Trading off efficiency and equity A Scandinavian puzzle?

Útdráttur

One of the most fundamental trade-offs in economics is that between efficiency and equity. The performance of the Scandinavian countries with high incomes and low inequality in an international perspective creates a paradox in this context since these countries are also high tax countries. The Scandinavian experience seems to suggest that tax distortions are small, and the trade-off between efficiency and equity therefore is relatively flat. This paper argues that this does not necessarily imply that economic incentives do not matter, but rather that the standard distortionary effects of taxation may be countered by other effects. The particular effect considered here is the interaction between taxation and risk. It is shown that the implication of taxation for labour supply depends critically on whether the return to work is risky since taxes provide implicit insurance of income risk. The wedge implied by income taxation depends negatively on risk, implying that tax distortions are smaller when explicit account is taken of risk. As a consequence, labour supply may be rather insensitive to tax changes or may even be increasing in the tax rate. It is an implication that the trade-off between incentives and insurance, or equivalently efficiency and equity, may be rather flat or even non-monotone.