Tax Avoidance and Excess Burden of Income Tax

Our main objective in this paper is to show that income taxation creates an extra burden or distortion when tax avoidance is available. We present a labor supply model with endogenous asset portfolio choice and show that tax avoidance by trading assets impacts labor supply response and total excess burden of income tax. In our model individuals are allowed to change their asset portfolio to reduce their tax liabilities, and this distortion is the main source of the higher efficiency cost in our model. Furthermore, we show that ignoring the avoidance responses leads to biased results when estimating the labor supply distortion and welfare cost of a tax reform. Progressivity of a given tax system is predicted to be less than the formal tax code due to tax avoidance through tax arbitrage.