Optimal Deductibility: Theory, and Evidence from a Bunching Decomposition

38 Pages Posted: 3 Mar 2018 Last revised: 29 Apr 2018

See all articles by Steven Hamilton

Steven Hamilton

George Washington University - Department of Economics

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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

Hamilton, Steven, Optimal Deductibility: Theory, and Evidence from a Bunching Decomposition (April 12, 2018). Available at SSRN: https://ssrn.com/abstract=3125568 or http://dx.doi.org/10.2139/ssrn.3125568

Steven Hamilton (Contact Author)

George Washington University - Department of Economics ( email )

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