This paper generalizes the standard model of how taxes affect the labor-leisure choice by allowing individuals to change both their labor supply and avoidance effort in response to tax changes. Doing so reveals that both the income and substitution effect of taxes depend on both preferences and the avoidance technology, and econometric analysis will not in general allow one to separately identify the two influences, unless one can specify observable determinants of the cost of avoidance. The effective marginal tax rate on working must be modified by the addition of an avoidance-facilitating effect, which measures how much the cost of avoidance declines with higher true income. In an extreme case in which the cost of avoidance depends only on reported income, taxation has no compensated effect on labor supply regardless of preferences. This model provides a conceptual structure for evaluating to what extent, and in what situations, the opportunities for avoidance mitigate the real substitution response to tax reform.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
6582.
Length: Date of creation: May 1998 Date of revision: Handle: RePEc:nbr:nberwo:6582
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Find related papers by JEL classification: H20 - Public Economics - - Taxation, Subsidies, and Revenue - - - General
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