TAX ARBITRAGE: Introduction

In the 1970s and 1980s, Sweden imposed the industrialized world’s most steeply progressive income tax schedule. Due to the compound impact of income taxes, value added taxes, and payroll taxes, the marginal tax wedges (differences between productivity and real take home pay) for some broad categories of employees was in the range 80-90 percent. The gut reaction of most economists would certainly be that tax distortions of such magnitudes ought to imply a high and easily detectable cost in the form of lost work hours.

Even so, recent studies suggest that the response in work effort was quite modest. A recent evaluation of the major 1990-91 Tax Reform Act conveys a similar picture. Despite marginal rate cuts by between 24 and 27 percentage points for large groups of full-time employees, labor supply appeared unresponsive.

Do Swedes bother less about incentives than people at large? We believe the answer is no. There are many ways of rationalizing a small labor supply response to high tax wedges. Lindbeck (1995) maintains that because of the slow-moving influence of habits and social norms, it may take a long time until disincentive effects harm the economy.

Sandmo (1991) discusses the possibility that the welfare state may mitigate tax disincentives by public spending programs that promote labor supply. Similarly, Bergstrom and Blomquist (1996) suggest that the extensive provision of heavily subsidized child care favors market work in spite of high taxes. According to Summers, Gruber and Vergara (1993), the corporatist Swedish wage bargaining system may have internalized some of the negative labor supply disincentive effects.