Taxation of Entrepreneurs Relative to Well Diversified Investors - A Swedish Perspective

The paper argues that cost of capital comparisons across closely held companies and entrepreneurial ventures on the one hand and widely held companies on the other, ought not to be based on an equal level assumption regarding the investors’ required rates of return, net of taxes. Theoretical considerations as well as empirical evidence show that the return requirements are much higher on investments by entrepreneurs in venture startups than on those by well diversified investors. Using earlier results based on the capital asset pricing model (CAPM), it is shown that the difference can be as high as a factor three. Given these circumstances, the paper concludes that by more or less neglecting this difference, the Swedish dual income tax system heavily discriminates against entrepreneurship and growth of small firms. This should be a lesson to other countries considering the mitigation of effects of capital mobility by a dual income tax, i.e. by using standardized measures of the amount of capital income to be taxed at lower rates than labour.