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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. 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.
  2. Zhang, Yuzhe, 2009. "Dynamic contracting with persistent shocks," Journal of Economic Theory, Elsevier, vol. 144(2), pages 635-675, March.
  3. Mikhail Golosov & Aleh Tsyvinski, 2004. "Designing Optimal Disability Insurance: A Case for Asset Testing," NBER Working Papers 10792, National Bureau of Economic Research, Inc.
  4. Ravikumar, B. & Zhang, Yuzhe, 2010. "Optimal Auditing in a Dynamic Model of Tax Compliance," MPRA Paper 23218, University Library of Munich, Germany.
  5. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  6. Armenter, Roc & Mertens, Thomas M., 2013. "Fraud deterrence in dynamic Mirrleesian economies," Journal of Monetary Economics, Elsevier, vol. 60(2), pages 139-151.
  7. Monnet, Cyril & Quintin, Erwan, 2002. "Optimal contracts in a dynamic costly state verification model," Working Paper Series 0126, European Central Bank.
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