TAX ARBITRAGE: Introduction 3

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As a consequence, the statutory tax rate is not a reliable measure of how the tax system affects the opportunities of individuals and firms, and the true budget sets reflects not only the apparent relative prices that would prevail in the absence of avoidance, but also how real behavior facilitates avoidance and vice versa” (Auerbach and Slemrod, p. 627).
From empirical observations such as these it is surprising that the labor supply literature abstracts from issues of tax planning and tax arbitrage.

The econometric analysis of labor supply typically treats an individual’s asset income as exogenous, and determined independently of the supply of hours; see e.g. Hausman (1981), MaCurdy, Green and Paarsch (1990) and Blomquist (1996). The positive analysis of how tax changes affect labor supply implicitly assumes that the effective marginal tax rate changes in tandem with the statutory marginal tax rate. The normative analysis of income taxation following Mirrlees (1971) rests on the assumption that the optimal income tax schedule is some nonlinear function applied to true labor income.
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TAX ARBITRAGE: Introduction 2

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But there might be an even simpler reason for the modest labor supply response. There is good reason to believe that the statutory rate of tax progression exaggerated the labor supply distortions that confronted Swedes with high incomes and high education. Two decades ago, Nobel Laureate Gunnar Myrdal (1978) complained that high marginal tax rates had created so strong incentives for high-income individuals to exploit a variety of tax avoidance schemes that the tax system no longer redistributed income.

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TAX ARBITRAGE: Introduction

In the 1970s and 1980s, Sweden imposed the industrialized world’s most steeply progressive income tax schedule. Due to the compound impact of income taxes, value added taxes, and payroll taxes, the marginal tax wedges (differences between productivity and real take home pay) for some broad categories of employees was in the range 80-90 percent. The gut reaction of most economists would certainly be that tax distortions of such magnitudes ought to imply a high and easily detectable cost in the form of lost work hours.

Even so, recent studies suggest that the response in work effort was quite modest. A recent evaluation of the major 1990-91 Tax Reform Act conveys a similar picture. Despite marginal rate cuts by between 24 and 27 percentage points for large groups of full-time employees, labor supply appeared unresponsive.
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LIBERALIZATION IN SERVICE NETWORKS: The size of the gains 5

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Sensitivity Analysis of Regional Welfare Results for international telecom service liberalization (Welfare effects of Hicksian EV as percentage of GDP)
We have performed some limited sensitivity analysis using this model to explore ranges of welfare estimates by region as we vary production side elasticities (the model demand side is Cobb-Douglas). Results are reported in Table 7, and the money metric welfare effects by region are little affected as elasticities of transformation change.

Conclusion

In this paper we explore the implications of international liberalization of network related services, such as telecoms. We argue that in the presence of network externalities, larger per capita benefits accrue to residents of smaller countries on expanding international networks, which roughly offsets differences in numbers of residents (country size). Unlike for trade in goods, gains from liberalization can be of approximately equal absolute size across small and large countries.
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LIBERALIZATION IN SERVICE NETWORKS: The size of the gains 4

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Table 4 and its accompanying notes set out the details of how we have manipulated basic data to obtain a model admissible benchmark equilibrium data set for model calibration10. We use this for counterfactual equilibrium analysis in which we reduce the differential pricing in all regions between international and domestic calls by one half, and then perform sensitivity tests in order to assess the robustness of model results to alternative values of elasticity parameters in production.

Calibrating our two service model to the information in table 4 yields the calibrated model parameters reported in table 5. The share parameters in the demand functions are computed using income and price information applied to Cobb-Douglas demand functions, with the sum of share parameters constrained to equal one. Share parameters in the production possibility frontier are computed using information on the value of goods and two types of services produced, and the elasticities of transformation by region. Both sets of share prameters are dominated in their first component by GNP which is large relative to the service categories.
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LIBERALIZATION IN SERVICE NETWORKS: The size of the gains 3

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To empirically parameterize the model, we need estimates of preference and technology parameters for each of these regions in the model. In the absence of literature estimates on the relevant elasticities, we have used a value of unity for the transformation elasticities in each region, which we then vary in subsequent sensitivity analysis.

The X parameters in preferences determining the strength of the network externality effects are also important, and we have assumed them to be 0.1 in all countries. Using these assumptions, we calibrate share parameters of preference functions and production frontiers using 1991 data on call volumes, implied call prices, and GDP published in the World Telecommunication Development Report (WTDR) (ITU, 1994) and the World Development Report (WDR) (World Bank (1993)).
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LIBERALIZATION IN SERVICE NETWORKS: The size of the gains 2

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Table 2 lists both specifications and results from both of these calculations, and compares Nash equilibrium outcomes to those under no intervention (free trade in the goods trade model). Because of the network externality accruing to own country residents, origin countries have an incentive to subsidize own consumption of internationally traded services, but destination countries have an incentive to apply a significant tax due to revenues transferred from abroad under the tax.

As a % of national income, results in Table 2 suggest that the welfare gains from moving to no intervention (the analogue of free trade) are larger in the two service type model than in the trade model. On the basis of these calculations we suggest that country size seems to play a more pronounced role in the services case than in the goods trade tariff war. The gains from liberalization are the considerably larger in the network related services case than in the goods case with a similar parametric specification.
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LIBERALIZATION IN SERVICE NETWORKS: The size of the gains

Having argued that the country division of the gains from international liberalization in network related services will typically differ from that for trade in goods, we next proceed to a discussion of the size of the gains from such liberalization.

We analyze the size of the gains from liberalization in a cross country policy game by comparing Nash equilibrium and free trade outcomes. The network related service policy game differs from a conventional tariff game (Johnson (1954), Gorman (1957)) in which both countries apply tariffs to their own imports. In this game, both countries have the ability to tax service flows between countries; the origin country through regulation of the service flow as it leaves its own border, and the destination country through regulation of flows from its own border onward within the country of the eventual recipient of the network related service9. Thus, in the two country case four tax rates t. are involved in the game; the tax rates charged by country j on services originating in country i.
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LIBERALIZATION IN SERVICE NETWORKS: Two Service Model 2

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and this income is spent on purchasing goods and services. Household budget constraints now imply that
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and demands for goods and services by each household are derived from maximization of Cobb-Douglas household utility functions subject to the household budget constraints (19).
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Taxes charged by national governments on S2 purchased at home can be incorporated into this framework, and distort the relative prices of both services and goods, and among services, reducing purchases of externality generating international services.
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LIBERALIZATION IN SERVICE NETWORKS: Two Service Model

Liberalization in this case involves lowering barriers to international communication, and is reflected in reduced tax rates in all countries on purchases of international network related services. This form of services liberalization, unlike that considered in the previous section, generates relative price effects and, hence, quantity responses.
We use specific functional forms for this purpose; in this case a constant elasticity of transformation (CET) function to describe the transformation of endowments into goods and services, but now one which incorporates two service types S1 and S2 one of which is supplied domestically and the other internationally, i.e.
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where Yn is the fixed resource endowment of county n, GtJ is goods production in country n, S’n is production of service type 1 in country n, and S2 is production of service type 2 in country n. ij\ ifn and rfn are share parameters in production, and cr is the country n elasticity of transformation.

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