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Discrete earnings responses to tax incentives: Empirical evidence and implications

Author

Listed:
  • Tuomas Kosonen

    (Palkansaajien tutkimuslaitos)

  • Tuomas Matikka

Abstract

We study the consequences of discrete rather than continuous earnings choice sets on individual responses to income taxes. In our empirical application, we utilize an income notch created by the study subsidy system for higher education students in Finland and a reform that shifted out the location of this notch. We find that the reform, which changed the income tax schedule by increasing the location of the notch from 9,000 euros to 12,000 euros, affected the income distribution from earnings of about 2,000 euros onward. Because the tax schedule did not change around these lower incomes, the wide-ranging response to the reform constitutes a puzzle from a standard model point of view. We develop further results, theoretical arguments and a simulation model that all suggest that the shifting of the distribution can be explained with discrete earnings choices. Moreover, we discuss the welfare implications of discrete earnings choices, and find that welfare losses can be greater than empirically estimated if the underlying behavior is constrained by discrete earnings and they are thought to be represented by continuous earnings choices.

Suggested Citation

  • Tuomas Kosonen & Tuomas Matikka, 2019. "Discrete earnings responses to tax incentives: Empirical evidence and implications," Working Papers 326, Työn ja talouden tutkimus LABORE, The Labour Institute for Economic Research LABORE.
    • Handle: RePEc:pst:wpaper:326
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    References listed on IDEAS

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    Cited by:

    1. Spencer Bastani & Daniel Waldenström, 2020. "The Ability Gradient in Bunching," CESifo Working Paper Series 8233, CESifo.
    2. Drahomir Klimsa & Robert Ullmann, 2023. "Threshold-dependent tax enforcement and the size distribution of firms: evidence from Germany," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 30(4), pages 1002-1035, August.

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    More about this item

    Keywords

    Tax incentives; optimization frictions; discrete earnings choices;
    All these keywords.

    JEL classification:

    • H21 - Public Economics - - Taxation, Subsidies, and Revenue - - - Efficiency; Optimal Taxation
    • H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies
    • J22 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Time Allocation and Labor Supply

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