Estimating the Elasticity of Taxable Income When Earnings Responses Are Sluggish

Abstract

Estimates of the elasticity of taxable income (ETI) is conventionally obtained by "stacking" three-year overlapping differences in the estimation. In effect, this means that the ETI estimate is an average of first-, second-, and third-year effects. The present paper draws attention to this implication and suggests that if there is gradual adjustment the analyst should rather estimate the ETI by a dynamic panel data model. When using Norwegian income tax return data for wage earners over a 14-year period (1995−2008) in the estimation, an ETI estimate of 0.15 is obtained from the dynamic specification, compared to 0.11 for the conventional approach. Importantly, the conventional approach fails to render a long-term elasticity estimate by increasing the time span of each difference.

Labor Supply Responsiveness to Tax Reforms

“…The standard ETI approach with overlapping differences has received critique for systematically underestimating the true elasticities if the behavioral adjustment process continues beyond the year of implementation. This is shown by papers such as Holmlund and Söderström (2008);Baekgaard (2014), andVattø (2020). They instead estimate short-run and medium-run effects separately by estimating dynamic income models.…”