Data-driven auditing of business and self-employment earnings

Entrepreneurs’ profits depend on their individual abilities and a common market shock. In some situations only low ability, high profit earners submit tax returns truthfully while high ability, high profit earners underreport, when in complementary situations high ability, high profit earners submit returns truthfully and low ability, high profit earners underreport. An ability type is truthful only if its likelihood ratio of high profits under favorable market shock relative to unfavorable market shock dominates the corresponding likelihood ratio of the other ability type. Auditor audits all low submissions if the proportion of ‘high submissions’ exceeds a cutoff. We provide a characterization of all pure strategy tax evasion and auditing equilibria. Because the number of high submissions depends on the ex-post distribution of types and the realization of the market shock, entrepreneurs cannot tailor tax returns to systematically avoid audit scrutiny unlike in the exogenous cutoff-income tax audit models. Data-based auditing helps combat the high ‘tax gap’, a well-known problem in tax enforcement.