Panel Data Techniques and the Elasticity of Taxable Income

This paper examines the elasticity of taxable income with special focus on income controls designed to control for divergence in the income distribution and mean reversion. Additional emphasis is placed on the difference between short-run and longer-run responses to tax rate changes. Several panel techniques are applied to tax return data for years 1991 to 1997, followed by a cross-section analysis covering the same period. For each panel regression, an innovative inverted panel regression framework is employed to test the efficacy of the controls for mean reversion apart from controls for divergence in the income distribution. Finally, cross-section (and repeated cross-section) regressions are estimated for comparison. A major finding from comparing estimates from the standard and inverted panels is that even some of the more sophisticated techniques likely fail to adequately control for mean reversion at the top of the income distribution. Furthermore, the residual impact from mean reversion may still exert an enormous influence on elasticity estimates, which could help explain the lack of robustness reported in a number of papers in this literature. Analysis of cross-section data circumvents the problem of mean reversion and results in estimates that are robust with respect to sample income cutoffs. However when vast differences likely exist between those experiencing a specific change in tax rates and other filers, estimates relying on either panel or cross-section data are likely to be poorly identified.