ESTIMATING BOTH SUPPLY AND DEMAND ELASTICITIES USING VARIATION IN A SINGLE TAX RATE

We show how an insight from taxation theory allows identification of both the supply and demand elasticities using only one instrument. Most models of taxation since Ramsey (1927) assume that a tax levied on the demand side only affects demand through the price after taxation. Econometrically, we show that this assumption acts as an exclusion restriction. Under the Ramsey Exclusion Restriction (RER), a single tax reform can serve to simultaneously identify the demand and supply elasticity. We develop an estimation method, which includes 2SLS estimators for the elasticities, and a test for strength of the instrument. We discuss possible applications.