Estimating Adjustment Frictions Using Nonlinear Budget Sets: Method and Evidence from the Earnings Test

Abstract

We introduce a method for estimating the cost of adjusting earnings, as well as the earnings elasticity with respect to the net-of-tax share. Our method uses information on bunching in the earnings distribution at convex budget set kinks before and after policy-induced changes in the magnitude of the kinks: the larger is the adjustment cost, the smaller is the absolute change in bunching from before to after the policy change. In the context of the Social Security Earnings Test, our results demonstrate that the short-run impact of changes in the effective marginal tax rate can be substantially attenuated.