Bunching and Adjustment Costs: Evidence from Cypriot Tax Reforms

Abstract

We study adjustment costs in behavioral responses to income taxation, exploiting tax reforms that create and subsequently eliminate income tax kinks in Cyprus. Reduced-form evidence reveals substantial adjustment frictions attenuating bunching and de-bunching responses. Combining the empirical bunching moments with a structural model of frictional earnings supply, adjustment costs are estimated between EUR 93 and EUR 238 for wage earners. Moreover, we uncover important asymmetries in adjustment frictions, where bunching at a kink is costlier than de-bunching away from the kink. Finally, we find that self-employed individuals face considerably lower adjustment costs than wage earners.