Optimal Deductibility: Theory, and Evidence from a Bunching Decomposition
38 Pages Posted: 3 Mar 2018 Last revised: 29 Apr 2018
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Optimal Deductibility: Theory, and Evidence from a Bunching Decomposition
Optimal Deductibility: Theory, and Evidence from a Bunching Decomposition
Date Written: April 12, 2018
Abstract
I define a new tax instrument, the 'deductibility rate,' which specifies the proportion of eligible expenses a taxpayer may deduct when preparing her taxes. If the utilities of gross income and deductions are separable, then the deduction elasticity reflects the revenue leakage caused by greater deductibility. To identify this elasticity, I develop the first method to decompose bunching in taxable income into its constituent parts, exploiting the removal of a notch in the tax schedule. This setting also generates an observed counterfactual density, obviating the parametric assumptions routinely made in bunching studies. Applying this method to new administrative tax data from Australia, I find that while deductions account for just 5% of taxable income, they account for 35% of the response of taxable income to the tax rate. Based on an elasticity of taxable income of 0.06, the deduction elasticity is -0.45, and the gross-income elasticity is 0.04. Consistent with standard optimal-tax logic, the sensitivity of deductions to the tax rate suggests that restricting deductions could raise welfare.
Keywords: Deductions, bunching, decomposition, optimal taxation, elasticity of taxable income
JEL Classification: H21, H24, H26, C21
Suggested Citation: Suggested Citation