Finnish firm owners react to changes in dividend taxation by adjusting income shifting – investment and output responses negligible

Concerns over investment, international competitiveness, and growth have led to lower income tax rates for dividend income in several countries, recognizing the crucial role of firms in driving innovation and growth. Dividend taxes reduce the return on invested capital and the owner’s own work, hence decreasing the incentives for new investments and exerting effort. However, these distortions could be small. This is because business owners have many channels for adjusting their tax burden, such as tax planning, and several channels to fund investment.

A study by Aliisa Koivisto (VATT Institute for Economic Research) utilizes detailed administrative data to examine how Finnish firms and firm owners respond to dividend taxation in different decision margins, including tax planning and investment. The Finnish dividend tax schedule provides exceptionally large incentives for firms to respond: There are large jumps in the marginal tax rates for dividends, and the owners of privately held corporations can quite freely choose whether to receive income from the firm as dividends or to pay wages. The dividend tax schedule includes deduction thresholds, effectively causing clearly lower marginal tax rates for certain amounts of dividend income in comparison to labor income.

The study finds high dividend tax elasticities and observes that more experienced owners have higher tax base elasticities. When studying changes in the tax thresholds, the study finds evidence of clear income shifting between wages and dividends with negligible effect on gross income received from the firm. Furthermore, the study does not find significant real responses to dividend tax changes in output or investment, and evidence on the asset composition of firms indicates that a notable part of the payment response is due to inter-temporal income-smoothing.

The results of the study highlight that large differences in taxation between income bases create behavioral responses with mainly distributional implications. The extensive income shifting responses underline that when predicting the revenue impacts of tax changes, the variety of tax bases and the implications for inter-temporal income shifting should be considered. From a tax authority perspective, inter-temporal income shifting may also reduce the cyclicality of business income tax revenue.

The article Tax planning and investment responses to dividend taxation has been published in International Tax and Public Finance in April 2024.

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