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Studies and research papers

ALESSANDRA T ACCONE Taxation of the income

of small businesses

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Taxation of the income

of small businesses

Alessandra TacconeProfessor of Finance, LUISS University, Rome

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

The traditional theory of public finance founded taxation onhorizontal 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) isthe principal international indicator of an economy’s 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 informationon firms’ operations (and prospects).1

1 Tax laws essentially transposed the civil law provisions to determine taxable netbusiness income, but with specific variations to counter underreporting of net incomeby taxpayers using the margins of discretion allowed them by civil law with regard tothe 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 taxpayer’s 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 alsogave 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

2 The corporate tax was also advocated on the grounds that companies have an

independent ability to pay inasmuch as they exercise an economic power thattranscends the sum of the incomes attributed pro rata to the shareholders, and thatthere is often a separation between ownership and management in large corporations.This view, challenged by theorists who maintain that economic power is in any caseexpressed 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 inItaly (1997-2001). In Norway, the recent (2006) reform that introduced the personalshareholder income tax neutralizes the tax’s effect on the decision whether or not torealize capital gains: SØRENSEN (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 medium-

sized 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 capitalinvested 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 man’s 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 takeaccount 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

Taxation of the income of small businesses

4 See SØRENSEN (2006).5 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 low-

tax 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 thefactors 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 thenational 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 andprompted 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

6 For this theory of incidence, see GORDON (1986); R AZIN and S ADKA (1991);T ANZI

(2002); SØRENSEN(2006).7 See SØRENSEN (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 incometaxation 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 SØRENSEN (1994; 2005; 2006; 2007; 2008); CHRISTIANSEN (2004); LINDHE, SÖDERSTEN,ÖBERG (2004). The difficulty of reconciling income tax rules generally designed forlarge corporations with the operational reality of small and medium-sized enterprisesis 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 soongained a broad consensus among experts, many of whom have recommended it as amodel 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 taxsystem but also take ample account of the structural question of the treatment of self-employment labour income with respect to capital income as part of entrepreneurialactivity, essentially using arguments that emerged from the Nordic DIT experience.9 In Italy, the presumptive estimates of incomes resulting from sector studies areapplied to businesses with annual revenues of up to €7.5 million. See R EY (2008).

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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 ordecisions (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 rendersevaluations of their distributive effects (on equity) problematic.10

In part for this reason and in part because of the weakening socio-

political 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

10 On the criteria of corporate taxation in an international context DEVEREUX (2004)observes: “With regard to taxpayers, equity is only meaningful with respect to effectiveincidence; 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 SØRENSEN (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 non-

utilitarian motivations.13


12 The second fundamental theorem of welfare economics has been demonstrated inits specific normative theory, but it rests on assumptions and has implications that

render it inapplicable to today’s reality. Neo-classical normative theory has beenchallenged by schools of thought that reject the assumption that the rate of profit isdetermined by the marginal productivity of capital and hence rejects the neo-classicaltheory of distribution.13 On this subject, see SEN (1970; 1979). In truth, the definition of “equity” in publicfinance is inevitably subject to value judgment, as MUSGRAVE (1959) himself admits inhis explicitly neoclassical “theory”. In a recent essay, PEDONE (2009) highlights thecomplexity 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 actualincidence of the tax, which often determines a different economic distribution of taxburdens 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 infirms’ 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, widely-

held companies, which can rationally bring the tax cost of the alternativeforms 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 asclosely-held (and mainly family-controlled) corporations. Small and

14 The analysis is formalized using the marginalist neoclassical model of investmentdecisions (the most frequently used version is that of JORGENSON, 1963), which showsthat in the case of debt financing there is, at the margin, no taxation of the return oncapital invested (as the interest payments to service the debt are deductible), whereasfor equity financing the conventional tax on income increases the gross return neededto 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 acapital increase the condition for additional lending (because it

enhances the firm’s 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 firm’s

solvency, it makes no substantial difference whether the owners inject apart of their personal assets into the firm by subscribing the capital

increase or instead pledge those assets as collateral for the firm’s 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 tax-

based distortion of financing decisions is the particular form of dual

income tax introduced in Italy in 1997. Briefly, it was decided thatfirms 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 25per cent of the company’s share capital). In addition, such loans must be of substantialamount. 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 takenout for purposes of tax avoidance). It is important to note that the rule against thincapitalization does not apply to small firms with sales of €7.5 million or less, which aresubject to tax assessment on the basis of sector studies. This indirectly confirms thedifference 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 thefirm were taxed at a lower rate than ordinary corporate income tax or (forunincorporated firms) personal tax. Italy’s dual income tax was applied on a fully-phased-in basis, i.e. applying the lower rate to the normal profits on all the capitalinvested (and not just the fresh capital) in favour of sole proprietorships andpartnerships 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 family-

controlled 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 factorsin 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


18 For the lively debate surrounding this tax measure, see T ACCONE, 2005, ch.. II).

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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 comprehensiveincome 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 promptedthe 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

SØRENSEN, 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

19 In truth, other European countries also introduced elements of duality in thestructure of income taxation, in particular by excluding interest income and othertypes of investment income from progressive personal income tax and by exempting

or applying favourable tax treatment to specific forms of saving. See EGGERT andGENSER (2005).20 See SØRENSEN (2006); ZODROW (2006); BOADWAY (2004).21 See CNOSSEN (2000; 2003).22 This is a personal tax on the part of the shareholder’s income (dividends andrealized capital gains) that exceeds an imputed after-tax rate of interest, excluding therisk 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, whoseneutrality should make it no longer advantageous for active shareholders to engage inincome shifting as they did under the dual income tax, see SØRENSEN (2005).23 SØRENSEN (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 thatthe 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, haveopted 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


24 See CHRISTIANSEN (2004).25 As early as the 1960s France introduced forfaits for the determination of the taxableincome of small businesses. The presumptive income levels were decided by the taxauthorities after discussion with trade associations and adapted to the specificsituations of individual taxpayers. See LONGOBARDI (1990). For the well-known Israeliexperience with a presumptive tax regime, see L APIDOTH (1977).26 In Italy, the advantages of the cadastral determination of taxable income wereunderscored 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 notnecessarily 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 actualearned 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

27 The wide-ranging debate on the application of sector studies in Italy is summarized

in R EY (2008). The latest developments, marked by the economic crisis that erupted in2008, have revealed the rigidity of the presumptive determination of business salesand incomes based on “normal” economic growth, whose application in times of deflation (or stagnation) draws strong protests from taxpayers. The authorities havesought to mitigate this rigidity with corrective measures and interpretative guidance,but this creates room for uncertainty and arbitrary judgment. Further, assessmentsrefer to prior tax periods (even several years earlier), which can create liquidity problems for firms that must make current tax payments. The problem of theprocedures and the criteria for rapid adjustment of sector studies to changes in generaleconomic 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 theobjection 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 theparameters 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 notclarified 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 popularsupport for the tax system is still founded upon the concept of ability

to pay, a principle that is even enshrined in some constitutions.


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

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