Optimal deductibility - evidence from a bunching decomposition

Presented by ANU College of Asia & the Pacific

Assistant Professor Steven Hamilton defines a new tax instrument, the ‘deductibility rate’, which specifies the proportion of eligible expenses a taxpayer may deduct when preparing her taxes. If the utilities of gross income and deductions are separable, then the deduction elasticity reflects the revenue leakage caused by greater deductibility. To identify this elasticity, he developed the first method to decompose bunching in taxable income into its constituent parts, exploiting the removal of a notch in the tax schedule.

This setting also generates an observed counterfactual density, obviating the parametric assumptions routinely made in bunching studies. Applying this method to new administrative tax data from Australia, Hamilton found that while deductions account for just 5 per cent of taxable income, they account for 35 per cent of the response of taxable income to the tax rate. Based on the elasticity of taxable income of 0.06, the deduction elasticity is -0.45, and the gross-income elasticity is 0.04. Consistent with standard optimal-tax logic, the sensitivity of deductions to the tax rate suggests that restricting deductions could raise welfare.

Steven Hamilton is Assistant Professor of Economics at The George Washington University in Washington, DC, and Visiting Scholar at the Tax and Transfer Policy Institute at the Australian National University. Steven is a tax economist who uses tax data to uncover the effects of taxes, which can inform the design of better tax policy. He has a PhD and MA in economics from the University of Michigan, and a Bachelor of Economics with First-Class Honours from the University of Queensland. Before graduate school, Steven worked on budget policy at the Australian Treasury.

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