Monday, June 10, 2013

Biased taxable income elasticities

Anytime you apply a distortionary tax, it bring well-being losses from the distortion (although the revenue can be used for well-being enhancing public goods). In addition, there are social losses that arise from the fact that people try to evade the tax by shift to other goods, go informal, or in the case of income shift compensation to non-taxable benefits or other amenities like more flexible work hours. Traditionally, the literature has evaluated the deadweight loss from taxation by looking at the income elasticity of the tax. That may be too simple a statistic in this case.

Brendan Epstein and Ryan Nunn show that ignoring the endogeneity of the non-taxed benefits and amenities leads to serious biases in the income elasticity and thus deadweight loss, to the point that it provide not good guidance on how to set tax rates. They basically do this by providing examples: build simple models, calibrate them, generate data from them and show that the usual empirical method provide crassly wrong estimates. An econometrician could in principle do better by taking all this in account, unfortunately data will be very hard to come by for this.

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