2 Welfare economics framework

The theory of welfare economics assumes that the market will work. Based on welfare economics, two theorems will apply. The first one assumes that the Pareto efficient outcome will be achieved in the case of perfect competition. A Pareto efficient allocation does not necessarily have to coincide with the allocation as desired by the community. According to the second welfare theorem the Government could achieve each Pareto efficient result by redistributing income appropriately and subsequently let the market work following perfect competition. The reality is however that the conditions of the first and second welfare theorem cannot be achieved. This is primarily the result of market failures. Government intervention could be necessary for that reason. In addition the Government does not possess the correct information necessary to redistribute income. If the Government did possess this information, no usage of distortionary tax legislation would be necessary. As in reality distortionary tax legislation exists, the Government has reason to correct its own actions.

First of all there is reason for Government action in the case of market failure. Where it concerns the taxation regarding business transfers, forms of relevant market failure are (positive) external effects and a deficient operating capital market. There are external effects when consequences occur summoned by production and consumption, which are not processed in the price. In the context of business transfer issues the essence is whether business transfers provide advantages for parties, which are not directly involved in the transfer. Based on studying literature, I have come to the conclusion that it has not been empirically underpinned that these external factors do occur. Only parties directly involved seem to profit from the transfer. The value of a business will be taken into account in the price. External factors are therefore in my opinion no reason for the Government to intervene. Intervention is however considered legitimate when capital markets are not functioning properly. Asymmetrical information is especially important in the context of this research. Supply of debt can therefore be more than the demand for debt. It could therefore indeed be possible that the entrepreneur is not able to attract funds to finance the business transfer. Equally, a deficient operation capital market could affect the transferor financing the income tax claim resulting from the transfer. This also applies to the transferee as regards the gift or inheritance tax. Intervention by the Government can be legitimate, but only if the right conditions are set.

In a case where the tax legislation evokes distortions, this could be a reason for the Government to correct its own actions. It has been shown in the study that the way of taxing capital gains creates a distortion. The H-S income concept is the most pure income concept according to an ability-to-pay point of view. On the basis of this income concept all the advantages need to be included in the levy, also the unrealized capital gains. This happens under a capital appreciation tax. Under a capital appreciation tax, business transfer facilities aimed on the income tax claimwould no longer be necessary. Introduction of a capital appreciation tax however raises valuation and liquidity issues. Based on these reasons I reject a capital appreciation tax relating to substantial interests in incorporated businesses and also for unincorporated businesses. However, I still consider that theoretically the capital appreciation tax is the most desired system. Within the current regime, a capital gains tax, capital gains will only be taxed when realized. This could encourage the taxpayers to delay the transfer and resulting taxation. Taxpayers however are disadvantaged under the capital gains tax, as the capital gains will suddenly be taxed against the progressive rate, which can lead to a substantial taxation. In my opinion Government interference as a result of a distortion in the capital gains tax is only legitimate in a case where the outcome under the capital gains tax is more disadvantageous for the taxpayer than the outcome under a capital appreciation tax. The conclusion in this respect will be discussed under section 6.

Even when it has been determined that Government interference is legitimate, the Government should consider carefully whether actions should be undertaken via the tax legislation. There are advantages and disadvantages to be taken into account relating to tax expenditures, which need to be well balanced. The main advantage of tax expenditures versus direct expenses is that these are included in the existing implementing agency. An important disadvantage of tax expenditures is that this enhances complexity of the tax legislation. In addition the injection of tax expenditures creates a tension between efficiency and fairness. One group of taxpayers will be favored compared to another group. This could be efficient, but the question is whether certain measures are able to stand the test of equality.

Even when it is determined that the Government has reason to intervene, this does not imply that the Government should need to do so. The question is whether the Government is able to perform better, as they have limited information, restricted control with regard to reactions from the market, limited control regarding bureaucracy, as well as restrictions, which are imposed by political processes. This has to be considered when the Government implements business transfer facilities.