed companies, proved unresponsive to the attenuation of the distortion engendered by the conventional income tax. Actual developments appear to have sustained the thesis of those who argued that in the financing decisions of Italian SMEs non-tax variables counted more than tax considerations (at least for the relevant interval of tax rates). In short, the elegant formal demonstrations of the conditions of neutrality of the taxation of business income with respect to financing choices are hard to square with the actual decisions of small firms. The transposition of the results of formal analyses, based on many restrictive assumptions, into concrete tax policy proposals can therefore produce ineffective and unexpected outcomes.

4. The determination of small firms taxable income

In the early 1990s fears for the effects of international tax competition on capital mobility induced three Nordic countries (Norway, Sweden and Finland) to separate the tax rate on capital income from that on labour

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For the lively debate surrounding this tax measure, see TACCONE, 2005, ch.. II). 465

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income.19 Some scholars considered the lower tax rate on income from capital not only a way to counter the flight of capital to low-tax jurisdictions but also an acceptable compromise in the traditional dispute between those who argued for the superiority of the comprehensive income tax and the advocates of an expenditure tax.20 The Nordic dual income tax solution thus gained the spotlight of international discussion and was authoritatively proposed as the model for EU convergence in the coordination of tax policies.21 As was observed earlier, the experience of the Nordic countries in applying the DIT to small firms with active owners has been problematic. The conventional definition of that category of firm necessarily entails margins of discretion, and in fact the tax prompted the shift of income to the capital income component enjoying the lower tax rate. This manipulation led the Norwegian authorities in 2006 to replace the conventional income splitting method applied to firms with active shareholders with a new shareholder income tax.22 SRENSEN, who was a member of committee of experts that proposed the new tax, observes: It still remains to be seen whether the new Norwegian shareholder income tax will provide a satisfactory solution to the problem of income shifting under the DIT.23 In theory, the DIT that taxes the imputed normal return to capital at a lower rate necessarily levies a higher tax on a residual income that is defined as labour income but that actually comprises, in addition to

In truth, other European countries also introduced elements of duality in the structure of income taxation, in particular by excluding interest income and other types of investment income from progressive personal income tax and by exempting or applying favourable tax treatment to specific forms of saving. See EGGERT and GENSER (2005). 20 See SRENSEN (2006); ZODROW (2006); BOADWAY (2004). 21 See CNOSSEN (2000; 2003). 22 This is a personal tax on the part of the shareholders income (dividends and realized capital gains) that exceeds an imputed after-tax rate of interest, excluding the risk premium, on the basis of his shares. The income in excess of this normal rate of return is taxed as ordinary capital income. On the properties of this tax, whose neutrality should make it no longer advantageous for active shareholders to engage in income shifting as they did under the dual income tax, see SRENSEN (2005). 23 SRENSEN (2006, p. 40).
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true labour income (whose amount is unknown), risk premiums, rents and windfall profits. The logic of this dual taxation of heterogeneous components of income is confused, and rationally determining the related deductions also becomes difficult. It has also been remarked that the prescribed imputation of a normal rate of return to capital (accompanied in the Nordic experiences by caps on the amount of residual income imputed to labour) opens thet path to political bargaining over the estimation of the normal rate.24 The problems encountered in applying the Nordic DIT model to small businesses may be grounds for concern in countries where SMEs account for a large share of output and employment. Turning to the countries that have retained uniform taxation of income (though of course commonly with special incentives for some forms of saving and investment), one of the most frequently cited problems is ascertaining SMEs actual income. Effectively auditing the tax returns of thousands of firms is very difficult and costly, and many governments have responded by imposing ever-more extensive formal and documentation requirements, thus increasing the costs of compliance but not necessarily the accuracy or truthfulness of tax returns. Accordingly some countries, France taking the lead in Europe, have opted for presumptive income tax systems for small businesses and the self-employed.25 The tax authorities use sectoral and company data to estimate the income that a firm with given structural characteristics should earn normally (in the absence of exceptional events). Tax policy has thus moved towards a notion of normal business income, conceptually analogous to the property assessments used to determine the tax liability on land and buildings. This approach, long familiar to scholars,26 has some definite advantages. For one thing, it drastically
See CHRISTIANSEN (2004). As early as the 1960s France introduced forfaits for the determination of the taxable income of small businesses. The presumptive income levels were decided by the tax authorities after discussion with trade associations and adapted to the specific situations of individual taxpayers. See LONGOBARDI (1990). For the well-known Israeli experience with a presumptive tax regime, see LAPIDOTH (1977). 26 In Italy, the advantages of the cadastral determination of taxable income were underscored by EINAUDI (1938).
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reduces the costs (including litigation costs) for both authorities and taxpayers. For another, it prevents firms from declaring incredibly low incomes, which, unaudited, fuel social discord, give other taxpayers an alibi for cutting corners and distort competition. These were the reasons why legislation in France (and Italy from the 1980s and 1990s)27 called for the tax authorities to set presumptive income standards for small businesses on the basis of sectoral and company indicators. Firms whose tax returns are in line with the parameters will ordinarily not be audited, while those declaring less than the parameters know they will be. Judgment of the tax policy of encouraging SMEs to declare incomes no smaller than the presumed amounts normal incomes that do not necessarily coincide with their actual earnings. Traditional theory acknowledges that the concept of normal income has administrative advantages and constitutes a defence against the tendency of some taxpayers, counting on the low probability of an audit, to declare patently understated incomes. In addition, this approach rewards the dynamic, efficient small businesses whose actual incomes exceed the presumed levels and penalizes the less efficient and less innovative ones. On the other hand, every deviation from the criterion of actual earned income moves farther from the objective of taxing according to ability to pay. Equity purists therefore argue that even when the tax authorities cannot carry out more than a few audits, the goal of ascertaining actual income must be retained (and the revenue service endowed with more resources and up-to-date audit methods). Some
The wide-ranging debate on the application of sector studies in Italy is summarized in REY (2008). The latest developments, marked by the economic crisis that erupted in 2008, have revealed the rigidity of the presumptive determination of business sales and incomes based on normal economic growth, whose application in times of deflation (or stagnation) draws strong protests from taxpayers. The authorities have sought to mitigate this rigidity with corrective measures and interpretative guidance, but this creates room for uncertainty and arbitrary judgment. Further, assessments refer to prior tax periods (even several years earlier), which can create liquidity problems for firms that must make current tax payments. The problem of the procedures and the criteria for rapid adjustment of sector studies to changes in general economic performance, which affects the individual sectors in varying degree, remains open.
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countries have adopted a practical compromise, in which the revenue agency determines sectoral presumptive incomes for internal use only, so that it can allocate limited resources to auditing the tax returns that deviate most markedly from the parameters. Lastly, there is the objection that presumptive income tax systems create scope for lobbying and political bargaining (in France and Italy, trade associations collaborate in the preparation of the sector studies). One thing is certain. Ascertaining small businesses income presumptively splits business taxation in two: large companies are required to file tax returns reflecting the amounts actually earned, as shown in their financial statements, while SMEs (with revenues up to the sector study ceiling) generally declare income in line with the parameters laid down by the tax authorities. For the countries that have taken this course, the policy carries a significant implication about the Nordic DIT as the model for taxation in the EU. If the Nordic option were adopted, the income of SMEs in those countries would first be determined presumptively and then divided, again on a presumptive basis, between capital and labour income in order to apply the two different rates in accordance with the arguments that justify the lower rate on capital income but have not clarified the logic for the gap with respect to the tax rate on labour income.28 Additional scope for discretion is likely to be found in the rules for imputing costs and losses to the two components of income and for deductions. And the degree of integration with the taxation of personal income and/or wealth remains unsettled. In conclusion, it would be difficult in the extreme to make the resulting system of presumptive taxation accord with any rational and transparent principle of the ability to pay. Yet much of popular support for the tax system is still founded upon the concept of ability to pay, a principle that is even enshrined in some constitutions.

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ZODROW (2006) offers numerous arguments to rationalize the choice of a DIT tax rate on capital income that is intermediate between zero and the full rate characteristic of the comprehensive income tax model. 469

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REFERENCES BOADWAY R. (2004), Dual Income Tax, CESifo, Report 3. CHRISTIANSEN V. (2004), Norwegian Income Tax Reforms, CESifo, Report 3. CNOSSEN S. (2000), Taxing capital income in the Nordic countries: a model for the European Union?, in S. CNOSSEN (ed.), Taxing Capital Income in the European Union Issues and Options for Reform (Oxford). CNOSSEN S. (2003), How much tax coordination in the European Union?, International Tax and Public Finance, vol. 10. C RAWORD C. and F REEDMAN J. (2008), Small Business Taxation, Mirrlees Review. D EVEREUX M. (2004), Debating Proposed Reforms of the Taxation of Corporate Income in the European Union, International Tax and Public Finance, 11. E GGERT W. and B. G ENSER (2005), Dual income taxation in EU member countries, CESifo, Report 3. EINAUDI L. (1938), Miti e paradossi della giustizia tributaria (Turin: 3rd ed. 1959). EUROPEAN CENTRAL BANK (2007), Monthly Bulletin, August. EUROPEAN COMMISSION, Observatory of European SMEs, various years. FUEST C. and HUBER B. (2001), Can corporate personal tax integration survive in open economies? Lessons from the German reform, FinanzArchiv, vol. 57, no. 4. G ORDON R. H. (1986), Taxation of investment and savings in a world economy, American Economic Review, no. 76. J ORGENSON D. W. (1963), Capital Theory and Investment Behavior (Cambridge, MA). LINDHE T., SDERSTEN J. and BERG A. (2004), Economic effects of taxing closed corporations under a dual income tax, International tax and public finance, no. 11. LONGOBARDI E. (1990), Lesperienza francese del forfait, in LECCISOTTI (ed.), Per unimposta sul reddito normale (Bologna). MINTZ J. (1995), The Corporation Tax: a Survey, Fiscal Studies, vol. 16. MUSGRAVE (1959), The Theory of Public Finance (New York). PEDONE A. (2009), Tax Theory and Tax Practice: The Problems of Defining, Measuring and Assessing Tax Bases, Department of Public Economics WP 119, http://dep.eco.uniroma1.it/docs/working_papers /WP119.pdf. R AZIN A. and S ADKA E. (1990), Capital Market Integration: Issues of International Taxation, NBER, Working Paper no. 8281 March.
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REY G. M.(ed.) (2008), Le problematiche di tipo giuridico ed economico inerenti alla materia degli studi di settore, (Rome, SSEF). SEN A. (1970), The Impossibility of a Paretian Liberal, Journal of Political Economy, 78. SEN A. (1979), Personal utilities and public judgements: or whats wrong with welfare economics?, Economic Journal, vol. 89. SINN H.W. (1991), Taxation and the Cost of Capital: The Old View, The New View and Another View, in D. F. BRADFORD (ed.), Tax Policy and the Economy 5 (Cambridge, MA). SRENSEN P. B. (1994), From the Global Income Tax to the Dual Income Tax: Recent SRENSEN Tax Reforms in the Nordic Countries, International Tax and Public Finance, 1. S RENSEN P. B. (2005), Dual income taxation Why and how?, FinanzArchiv, vol. 61, 559-586. SRENSEN P.B. (2006), Can capital income taxes survive? And should they?, CESifo. SRENSEN P.B. (2007), The theory of optimal taxation: what is the policy relevance?, International Tax and Public Finance, 14. SRENSEN P.B. and WOLFGANG E., (2008), The effects of tax competition when politicians create rents to buy political support, Journal of Political Economy, 92. TACCONE A. (2005), Questioni aperte sulla tassazione delle societ (Naples). TANZI V. (2002), Globalizzazione e sistemi fiscali (Rome). ZODROW G. (2006), Capital mobility and source-based taxation of income in small open economies, International Tax and Public Finance, 13.

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