Tax Evasion as an Optimal Solution to a Partially Observable Markov Decision Process

Motivated by the persistent phenomenon of tax evasion and the challenge of tax collection during economic crises, we explore the behavior of a risk-neutral self-interested firm that may engage in tax evasion to maximize its profits. The firm evolves in a tax system which includes many of “standard” features such as audits, penalties, and occasional tax amnesties, and may be uncertain as to its tax status (not knowing, for example, whether a tax amnesty may be imminent). We show that the firm’s dynamics can be expressed via a partially observable Markov decision process and use that model to compute the firm’s optimal behavior and expected long-term discounted rewards in a variety of scenarios of practical interest. Going beyond previous work, we are able to investigate the effect of “leaks” or “pre-announcements” of any tax amnesties on the firm’s behavior (and thus on tax revenues). We also compute the effect on firm behavior of any extensions of the statute of limitations within which the firm’s tax filings can be audited, and show that such extensions can be a significant deterrent against tax evasion.