Also, all our models are single-period ones, and they do not account for the fact that there is an intertemporal dimension to many tax arbitrage strategies (think of the postponed taxation associated with pension plans). Developing models that explore the implications of such alternative mechanisms certainly seem like a worthwhile exercise read only.
We believe that research on how tax arbitrage interacts with labor supply decisions may shed light on a number of important questions concerning modem systems of income taxation. First, what makes people work, given the very high marginal tax rates that can be observed for some countries during some periods? The traditional answer has been that labor supply is rather inelastic. Our proposed answer is different. With the tax avoidance technologies that became increasingly available during the 1980s, those who care about incentives need not pay those high tax rates.
Second, how come so many countries turned their tax systems into simple, linear ones during the 1980s and 1990s? Our suggested answer is that during this period, credit markets became increasingly well-functioning. Thus the effective tax schedules became more linear, and the reforms that were undertaken can be seen as a simple recognition of this fact.
Third, are sophisticated non-linear optimal tax schedules in the spirit of Mirrlees (1971) really relevant? In the presence of tax arbitrage such second-best tax schedules are not attainable. Regardless of the ambitions underlying the official, nonlinear schedule, the effective tax schedule tends to be linearized.18 A benevolent government may thus have to settle for a third-best solution, which involves finding an optimal linear, or piece-wise linear, income tax.