Bias Reduction in Instrumental Variable Estimation through First-Stage Shrinkage

Abstract: The two-stage least-squares (2SLS) estimator is known to be biased when its first-stage fit is poor. I show that better first-stage prediction can alleviate this bias. In a two-stage linear regression model with Normal noise, I consider shrinkage in the estimation of the first-stage instrumental variable coefficients. For at least four instrumental variables and a single endogenous regressor, I establish that the standard 2SLS estimator is dominated with respect to bias. The dominating IV estimator applies James-Stein type shrinkage in a first-stage high-dimensional Normal-means problem followed by a control-function approach in the second stage. It preserves invariances of the structural instrumental variable equations.