Abstract
We exploit kinks and notches in the UK personal tax schedule over a 40-year period to investigate how taxpayers respond to income tax and social security contributions. At kinks, where the marginal rate rises, we find bunching by company owner-managers and the self-employed, but not those with only employment income. Responses to notches, where the average rate rises, provide compelling evidence that this is because most employees face substantial frictions: fewer than a quarter bunch even where doing so would increase both consumption and leisure. We develop a new approach for identifying selection in who responds and for decomposing responses into hours and wage components. We find that those employees who do bunch at notches are almost exclusively part-time workers, but tend to have lower wages and work more hours than those part-time workers who do not bunch.
Highlights
How individuals respond to personal income taxes is of enormous importance for public policy, with both the revenue yield from reforms and the efficiency costs of taxation highly dependent on the magnitude and nature of responses
This paper has investigated behavioural responses to income tax and social security contributions, exploiting cross-sectional variation created by thresholds in UK tax schedules over a 40-year period
At thresholds where the marginal tax rate fell, we found no sign of a dip in the density of the earnings distribution
Summary
How individuals respond to personal income taxes is of enormous importance for public policy, with both the revenue yield from reforms and the efficiency costs of taxation highly dependent on the magnitude and nature of responses. New ‘bunching’ estimators have been developed which attempt to estimate the ETI by exploiting the prediction of basic neoclassical labour supply models that individuals should bunch at upward kinks and notches in the tax schedule (where, respectively, the marginal and average rates rise at a threshold) While research adopting this design has found evidence of substantial bunching by those (such as the self-employed) with significant scope for income manipulation, tax planning and evasion, evidence of bunching by employees is limited and appears to imply very low elasticities (Kleven 2016).. Kleven and Waseem (2013) look at bunching for a group of relatively high-income workers in the formal sector in Pakistan, finding that around 90% of them do not optimise their earnings in response to a notch due to frictions Applying this same approach, we show that in an advanced economy, most working-age employees at various points across the earnings distribution face frictions in excess of 2% of earnings, and that for most low-paid workers the frictions are much bigger than that.
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