As a consequence, the statutory tax rate is not a reliable measure of how the tax system affects the opportunities of individuals and firms, and the true budget sets reflects not only the apparent relative prices that would prevail in the absence of avoidance, but also how real behavior facilitates avoidance and vice versa” (Auerbach and Slemrod, p. 627).
From empirical observations such as these it is surprising that the labor supply literature abstracts from issues of tax planning and tax arbitrage.
The econometric analysis of labor supply typically treats an individual’s asset income as exogenous, and determined independently of the supply of hours; see e.g. Hausman (1981), MaCurdy, Green and Paarsch (1990) and Blomquist (1996). The positive analysis of how tax changes affect labor supply implicitly assumes that the effective marginal tax rate changes in tandem with the statutory marginal tax rate. The normative analysis of income taxation following Mirrlees (1971) rests on the assumption that the optimal income tax schedule is some nonlinear function applied to true labor income.
In the following, we examine how tax avoidance in the form of trade in well-functioning asset markets interacts with the basic labor supply model. In the words of Stiglitz (1985), we study mainly those ‘paper transactions’, which at a negligible social resource cost lead to a reduction in tax liabilities whenever marginal tax rates differ across individuals.
Within the simplest model, we show that unlimited trade in perfect asset markets has a number of striking implications. Tax arbitrage will continue until all individuals have the same marginal tax rates and taxable incomes.