In the process the gains from tax arbitrage will be concentrated to the tails of the wage distribution, while individuals with average wages might lose out. We also show that it is easy to construct examples where tax arbitrage leads to increased efficiency. When we introduce various – seemingly realistic – limitations on the arbitrage process marginal tax rates and taxable incomes will no longer be the same for all individuals.
But the distribution of taxable income will still be more compressed than the wage distribution, and the formal rate of tax progression will still exaggerate the labor supply disincentives of high-wage individuals. A final insight, which appears robust across models, is that a failure to account for tax arbitrage in econometric work on labor supply and in applied work on income distribution may lead to serious problems.
We do not suggest that our analysis is universally applicable. The kinc/of mechanism^ that we examine here seeing most relevant in countries with high marginal tax rates, non-uniform capital taxation, and well-developed financial markets.
As we discuss in the next section, Sweden seems to fit these conditions quite well – at least before the 1990-91 tax reform. In countries with less developed financial markets, lower marginal tax rates, and/or uniform capital taxation, there is much less scope for tax arbitrage. Even so, the rapid pace of innovation in financial markets seems to suggest that our topic is of more general interest.