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Optimal Auditing in a Dynamic Model of Tax Compliance

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  • Ravikumar, B.
  • Zhang, Yuzhe

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

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 23218.

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Date of creation: 2010
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Handle: RePEc:pra:mprapa:23218

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Keywords: Tax Compliance; Tax Auditing; Stochastic Costly State Verification;

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References

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  1. Zhang, Yuzhe, 2009. "Dynamic contracting with persistent shocks," Journal of Economic Theory, Elsevier, vol. 144(2), pages 635-675, March.
  2. Gary S. Becker, 1968. "Crime and Punishment: An Economic Approach," Journal of Political Economy, University of Chicago Press, vol. 76, pages 169.
  3. Stigler, George J, 1970. "The Optimum Enforcement of Laws," Journal of Political Economy, University of Chicago Press, vol. 78(3), pages 526-36, May-June.
  4. Reinganum, Jennifer F & Wilde, Louis L, 1986. "Equilibrium Verification and Reporting Policies in a Model of Tax Compliance," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 27(3), pages 739-60, October.
  5. Ana Fernandes & Christopher Phelan, 1999. "A recursive formulation for repeated agency with history dependence," Staff Report 259, Federal Reserve Bank of Minneapolis.
  6. Reinganum, Jennifer F. & Wilde, Louis L., 1985. "Income tax compliance in a principal-agent framework," Journal of Public Economics, Elsevier, vol. 26(1), pages 1-18, February.
  7. Cyril Monnet & Erwan Quintin, 2005. "Optimal contracts in a dynamic costly state verification model," Economic Theory, Springer, vol. 26(4), pages 867-885, November.
  8. Wang, Cheng, 2005. "Dynamic Costly State Verification," Staff General Research Papers 10832, Iowa State University, Department of Economics.
  9. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  10. Cheng Wang, 2005. "Dynamic costly state verification," Economic Theory, Springer, vol. 25(4), pages 887-916, 06.
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Cited by:
  1. David L. Fuller & B. Ravikumar & Yuzhe Zhang, 2012. "Unemployment insurance fraud and optimal monitoring," Working Papers 2012-024, Federal Reserve Bank of St. Louis.
  2. B. Ravikumar & Yuzhe Zhang, 2011. "Optimal auditing and insurance in a dynamic model of tax compliance," Working Papers 2011-020, Federal Reserve Bank of St. Louis.

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