Understanding the elasticity of taxable income: A tale of two approaches

This paper conducts the first formal comparison of two main approaches (tax reform versus bunching approach) to estimate the elasticity of taxable income (ETI), a central parameter in the public finance literature since Feldstein (1999). Using a novel panel of administrative tax data from China and exploiting China’s progressive monthly wage income tax schedule and a tax reform in 2011, we document two key differences in the ETI estimates obtained from these two approaches. First, the tax reform ETI estimates increase concavely over time, while the bunching ETI estimates are much more stable. Second, the tax reform ETI estimates (around 4 in the long-run) are much larger than the bunching ETI (around 0.5), and the difference is statistically significant. To account for these facts, we develop a simple model where individuals in each period have some probability to permanently change hours of work without paying other costs but can temporarily adjust hours by paying additional costs. With stable wage rates, the two estimators should converge to the same underlying value. But with normal wage growth, the tax reform estimates converge to the true underlying parameter, whereas the bunching estimates can be far below the true figure.