Estimating Earnings Adjustment Frictions: Method and Evidence from the Social Security Earnings Test

Abstract

We study frictions in adjusting earnings in response to changes in the Social Security Annual Earnings Test (AET), using a panel of Social Security Administration microdata on one percent of the U.S. population from 1961 to 2006. Individuals continue to "bunch" at the convex kink the AET creates even when they are no longer subject to the AET, demonstrating that adjustment frictions help drive behavior in a new and important context. We develop a novel framework for estimating an earnings elasticity and an adjustment cost using information on the amount of bunching at kinks before and after policy changes in earnings incentives around the kinks. We apply this method in settings in which individuals face changes in the AET benefit reduction rate, and we estimate in a baseline case that the earnings elasticity with respect to the implicit net-of-tax share is 0.23, and the fixed cost of adjustment is $152.08. Our results demonstrate that the short-run impact of changes in the effective marginal tax rate can be substantially attenuated.