Earnings Adjustment Frictions: Evidence from the Social Security Earnings Test

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Abstract

We study frictions in adjusting earnings in response to changes in the Social Security Annual Earnings Test (AET), using a one percent sample of earnings histories from Social Security Administration microdata from 1983 to 1999. We introduce a novel method for documenting adjustment frictions: individuals continue to “bunch” at the convex kink the AET creates even when they are no longer subject to the AET. We develop a 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 0.35, and the Öxed cost of adjustment is around $280. Our results demonstrate that the short-run impact of changes in the effective marginal tax rate can be substantially attenuated.

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