Optimal deductibility: Theory, and evidence form a bunching decomposition

I define a new tax instrument, the ‘deductibility rate’, which specifies the proportion of eligible
expenses a taxpayer may deduct when preparing her taxes. If the utilities of gross income and
deductions are separable, then the deduction elasticity reflects the revenue leakage caused by
greater deductibility. To identify this elasticity, I develop the first method to decompose bunching
in taxable income into its constituent parts, exploiting the removal of a notch in the tax schedule.
This setting also generates an observed counterfactual density, obviating the parametric
assumptions routinely made in bunching studies. Applying this method to new administrative tax
data from Australia, I find that while deductions account for just 5% of taxable income, they
account for 35% of the response of taxable income to the tax rate. Based on an elasticity of
taxable income of 0.06, the deduction elasticity is -0.45, and the gross-income elasticity is 0.04.
Consistent with standard optimal-tax logic, the sensitivity of deductions to the tax rate suggests
that restricting deductions could raise welfare.