Income Mobility of Owners of Small Businesses when Boundaries between Occupations are Vague



1. Introduction

Policy-makers are paying increasing attention to the economic conditions under which owners of
small firms operate, not least because small businesses are considered to be vital to economic growth,
innovation and the dynamics of economic systems. This concern for the small business is reflected in
tax policies. For instance, the low, flat-rate capital income tax that is common to the dual income tax
systems of Norway and the other Nordic countries was designed to encourage entrepreneurial
initiative and other business activities. In this paper we ask whether owners of small businesses have
experienced any improvement in their position on the income scale (relative to wage earners) in the
period from 1993 to 2003. This particular timeframe was chosen because the dual income tax system
came into force in Norway in 1992.1 Insofar as dual income tax systems are clearly of some
considerable interest to policy-makers worldwide, it is desirable to obtain information about effects of
such tax systems on, for instance, the performance of owners of small businesses.

A main point of this paper is that identifying business owners in the data is a significant
challenge, a problem exacerbated by the dual income tax system. The present study uses income
statistics for persons and families compiled by Statistics Norway (2006a). They include information
obtained from income tax returns for the whole population for every year between 1993 and 2003. As
the whole population is covered, it is a rich source of information. However, owners of incorporated
businesses are categorized as employees in these data, whereas in most other respects they are
classified as business owners, similar to the self-employed. This is a definitional measurement
problem in many countries, including the US and the UK (Parker, 2004).

The Norwegian dual income tax system exacerbated the problem. It levyed a flat 28 percent
tax rate on corporate income, capital and labor income, and then imposed a progressive surtax
schedule on labor income, taxing wage income at 49.5 percent at the margin.2 While this system did
away with the double taxation of dividends and gave tax-payers full credit for dividend payments at
the corporate level, the capital gains taxation system introduced a valuation system to control for gains
already paid for through retained firm profit. However, as these disparate schedules for capital and
labor income threatened to increase the likelihood of income shifting, preventive regulations were
enforced with the introduction under the tax reform of 1992 of what was known as the split model of
taxation for the self-employed and closely held firms (i.e., firms in which more than two-thirds of the
shares are held by one person). Under this model, business income was divided into a capital and a
labor income tax base, the latter being subject to surtax. Owners of closely held firms are normally

1 A reformed tax system was put in place in 2006, see S0rensen (2005).

2 This is according to the schedule of 1993, in which the second tier of the surtax was applicable for incomes above NOK
230,000 (US$ 32,500 according to exchange rates for 2003, 1USD=7.08 NOK, which we use in this paper).



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