The Dual Income Tax (DIT) is a combination of both comprehensive income tax system and flat tax system. It is not a plain comprehensive system with a single progressive tax development or a flat tax with only a proportional tax, but a combination of both. It attempts to tax the personal capital income at a uniform (low) proportional tax while maintaining a (higher) progressive rate on the labour income.
This taxation system was first introduced in Denmark 1987, other northern countries as Finland, Norway or Sweden followed. Until today the Norwegian system is seen as the most experienced one and is seen as very respected for the consistency with which it was implemented. Until today the system as such had to be subject to changes. Germany introduced the dual income tax system in 2009. Income was taxed according to the global tax system with the progressive taxation method whereas capital income was taxed deducted at source at a rate of 25%, without exception.
A unique aspect of the dual income tax system is the problem of how to distinguish labor from capital income when the two are mixed together. A typical example is the business man who provides labor and capital with one business. These types of business are tempted to declare their gains of labor as capital income to avoid the higher progressive tax. The Finnish Government countered this problem with a division of dividends paid by unlisted companies into two components. Each half is then treated as either labor or capital income.
Advantages of the Dual Income Tax System
A country with lower capital income taxation becomes more attractive to foreign investors with a higher local capital income tax. This also has a positive effect on the attractivity of corporate investments. The further positive impact on the economic development is obvious.
The generation of capital income tax by collecting it at its source, creates a higher possibility of tax payment in comparison to individual tax declaration.
The incentive for capital exports and tax avoidance is reduced by a lower tax rate on capital income. It also diminishes the risk of tax evasion.
Neutrality or simplicity means an equal treatment of capital income tax without personalized deductions or any other special handling.
The main tax income which is raised for public finance can be brought up alone by the labour income tax.
Disadvantages of the Dual Income Tax System
Compared to the comprehensive taxation system, the dual income tax system has left the tax arbitrage is theory open. This is the (“income shifting between higher-taxed labor income and lower-taxed capital income”) to gain the difference between these two tax rates. Nevertheless it can reduce the incentives of capital exports to “cheaper” capital income neighbor countries.
A common mentioned disadvantage of the dual income tax system it the so called problem of the double taxation. This taxation problem does not only exist in this taxation system but is characteristic for this system. Double taxations is a taxation principle referring to income taxes that are paid twice on the same source of earned income. The problem herewith is the question when and how the best way is to tax capital income. The current scheme taxes the first time when earned as labor income. The taxpayer now has got two options, one would be to consume directly and have no further problems. In times of shrinking pension accounts many people prefer to save the money in forms of capital investment eg. shares, bonds etc. The real dual taxation problem now appears when these capital investments start to pay their interests or dividends. The argument behind this contra argument is that the capital to buy a investment was already taxed.