Nonparametric estimation of structural labor supply and exact welfare change under nonconvex piecewise-linear budget sets

Abstract

This paper contributes to the literature in both the estimation of structural labor supply and the calculation of exact welfare effects. It proposes a nonparametric method to estimate labor supply with nonconvex piecewise-linear budget sets. Different from previous literature such as Blomquist and Newey (2002) and Soest, Das, and Gong (2002), our method focuses on a nonparametric specification of an indirect utility function. We find that working with the indirect utility function is very useful in simultaneously addressing the labor supply problems with nonconvex budget sets, unobserved heterogeneity, labor nonparticipation, and measurement errors in working hours that previous literature was unable to account for. Further, two methods are developed to calculate exact welfare effects due to reforms of a nonlinear tax system. This paper also includes applications to the 1986 tax reform and 2001 Bush tax cut.