Misperceptions of Nonlinear Budget Sets: Evidence from Administrative Tax Data

Budget set kinks are much studied in economics, including in the context of “bunching” estimators that assume individuals react to the true marginal tax rate. We document that individuals disproportionately “left-bunch” below kinks in the context of the Social Security Earnings Test where incentives from its actuarial adjustments should instead push many rational agents to bunch above the kink. We show that the left bunching in this case cannot be explained through standard, rational reactions to the incentives. We demonstrate that these patterns represent the first empirical evidence consistent with “spotlighting,” wherein individuals misperceive the local marginal tax rates as applying throughout the tax schedule and therefore treat the kink as a notch. In the context of the Earnings Test, this misperception provides an explanation for why literature has found large earnings responses despite the fact that the Earnings Test typically creates weak incentives for rational agents to adjust earnings. More generally, if individuals perceive kinks as notches, then elasticities estimated from bunching at kinks where this misperception may be at play may be significantly over-estimated.