Optimal auditing and insurance in a dynamic model of tax compliance
AbstractWe 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 underreport his true income and evade his taxes. With a constant absolute risk-aversion utility function and a costly and imperfect 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 reports 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 InfoPaper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2011-020.
Date of creation: 2011
Date of revision:
Other versions of this item:
- Zhang, Yuzhe & Ravikumar, B., 2012. "Optimal auditing and insurance in a dynamic model of tax compliance," Theoretical Economics, Econometric Society, vol. 7(2), May.
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
- J65 - Labor and Demographic Economics - - Mobility, Unemployment, and Vacancies - - - Unemployment Insurance; Severance Pay; Plant Closings
This paper has been announced in the following NEP Reports:
- NEP-ACC-2011-09-22 (Accounting & Auditing)
- NEP-ALL-2011-09-22 (All new papers)
- NEP-CTA-2011-09-22 (Contract Theory & Applications)
- NEP-DGE-2011-09-22 (Dynamic General Equilibrium)
- NEP-IAS-2011-09-22 (Insurance Economics)
- NEP-IUE-2011-09-22 (Informal & Underground Economics)
- NEP-PUB-2011-09-22 (Public Finance)
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