Estimating Taxable Income Responses with Elasticity Heterogeneity 

Abstract: Previous research on estimating the elasticity of taxable income (ETI) only allowed one source of heterogeneity. By additionally introducing elasticity heterogeneity, we show that existing methods yield elasticities that are biased and local. We propose a novel instrument based on tax rate changes across the entire taxable income distribution to overcome these shortcomings. We illustrate the empirical importance of elasticity heterogeneity by using the NBER tax panel for 1979-1990. Reconciling the remarkable divergence of estimates in the previous literature, we find that a positive elasticity heterogeneity bias explains previous high estimates, whereas overweighting of inelastic taxpayers accounts for previous low estimates. Estimation based on the new instrument yields a global ETI of around 0.7.

DOI: https://doi.org/10.24149/wp1611r2

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