Using Notches to Uncover Optimization Frictions and Structural Elasticities: Theory and Evidence from Pakistan

We develop a framework for non-parametrically identifying optimization frictions and structural elasticities using notches–discontinuities in the choice sets of agents–introduced by for example 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. JEL Codes: H31; J22; O12. ∗We are grateful for constructive comments and suggestions from Editors Lawrence Katz and Robert Barro, five anonymous referees, Rashid Amjad, Tony Atkinson, Oriana Bandiera, Tim Besley, Michael Best, Richard Blundell, Raj Chetty, Estelle Dauchy, Roger Gordon, Damon Jones, Adnan Khan, Wojciech Kopczuk, Erzo Luttmer, Ben Olken, Torsten Persson, Thomas Piketty, Dina Pomeranz, Imran Rasul, Emmanuel Saez, John Karl Schultz, Monica Singhal, Joel Slemrod, Johannes Spinnewijn, Jakob Egholt Søgaard, and numerous seminar participants. Financial support from the International Growth Centre (IGC), Pakistan Programme is gratefully acknowledged. Corresponding author: Henrik Kleven, Department of Economics, London School of Economics and Political Science, Houghton Street, London WC2A 2AE, United Kingdom. E-mail: [email protected].