Second, the standard procedure in the literature is to trace out individuals’ budget sets by changing the supply of hours, holding capital income constant.
However, in the presence of tax arbitrage it is inappropriate to treat (reported) capital income as an exogenous variable in the regression. In our models, individuals’ asset transactions are an integral part of the labor supply decision, and the position and slope of individuals’ budget sets depend on the simultaneous determination of hours and portfolio composition.
Third, there is the issue of measurement error in net capital income. The prime evidence about labor supply in Sweden, and in many other countries, stems from studies that rely on data from individuals’ tax returns. But the essence of tax arbitrage is that people invest their wealth in ways that are imperfectly measured or registered by the tax authorities. More info The resulting error in the measurement of net capital income will typically be correlated with the gross wage.
The income tax returns of high-wage individuals will to a much greater extent than the income tax returns of low-wage individuals understate true capital income. As a consequence, there will be a downward bias in the estimate of the gross wage coefficient. What the econometrician interprets as evidence of a backward bending labor supply function may simply reflect the influence of unobservable asset income.
Of course, the severity of these problems differ quite a lot across countries, and between different time periods. In a situation with binding credit constraints, and low tax rates, it might be quite innocent to ignore the implications of tax arbitrage. Also, the problems may not be equally severe for all subgroups in the labor market. The econometric issues that we raise are likely to be of particular importance for the study of the labor supply decisions of the affluent. These individuals have much to gain from lowering their taxable income, and there is reason to believe that they have easier access to the credit market than other people.