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Abstract
A wide range of tax policies create discontinuous jumps-notches-in the choice set of individuals and firms, arising when incremental changes in behavior cause discrete changes in net tax liability. This paper presents a taxonomy of different types of notch policies. It then discusses the mechanics of, and limitations to, estimating structural parameters using notches. Next, it considers the welfare consequences of notches and their role in optimal tax design. It concludes by speculating on why notches persist. Notches are shown to be welfare inferior absent considerations of administrative cost or salience.
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1. Introduction
A wide range of tax policies create discontinuous jumps-notches-in the choice set of individuals and firms, because incremental changes in behavior cause discrete changes in net tax liability. Recently, along with budget-set kinks, notches have attracted considerable attention on the grounds that the local behavioral response to their presence can provide especially convincing identification of the effect of taxation.2
Although this paper addresses tax policy, notch-like policies appear in other areas of economic policy. For example, certain regulations apply only to firms above a certain size.3 Earned income above a certain threshold renders one ineligible for Medicaid, which provides a basic set of free or subsidized medical services.4 Notches appear commonly outside of government policy, as well. For example, nonprofit organizations often publicize the names of donors and assign 'titles' (eg 'leader,' 'founder') according to brackets of gifts.5 Businesses often offer quantity discounts that create a notch, such that purchasing one extra unit discretely lowers the total price. Incentive contracts often include bonuses for reaching particular targets, and/or penalties for failing to reach certain quotas.6
In this paper I offer a critical review of tax policy notches, and the lines that create them. I begin, in Section 2, with a taxonomy of the wide range of policies that create notches. Sections 3 and 4 address some analytical and normative issues, respectively, raised by notches. Section 5 discusses the roles of different types of policy notches in optimal tax design. Section 6 concludes.
2. A TAXONOMY OF TAX NOTCHES
Tax notches come in many varieties. Perhaps the most important distinction is between what I will refer to as quantity notches and characteristic notches.
2.1 Quantity Notches