TAX ARBITRAGE: Introduction 2

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.

The tax system looked egalitarian, but in practice taxpayers restored the incentive structure by perfectly legal asset transactions. A decade later the perception that the rich and the highly educated could avoid the bite of the progressive income tax had reached the highest political circles. At a press conference in 1988, the Social Democratic Minister of Finance and the leader of the powerful confederation of blue-collar workers seemed to agree that thirty years of egalitarian tax policy had come to a dead end.

Both men denounced the old tax system as being ‘rotten’, or ‘perverse’. Due to the pervasive nature of tax avoidance, spurred by high marginal tax rates and financial deregulation, high-income individuals escaped their fair share of the tax burden. Two years later tax rates were drastically lowered.

The observation that the study of labor supply may require an integrated analysis of how decisions on tax planning and asset trade affect budget sets is not novel. In an overview of the lessons from the U.S. Tax Reform Act of 1986 (TRA86), Auerbach and Slemrod (1997) conclude that the most responsive decisions were financial and accounting activities that primarily seemed to serve the purpose of affecting reported income, while ‘real’ activities like labor supply, savings, and investment seemed to respond very little.