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Using notches to uncover optimization frictions and structural elasticities: theory and evidence from Pakistan

Kleven, Henrik J. and Waseem, M. (2013) Using notches to uncover optimization frictions and structural elasticities: theory and evidence from Pakistan. Quarterly Journal of Economics, 128 (2). pp. 669-723. ISSN 0033-5533

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Identification Number: 10.1093/qje/qjt004

Abstract

We develop a framework for nonparametrically identifying optimization frictions and structural elasticities using notches—discontinuities in the choice sets of agents—introduced by tax and transfer policies. Notches create excess bunching on the low-tax side and missing mass on the high-tax side of a cutoff, and they are often associated with a region of strictly dominated choice that would have zero mass in a frictionless world. By combining excess bunching (observed response attenuated by frictions) with missing mass in the dominated region (frictions), it is possible to uncover the structural elasticity that would govern behavior in the absence of frictions and arguably capture long-run behavior. We apply our framework to tax notches in Pakistan using rich administrative data. While observed bunching is large and sharp, optimization frictions are also very large as the majority of taxpayers in dominated ranges are unresponsive to tax incentives. The combination of large observed bunching and large frictions implies that the frictionless behavioral response to notches is extremely large, but the underlying structural elasticity driving this response is nevertheless modest. This highlights the inefficiency of notches: by creating extremely strong price distortions, they induce large behavioral responses even when structural elasticities are small.

Item Type: Article
Official URL: http://qje.oxfordjournals.org/
Additional Information: © 2013 The Authors
Divisions: Economics
Subjects: H Social Sciences > HC Economic History and Conditions
JEL classification: H - Public Economics > H3 - Fiscal Policies and Behavior of Economic Agents > H31 - Household
J - Labor and Demographic Economics > J2 - Time Allocation, Work Behavior, and Employment Determination and Creation; Human Capital; Retirement > J22 - Time Allocation and Labor Supply
O - Economic Development, Technological Change, and Growth > O1 - Economic Development > O12 - Microeconomic Analyses of Economic Development
Sets: Departments > Economics
Collections > Economists Online
Date Deposited: 14 May 2013 09:39
Last Modified: 20 Mar 2019 02:10
Funders: International Growth Centre (IGC), Pakistan Programme
URI: http://eprints.lse.ac.uk/id/eprint/50244

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