TAX ARBITRAGE: Implications for empirical research

The analysis of the previous sections suggests that there are few general results on the incidence and efficiency effects of tax arbitrage. The answers to questions such as “Who gains and who loses from introducing tax arbitrage?”, and “Does tax arbitrage lead to a Pareto improvement?”, depend on the exact specification of the model. However, more robust insights appear to emerge when we turn to the implications of tax arbitrage and asset trade for empirical research. All our models – irrespective of their precise assumptions – seem to suggest that empirical studies that fail to account for tax arbitrage may come up with estimates that are seriously biased. Let us see why.

Econometrics of labor supply

In one form or another, the static labor supply function (1) – extended to include a measure of exogenous “non-labor income” – has been at the center of attraction in a large number of microeconometric studies that try to estimate how labor supply reacts to changes in economic incentives. Much of this literature has been preoccupied with the design of econometric techniques capable of dealing with nonlinear tax systems. In this process, the typical individual is modeled as maximizing utility with respect to work hours, subject to a nonlinear budget constraint that treats reported capital income as a given constant. This procedure creates a number of methodological problems.

First, as suggested by our model of constraints on short sales in section 4.1, there is the issue of self-selectivity. Based on initial asset endowments and productivity in the labor market, individuals choose between two labor supply functions. For arbitrageurs, the formal bracket schedule provides no information about marginal work incentives, and some equation like (6), or (19), applies.

For individuals who face a binding constraint in the asset market, the formal bracket schedule conveys all the information that is needed about marginal work incentives, and equation (21) applies. Econometric studies that build on the assumption that the labor supply function looks the same for all individuals will come up with biased estimates. Electronic Payday Loans Online