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"Monetary review - 1st Quarter 2002"

Taxation of Asset Income and the Financial Markets

Kristian Kjeldsen, Financial Markets, and Erik Haller Pedersen, Economics

Introduction

Virtually every type of tax influences the behaviour of companies and private citizens by affecting incentives to save, invest or work. In some cases such effects on behaviour are unintentional, while in others the tax is aimed specifically at influencing behaviour, e.g. environmental taxes and taxes on spirits and tobacco. Often interests are conflicting, and compromises must be made. In addition, external circumstances can change over time, so that a tax which once seemed appropriate has now become inappropriate, e.g. as a result of changing attitudes to what is fair and reasonable, internationalisation or other circumstances.

This articles focuses on taxation of asset income in relation to private individuals, i.e. taxation of interest and other returns on private savings and investments. The most important asset-income taxes and the tax revenue collected in 2001 are shown in Table 1. The total revenue was approximately kr. 43 billion, including corporation tax, equivalent to almost 7 per cent of the total income from direct and indirect taxes. This tax source also has many inexpedient side effects, cf. the Danish Economic Council (2001) among others. The following sections will focus on the distorting effects of the taxation of asset income on the financial markets. Not all aspects of taxation of asset income will be discussed, however.

It is concluded that the Danish tax system, which has been subject to many changes over the last twenty years, has improved from the former situation, particularly in respect of taxation of asset income. Especially the latest amendments to pension taxation, where the real-interest tax was replaced by a general tax on pension yields with a uniform rate for all types of yields, has reduced the distorting effects on the financial markets. Nevertheless, there are still a number of inappropriate elements, e.g. a high degree of variation in the taxation of asset income, cf. the Table in Appendix 1. This increases the scope for speculation in minimising tax payments, while reducing the transparency of the tax system.

Table 1 revenue from taxation of asset income

The gap between the rate of tax on pension funds and free funds is wide. It is still worthwhile to borrow with a view to investment in a pension scheme, although the advantages are not as significant as before. Pension returns are taxed at market value, with a low nominal rate without progression, whereas taxation of bond yields is asymmetrical and is determined by whether the taxpayer has positive or negative net capital income. The progressive taxation of bond yields means that for many taxpayers placement in risk-free assets gives a negative real return after tax. An exception is placement in index-linked bonds, where taxation is real and lower than for nominal bonds.

Income from shares which are not part of a pension scheme is taxed progressively, but – contrary to the situation for bond yields – this progression is independent of the taxpayer's overall income and relates only to the size of the income from shares. Issues such as length of ownership, tax thresholds, and whether the shares are listed or unlisted, further complicate taxation.

For investment associations another complicating aspect is the wish for equivalence with the taxation of the underlying assets (the transparency principle). The taxation rules inhibit product development and external competition within this sector.

Taxation of asset income in a historical perspective

Until the tax reform which took effect in 1987, private individuals' asset income was taxed on a par with other income, e.g. wages and salaries. A system based on uniform taxation of all types of income is called a global income tax system. The Danish tax system was also progressive, which meant that the tax value of the deductibility of private indi-viduals' interest expenditure varied greatly, depending on the individual taxpayer's other fiscal circumstances. The combination of high inflation and the fiscal treatment of interest expenditure, of which the tax deductibility at one point was as high as 73 per cent, meant that for many people real interest after tax was negative for long periods from the 1960s up to the mid-1980s. The negative real interest after tax stimulated borrowing, large housing investments, and very low private savings.

Even though private savings were modest, considerable funds were placed in capital pension schemes, life insurance policies and pension funds, often financed by loans. The reason was that returns on pension savings were tax exempt up to 1983. Taxation of capital pension savings was also moderate. The high tax value of the interest deduction entitlement made it extremely advantageous, especially for high-income groups, to borrow funds and gain an interest deduction entitlement, and simultaneously place the funds in wholly or partly tax-exempt pension schemes.

There can be little doubt that inexpedient taxation of asset income combined with high inflation was a major reason for the imbalances characterising the Danish economy up through the 1970s and the first part of the 1980s. From a private financial point of view the system was to the great benefit of many people, however.

During the past twenty years the Danish tax system has undergone fundamental changes. Where taxation of asset income was previously based on Danish investors owning only Danish shares and bonds, the current system must take international placements into account too. However, the present Danish tax rules are still reminiscent of the former approach.

With the tax reform which took effect in 1987, a dual income-tax system was introduced by which asset income on the one hand and earned income and transfer income on the other are taxed separately. In 1994 a third category was introduced, namely share income. The taxation rate for negative net capital income, and thereby the tax value of the interest deduction entitlement, was reduced in several stages, so that now interest expenditure is deductible only from local-government tax, i.e. a typical deductible value of 32.5 per cent in 2001. Table 2 illustrates the historical development in tax rates. Progression has been maintained for positive net capital income, which is currently taxed at up to 58.5 per cent. Negative net capital income is thus taxed on a dual basis, while positive net capital income is taxed on a more or less global basis. Share income is also taxed progressively, but independently of other income.

Table 2 Development in selected capital income tax rates

Especially the taxation of pension savings has changed radically over the last 20 years. Back in the early 1980s the pension sector invested mainly in Danish bonds. As bond yields were taxed from 1984, with the introduction of the real-interest tax, investments were increasingly moved to shares and index-linked bonds. In recent years the tax base has been extended to include these assets too. This means that the taxation of pension savings has generally been increased. However, pension savings are still fiscally subsidised, cf. the calculations in Appendix 2. Taxation in this area is now more in line with taxation of other capital income. Although in many cases it is still worthwhile for private indi-viduals to take loans and place the funds in a pension scheme, the advantages are generally less significant than previously. In addition, particularly after the abolition of the real-interest tax, taxation of pension savings is structured so as to have fewer negative side effects on the financial markets. For instance, shares have been included in the taxation of pensions, which was not the case under the real-interest tax up to 1998.

Exemption of shares from real-interest tax was partly related to a wish to provide inexpensive capital to Danish companies, and partly to the fact that companies were already subject to corporation tax. The free movement of capital makes it very difficult to use tax legislation to give Danish shares a preferential position vis-à-vis foreign shares.

As regards the taxation of capital income, it can be concluded that the tax system today is more appropriate than 20 years ago. As revealed below, there are nevertheless still a number of problems.

Taxation theory

There are several arguments in favour of taxing capital income more leniently than earned income. The higher the tax on capital income, the more advantageous it is to acquire debt, and the less favourable it is to save. The disadvantages become more pronounced in periods of inflation. The combination of a nominal tax system and inflation means that in actual fact capital income is taxed more severely than earned income if the same rates are applied. This is because part of the yield merely compensates for price increases, and thus does not constitute real income to the investor. Finally, the international mobility of capital means that a rate of taxation which greatly exceeds that of other countries is not sustainable or requires extensive control measures, since it constitutes a major incentive to place income abroad, while interest expenditure is deductible in Denmark. Initiatives under EU auspices have been launched to improve tax collection internationally.

There are arguments both for and against progressive taxation of capital income. One argument against progression is that asymmetry leads to fiscal arbitrage, i.e. transactions undertaken to legally transfer highly-taxed income to income subject to lower taxation. Another argument against progression relates to citizens achieving positive real interest on savings. Under the current interest and tax rules, the real yield after tax on e.g. an investment in bonds is moderately negative for an upper-bracket taxpayer with positive net capital income. The financial incentive to save is thus in many cases eliminated for this taxpayer segment.

Arguments for progression include the principle of tax-paying ability and the fact that a low rate of tax on capital income is an incentive to attempt fiscal transformation of earned income into capital income, which can be a problem for sole proprietors in particular. The business taxation rules seek to solve this problem.

Overall, the requirement to optimise savings suggests that capital income should be taxed more leniently than earned income and transfer income. The asymmetry in the taxation of respectively negative and positive net capital income will often have a distorting effect, however.

Taxation of pension savings

On assessing the advantages of pension savings, not only the taxation of current returns, but also the tax value of the deduction of contributions compared with the taxation of disbursements are of relevance. The latter rate is not known for certain at the time of contribution. The calculation should also take into account that certain public benefits are reduced when income increases, which may influence the effective taxation of the pension savings, particularly regular-premium pension schemes and annuities.

If contributions are deductible, a savings scheme is subject to pension taxation. This applies to capital and regular-premium pension schemes, as well as annuities that include an insurance element. Other savings are subject to ordinary income tax.

The deductibility of contributions does not in itself entail preferential tax treatment. In terms of the yield on the pension savings it is in prin-ciple immaterial whether the contributions are deductible and the disbursements taxable, or the contributions fully taxable and the disbursements tax exempt, provided that the tax rate has not changed in the meantime. In Denmark, pension savings are taxed primarily at the time of disbursement. However, a labour-market contribution is always payable at the time that the pension contribution is made, whereas the disbursements are exempt from labour-market contribution. Deduct-ibility of contributions and taxation of disbursements do not necessarily benefit pension savers. If the marginal rate of tax increases over time, it would be more advantageous for savers not to have a deduction en-titlement at the time of contribution, and not to be taxed at the time of disbursement.

The introduction of the Whitsun package of economic measures made a capital pension scheme less advantageous. Previously, contributions were deductible from income, i.e. at up to the upper tax rate, whereas disbursements were taxed at 40 per cent, which is still the case. After the reform, contributions to capital pension schemes have a maximum tax deductible value of 43.5 per cent, whereas regular-premium pension schemes have retained their full deductible value. The advantages of capital pensions vis-à-vis regular-premium pension schemes and annu-ities have thus been reduced. However, disbursements under capital-pension schemes generally have fewer effects on pensioners' eligibility for supplementary public benefits than pensions subject to current payments.

The profitability of a pension scheme depends on the specific tax rates applying to the saver, cf. Table 3, which shows the isolated effect of variations in tax rates at the times of contribution and disbursement respectively. The essential aspect is that the benefits to savers vary considerably according to the savers' fiscal circumstances. Moreover, tax rates can change over time. The system has the drawback that the effective interest on particularly regular-premium pension schemes and annuities is difficult to assess. It depends on the life-long income profile of the saver, as well as the development in the tax rates of the income tax system over time. 

Although it is thus unclear whether the deductibility of contributions to pension schemes is an advantage to the saver, it is nevertheless apparent that it is important in a financial-market perspective. The Danish system of deducting contributions and taxing disbursements results in larger total registered pension capital than would have been the case had the contributions not been deductible. Part of the capital managed by pension funds and life assurance companies is thus in fact equivalent to deferred tax. On the other hand, the registered central-government debt is correspondingly greater.

Table 3 Differences in marginal tax rates at time of contribution and disbursement in private pension schemes

Taxation at the time of disbursement may also involve losses to the Treasury if the pensioner takes up residence abroad. In this case, contributions can be deductible, but disbursements are not taxed. On assessing the advantages and drawbacks of the tax deductibility of contributions, it should, however, be taken into account that a shift from one system to the other involves major problems of a practical nature.

The adoption of the Whitsun package of economic measures in 1998 brought extensive changes to the taxation of current yields on pension savings in Denmark. The compilation of the taxation basis was changed significantly. The real-interest tax basis of a realisation principle with mathematical revaluation was replaced by calculation at market value, i.e. the assets are stated at market value and any capital gains are taxed when they arise, regardless of whether they are realised or not. Capital losses are deductible. The shift from mathematical revaluation to the market-value principle is phased in over a 5-year period. Current taxation of yields stated at market value helps to ensure an efficient financial market, inter alia by counteracting tax arbitrage and preventing lock-in effects, i.e. situations where fiscal considerations make it less profitable to sell certain bonds, resulting in price distortion. However, the market-value principle can also give rise to problems of understanding in connection with general application, e.g. exchange-rate gains on debt, as well as the taxation of unrealised capital gains. This is one reason that it is not applied systematically in connection with taxation of personal income.

The new tax on pension returns broadens the tax base so that share returns, newly-issued index-linked bonds and real property returns are generally subject to taxation, whereas the real-interest tax mainly applied to nominal bonds. With the latest change, a uniform tax rate of 15 per cent has been introduced for all types of assets.

Whether the fiscal changes will cause pension savers to invest a larger or smaller proportion of their funds in shares is impossible to say at this stage. The higher taxation than before would, on an isolated basis, indicate a smaller proportion of shares, but this should be offset against the fact that the government now bears a larger share of the equity price risk, which points to a larger proportion of shares, cf. Møller, Parum and Sørensen (2001).

From the pension savers' point of view the current rules for share investments related to pension schemes are both transparent and symmetrical. The same rules apply to dividends and profits, regardless of length of ownership and ownership share, and of whether the shares are listed or unlisted. Losses are deductible from other returns in the pension scheme. This contrasts sharply with the fiscal treatment of free funds invested in shares, cf. below. 

With regard to index-linked bonds, all series closed before 1 January 1999 are exempt from taxation of asset income. This means that index-linked bonds issued after this date are priced on a par with ordin-ary bonds. At the same time, a reform of the financing of subsidised construction was adopted. Traditionally, this sector has been the main issuer of index-linked bonds. The reform gives access to financing via ordinary nominal mortgage-credit bonds.

Overall, the changes in the taxation of pensions are deemed to have a positive effect on the functioning of the financial market. With the shift to taxation at market value, the bond market avoids the lock-in effects which were a consequence of the real-interest tax. In other cases the opposite applied, i.e. tax-conditioned sale. The extension of the tax base to include shares and real property, as well as the uniform tax rate, help to prevent purely fiscally determined restructuring of pension portfolios with a view to investing in tax-exempt assets or assets that are taxed at low rates.

Appendix 2 outlines the effective taxation of a private investor's investment opportunities. As can be seen, pension savings are taxed at a lower rate than other types of savings. The preferential fiscal treatment of pension savings lies in the taxation of current yields rather than in differences in tax rates at the time of contribution and disbursement.

A further benefit of the new pension tax is that it makes it possible for pension funds and life assurance companies to use derivatives such as futures and options more actively in the future. Derivatives are already taxed at market value, so there is now consistency between the taxation of the derivative and the underlying asset, e.g. a bond holding.

Free savings

Bonds
Taxation of the current yield (interest) on a bond investment depends on whether the taxpayer has positive or negative net capital income, cf. Box 1. If the net capital income is negative, the yield is subject to local-government tax, i.e. approximately 32.5 per cent. If it is positive, it is taxed progressively at up to 58.5 per cent, cf. Table 4. This also means that the tax value of the deductibility of interest payments on a loan can be as high as 58.5 per cent, provided that the total capital income remains positive. In actual figures, around 2.6 million Danish taxpayers have negative net capital income, while 1 million have positive net capital income, 170,000 of whom are in the upper income-tax bracket.

Table 4 Marginal tax rates for positive and negative net capital income

Turning to capital gains on bonds, private individuals are exempt from tax if the lower limit applying under the Capital Gains Act is fulfilled. If, at the time of issue, the asset has a coupon rate at least equivalent to the current minimum coupon rate, any capital gain is not taxed, and a loss is not deductible. This applies to virtually all krone-denominated bonds issued in Denmark. On the other hand, if the coupon is below the minimum coupon, private individuals' capital gains are taxed. A capital gain on premature redemption of a cash loan is always taxed, however, provided that the loan was raised on 1 January 1996 or later. A gain is typically realised on a cash loan in connection with conversion to a higher interest rate and reduction of the outstanding debt. Cash loans are not subject to taxation of capital gains on the first redemption in connection with change of ownership.

Box 1 Yield on a bond investment

 The rules relating to the minimum coupon rate introduced in 1985 are to prevent the issue of bonds at yields which include a significant capital-gain element that was previously tax exempt for private individuals, e.g. cash loans financed via bonds issued considerably below par. The minimum-coupon-rate rule means that the coupon rate on issue of mortgage-credit bonds is always close to the market rate. As a con-sequence, when the level of interest rates fluctuates loan conversion activity is considerable. Loans can be converted down to a lower interest rate in line with declining market rates, or up to a higher rate, but a lower outstanding debt, if the market rate increases.

The minimum-coupon-rate rule applies only to accounts in Danish kroner. For loans in other currencies, e.g. euro, all capital gains are tax liable, and all capital losses are deductible. This applies to private and corporate borrowers alike, regardless of loan type and purpose, including change of ownership. The tax rules relating to foreign-exchange loans are thus far more transparent and symmetrical than the tax rules for loans in Danish kroner, which, as stated, are subject to distinctions between individuals and companies and between loan types.

Shares
Table 5 taxation of private individuals' share holdings

¹    2001 limit, called the "kr. 100,000 limit".
²    Income from shares is taxed at 28 per cent of the first kr. 38,500 (2001 limit), and thereafter at 43 per cent.

In contrast to the simple rules applying to shares under pension schemes, private individuals' income from shares is subject to complex taxation rules. The yield received by the shareholder comprises dividend, as well as realised capital gains or losses, hereinafter referred to as gains. Table 15 outlines the main rules for taxation of share dividends and gains arising from free savings invested in shares. Dividend is always taxed as equity income for the shareholder, i.e. at 28 per cent of the first kr. 38,500 (2001 limit), and thereafter at 43 per cent. Taxation of gains on shares depends on length of ownership, share type, i.e. listed or unlisted share, and the size of the share holding (known as the kr. 100,000 limit). If the shares have been owned for less than 3 years, gains are always taxed as capital income and thereby independently of the shareholder's other fiscal circumstances, cf. above. If the shares have been owned for more than 3 years, gains are taxed as income from shares, i.e. taxation is fully symmetrical, so that no distinction is drawn between capital gains and dividend. For portfolios of listed shares below a certain value, however, gains are tax exempt after 3 years' ownership, cf. Table 5.

The entitlement to deduct capital losses is a complex issue that depends, inter alia, on whether the shares are listed or unlisted, and whether there is a share gain from which the loss can be deducted. Capital gains and losses are thus not treated symmetrically. For details, see Møller and Plenborg (1997).

In addition to being complex and administratively cumbersome, the rules on taxation of share income entail that the real taxation of shareholders can vary considerably from person to person. If, for instance, the share portfolio is small, and the entire income relates to gains, i.e. the company does not pay out dividends, the taxation will be zero. At the other extreme, a shareholder with positive net capital income who is in the upper income-tax bracket and sells the shares within 3 years may have to pay tax of up to 58.5 per cent on the share, again assuming that all of the profits are retained by the company. However, the real taxation can be reduced by retaining the share, as the taxation relates to realised gains. In combination with the 3-year rule and the kr. 100,000 limit an inappropriate lock-in effect may be created, which is inexpedient from a financial-market point of view. 

A working group under the Ministry of Taxation has put forward a proposal for considerable simplification of the taxation of capital gains on shares, cf. the Ministry of Taxation (1999).

Investment associations
Accumulative investment associations are fully taxable under the Corporation Tax Act. At the same time, the owners of investment certi-ficates are taxed under the Act on taxation of capital gains on shares, so that the 3-year rule and the kr. 100,000 limit, etc. apply, as described above. Losses can be deducted from the corresponding share gains if they are realised within the first 3 years of ownership, but otherwise not. Investment in these associations, which invest mainly in bonds, may therefore be taxed differently from direct investments in bonds.

Unlike accumulative funds, dividend-paying funds are not independently tax liable if they meet the distribution requirement. To remain tax exempt, all income which would have been taxed had the owner of the investment certificate owned an equivalent portfolio directly must be distributed. This ensures that the distributed profits are taxed as the underlying income types, i.e. capital income as capital income, share income as share income, etc. This is known as the transparency principle. The account-holding investment associations are taxed according to the same principle.

The yield on an investment-association certificate consists of current yields such as interest and dividend, and of the capital gains or losses on the certificates. The varying fiscal treatment of pension customers versus private customers investing free funds may result in a conflict of interest for the investment association. For the pension customer, both current yields and capital gains are taxed at 15 per cent. The free funds invested in an accumulative investment association are, however, subject to taxation of capital gains on shares, so that capital gains on minor portfolios are generally tax exempt after 3 years' ownership. This can lead to a conflict between the two types of investor, since the investment association may have to choose between a high dividend, to the advantage of the pension customers, or minimisation of the tax burden, to the benefit of private customers investing free funds. A high dividend may not always be in the latter's interest if it also triggers additional tax. An investment association which trades frequently and cashes in capital gains in order to achieve a high yield may therefore be attractive to pension customers, and less attractive to private customers with free funds. The trend is therefore to split the associations according to fiscal allegiance, so that they cater for either pension customers or private individuals. This must be described as an unintentional consequence of the tax rules, and entails a considerable need to advise investors.

The rules relating to taxation of investment associations are very detailed and thereby complicated as they often seek to set out taxation conditions relating to the individual types of investment-association products offered. These highly product-specific taxation rules may contribute to inhibiting product development in the market. In addition, the rules help to keep foreign providers away from the Danish market, and thus hamper competition. Finally, it is inexpedient that for many investors in investment certificates the tax rules are impenetrable. There appears to be a need for simpler, less product-specific taxation of investment associations. This was also the conclusion in the report from the Committee on the Financial Sector after the Year 2000, cf. the Ministry of Economic Affairs (1999).

Appendix 1

 Table 6 bonds - ownership

Table 6 (cont.)

Table 7 shares – ownership 

Table 7 (cont.)

Table 8 index-linked bonds 

Appendix 2

Table 9 Effective real taxation of various types of savings

To gain an impression of the extent to which the tax system is neutral in terms of the savings opportunities open to a private investor, a compar-ison can be made between the real effective tax rate, calculated as the difference between the real return before and after tax in relation to the real return before tax, cf. Table 9. It is assumed that the real return after tax in the international markets is 2 per cent, regardless of whether savings are made via home ownership, shares, bonds or a pension scheme.

Pension savings are seen to be taxed more leniently than other savings. This is a long-standing tradition. It is disputable whether this results in higher overall savings or merely shifts the pattern of savings which would still have taken place. Owner-occupied homes are also taxed at a lower rate than e.g. bond investments, in any case at the lower end of the progression scale. As a consequence of the asymmetrical fiscal treatment of respectively positive and negative net capital income the taxation of an investment in bonds is greatly dependent on the invest-or's fiscal circumstances. 

The real effective yield requirements before tax in Table 9 are calculated as follows:

R^Housing (2%) = Rental value - tax on value of property (1%) - land tax (0.25*2.5%)

If it is assumed that the land tax is shifted to the land value, the last leg is disregarded. This shifting means that land prices fall in line with the present value of the future land taxes.

R^Share (2%) = Gain from share*(1 - 0.43) - 0.385*(0.43 - 0.28)

A gain of kr. 100,000 is used. The proportion below kr. 38.500 kr., taxable at 28 per cent, is thus 0.385. Corporation tax is payable by both domestic and foreign investors. Differences in corporation tax rates between the countries are capitalised in the share price and thus do not affect the tax calculation.

R^Bond (2%) = Yield - coupon rate (6%)*0.32

The bond is assumed to be issued close to par.

R^Pension (2%) = Return*(1 - 0.15)

It is assumed that the tax rate at the time of contribution is equivalent to the rate at the time of disbursement of pension payments. Only the current taxation is thus taken into consideration.

The figures in Table 9 are reached by determining the value of gain for which the equation is true.

The figures are sensitive to the assumptions made, but the ranking of the various types of savings is reasonably robust. 

Literature

Andersen, J. V. and J. Gyntelberg, Index-Linked Mortgage Bonds, Danmarks Nationalbank, Monetary Review, 1st Quarter 1999.

Direct and indirect taxes (in Danish), Statistics Denmark, 2001

The Danish Economic Council, Danish Economy, Spring 2001.

Møller, M., C. Parum and T. Sørensen, The New Act on Taxation of Pensions (in Danish), Finans/Invest no. 1, 2001.

Møller, U. G. and T. Plenborg, Taxation of Income from Shares in Denmark (in Danish) , Finans/Invest no. 7, 1997

Ministry of Taxation, Betænkning nr. 1392, Taxation of Capital Gains on Shares (in Danish), 1999.

Ministry of Economic Affairs, Venture capital (in Danish), Delrapport nr. 4 published by the Committee on the Financial Sector after the Year 2000, 1999.

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Version 1.0 April 2002 Nationalbanken.
Published by Danmarks Nationalbank December 2002, http://www.nationalbanken.dk