Better Bunching, Nicer Notching

Abstract

Bunching-type estimators use mass points in an observed distribution to estimate elasticities, such as the elasticity of taxable income with respect to the net-of-tax rate. We clarify the assumptions necessary to identify these elasticities using as a single budget constraint that may contain any number of kinks and notches. Next, we derive the partially identified set for the elasticity and relate bunching estimators to censoring models. The result is an updated method that combines the insights of the bunching-type approach and a depth of knowledge from a vast econometric literature. Our approach results in quantitatively different estimates of the compensated elasticity of taxable income with respect to net-of-tax rate than bunching estimators in both Monte Carlo experiments and the context of the earned income tax credit.

Keywords: bunching, notching, tax kink, earned income tax credit

JEL Classification: H23, H24, H26