The Degree of Integrating Corporate and Capital Gains Tax into Income Tax and its Impact on Investment Decisions

Abstract

We investigate the influence of different systems of current income and capital gain taxation on investors' decisions to either invest in corporate shares or to invest funds on the capital market. We analyze three basic tax systems. We show that even under certainty, we cannot derive general analytical solutions to the investment problem for different categories of tax regimes. Using a growth model, under restrictive assumptions we find that the shareholder relief system results in more severe distortions than does the full imputation system. In an attempt to prove this finding in a more realistic setting with uncertainty, we use Monte Carlo simulation for random rates of turn and random income tax rates. We find that tax-induced uncertainty and distortion is often higher under a shareholder relief system than under full imputation, but find opposite results for low income tax rates if either the retention rate is low or income tax rates are subject to high degrees of uncertainty. These results contradict the traditional view of full imputation and suggest that under uncertainty, full imputation may cause more severe distortions than would shareholder relief, especially if personal income tax rates are low and volatile. This result is important, because simulated low income tax rates correspond to empirical rates. Furthermore, the simulation clarifies the trade-off between opposing effects, i.e., tax and interest-rate effects, and the overwhelming impact of capital gains taxation. Apart from tax parameters, we identify the dividend rate and the point in time of selling the shares as important value drivers.