We see, first, that one has to take the non-negativity constraint on labor supply seriously. By (15), t can be negative for small values of w. We have therefore simply assumed that the parameters are such that labor supply will be positive, the parameter configurations in the (v, k) space not satisfying this being in the upper left part of Figure 2. For other, admissible, parameter configurations, we see that it is easy to find cases where both high- and low-income earners would gain from the introduction of tax arbitrage, i.e., where both Дя and AL are positive. Finally, a word of caution is warranted.
In this model, we have assumed that tax arbitrage is costless, and it is therefore hardly surprising that one can find cases where the introduction of such arbitrage is welfare-enhancing in the sense of Pareto. In practice, there are real resource costs associated with most tax avoidance schemes, ranging from transactions costs and legal fees to costs associated with an inefficient allocation of risk, consumption, and productive capital. For example, since much tax avoidance activities involve real estate, an important cost probably consists of an oversized housing sector, and the possibility that the introduction of tax arbitrage leads to a Pareto improvement then becomes correspondingly smaller.
Introducing limitations on the arbitrage process
In the preceding section, we have seen how a simple arbitrage technology will lead to labor supply responses that are quite different from the ones commonly analyzed in the literature. The most striking implication is that unlimited arbitrage will lead to a complete equalization of taxable incomes, and of the effective marginal tax rates on labor income. Although data for some countries indicate that tax avoidance leads to a substantial compression of the distribution of taxable income relative to the distribution of labor income, incomes are of course not completely equalized – a fact that suggests that there are limits to the arbitrage process.
Obvious explanations are that imperfections in the capital market make it difficult to completely avoid taxation, or that the government is efficient in closing the loopholes that open up for arbitrage in the first place. In this section we will explore two ways of incorporating such considerations in the analysis, limitations on short sales, and tax arbitrage in an asset that yields a direct utility service. We discuss some implications for applied work on labor supply and income distribution in section 5. my payday loan