Do Taxpayers Bunch at Kink Points?

A large body of empirical work in labor and public economics analyzes the behavioral response of earnings to taxes and transfers using the standard static model where agents choose to supply hours of work until the marginal disutility of work equals marginal utility of disposable (net-of-tax) income. This model, which from now on we call the standard model, predicts that, if individual preferences are convex and smoothly distributed in the population, we should observe bunching of individuals at convex kink points of the budget set. Taxes and government transfers create such kink points. The progressive US individual income tax generates a piecewise linear budget set with kinks at each point where the marginal tax rate jumps. Means-tested government transfer programs also introduce piecewise-linear constraints because transfer benefits are “taxed” away as income rises. In particular, the Earned Income Tax Credit (EITC) creates two large convex kink points at the points where the credit is fully phased-in, and where it starts being phased-out. Looking for bunching evidence around kinks provides a simple test of the widely used standard model and of the presence of behavioral responses to taxation along the intensive margin. Furthermore, the amount of bunching generated by budget set kinks is proportional to the size of the compensated elasticity of income with respect to the net-of-tax rate.