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Optimal auditing and insurance in a dynamic model of tax compliance

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  • B. Ravikumar
  • Yuzhe Zhang

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 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 Info

Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2011-020.

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Date of creation: 2011
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Handle: RePEc:fip:fedlwp:2011-020

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Keywords: Tax auditing ; Taxation;

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  1. Mikhail Golosov & Aleh Tsyvinski, 2005. "Designing Optimal Disability Insurance: A Case for Asset Testing," Levine's Bibliography 784828000000000450, UCLA Department of Economics.
  2. Cyril Monnet & Erwan Quintin, 2005. "Optimal contracts in a dynamic costly state verification model," Economic Theory, Springer, vol. 26(4), pages 867-885, November.
  3. Thomas Mertens & Roc Armenter, 2010. "Fraud Deterrence in Dynamic Mirrleesian Economies," 2010 Meeting Papers 468, Society for Economic Dynamics.
  4. Ravikumar, B & Zhang, Yuzhe, 2010. "Optimal auditing in a dynamic model of tax compliance," MPRA Paper 22924, University Library of Munich, Germany.
  5. 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.
  6. Zhang, Yuzhe, 2009. "Dynamic Contracting with Persistent Shocks," MPRA Paper 23108, University Library of Munich, Germany.
  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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