Diffuse Bunching with Frictions: Theory and Estimation

We incorporate a general model of frictions into the bunching-based elasticity estimator. The new estimator replaces bunching-window bounds with a “lumpiness parameter” and uses fewer parameters than the conventional approach while delivering additional economically-interpretable quantities such as the size of frictions and unobserved adjustment costs. The model matches rich observed bunching patterns such as sharp-peaked diffuse bunching around tax kinks and depressed density in notch-adjacent dominated regions. We apply the estimator to canonical settings including the U.S. EITC kink, and to administrative tax data from South Africa, where we uncover novel insights on unobserved VAT compliance costs and kink misperceptions.