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Optimal auditing and insurance in a dynamic model of tax compliance

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  • Zhang, Yuzhe

    ()
    (Department of Economics, Texas A & M University)

  • Ravikumar, B.

    ()
    (Research Division, Federal Reserve Bank of St. Louis)

Abstract

We study the optimal auditing of a taxpayer's income in a dynamic principal-agent model of hidden income. Taxpayers in our model initially have low income and stochastically transit to high income that is an absorbing state. A low-income taxpayer who transits to high income can under-report his true income and evade his taxes. With a constant absolute risk-aversion utility function and a costly auditing technology, we show that the optimal auditing mechanism in our model consists of cycles. Within each cycle, a low-income taxpayer is initially unaudited, but if the duration of low-income report exceeds a threshold, then the auditing probability becomes positive. That is, the tax authority guarantees that the taxpayer will not be audited until the threshold duration is reached. We also find that auditing becomes less frequent if the auditing cost is higher or if the variance of income is lower.

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Bibliographic Info

Article provided by Econometric Society in its journal Theoretical Economics.

Volume (Year): 7 (2012)
Issue (Month): 2 (May)
Pages:

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Handle: RePEc:the:publsh:737

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Web page: http://econtheory.org

Related research

Keywords: Tax compliance; tax auditing; stochastic costly state verification;

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  1. Ravikumar, B & Zhang, Yuzhe, 2010. "Optimal auditing in a dynamic model of tax compliance," MPRA Paper 22924, University Library of Munich, Germany.
  2. Monnet, Cyril & Quintin, Erwan, 2002. "Optimal contracts in a dynamic costly state verification model," Working Paper Series 0126, European Central Bank.
  3. Armenter, Roc & Mertens, Thomas M., 2013. "Fraud deterrence in dynamic Mirrleesian economies," Journal of Monetary Economics, Elsevier, vol. 60(2), pages 139-151.
  4. Fernandes, Ana & Phelan, Christopher, 2000. "A Recursive Formulation for Repeated Agency with History Dependence," Journal of Economic Theory, Elsevier, vol. 91(2), pages 223-247, April.
  5. Zhang, Yuzhe, 2009. "Dynamic Contracting with Persistent Shocks," MPRA Paper 23108, University Library of Munich, Germany.
  6. Mikhail Golosov & Aleh Tsyvinski, 2004. "Designing Optimal Disability Insurance: A Case for Asset Testing," NBER Working Papers 10792, National Bureau of Economic Research, Inc.
  7. Marek Kapicka, 2013. "Efficient Allocations in Dynamic Private Information Economies with Persistent Shocks: A First-Order Approach," Review of Economic Studies, Oxford University Press, vol. 80(3), pages 1027-1054.
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