Toward obtaining a consistent estimate of the elasticity of taxable income using difference-in-differences

The elasticity of taxable income (ETI) is a central parameter for tax policy debates. This paper shows that mean reversion prevents most estimators employed in the literature from obtaining consistent estimates of the ETI. A new method is proposed that will resolve inconsistency due to mean reversion under testable assumptions regarding the degree of serial correlation in the error term. Using this procedure, I estimate an ETI of 0.858, which is about twice as large as the estimates found in the most frequently cited paper on this subject [13]. The corresponding elasticity of broad income is 0.475. •I show most estimators fail to obtain consistent estimates of the ETI.•I propose a new instrument that resolves the inconsistency due to mean reversion.•I estimate an ETI of 0.858 and an elasticity of broad income of 0.475.