Regression Estimates of the Elasticity

This chapter examines regression methods for estimating the elasticity of taxable income. There is an endogeneity problem, because income and the tax rate faced by individuals are jointly determined. Also, it would be desirable to compare incomes after the tax rate change to those that would have been reported had the change not taken place, but these are not observed. The chapter examines the use of instrumental variable regression methods. Early literature used, as an instrument for the net-of-tax rate, the rate that would be applicable post-reform but with unchanged income levels. The approach here instead involves estimating the dynamics of taxable income and using the parameters derived from this procedure to construct hypothetical post-reform incomes that would be expected in the absence of reform. From the resulting probability distribution of income for each taxpayer, two alternative instruments are obtained. One is based on the tax rate each individual would face if their income were equal to `expected income', conditional on income in the previous two periods. The other uses the conditional distribution of income for each taxpayer to obtain an instrument based on their `expected tax rate'.