Income Tax Compliance: the No-Commitment Game
We consider a tax enforcement game in which the fiscal authority cannot pre-commit to an inspection policy and its interaction with the taxpayer is modelled as a signalling game. We extend earlier work by allowing for imperfect auditing, non-linear taxation and non-linear penalties. Using the incentive compatibility approach in signalling games (Mailath, 1987) and making explicit out-of-equilibrium beliefs, we demonstrate that the separating equilibrium is the only equilibrium of this game. As for characterisation, we show that the game has a simple solution which displays a constant level of non-compliance, constant audit rates and a progressive bias in the sense that the distribution of true liabilities Lorenz-dominates the distribution of effective tax payments. We also study the impact on the equilibrium outcome of small changes in taxation, penalty, auditing quality and cost of audit. Lastly, we allow for the possibility that the taxpayer is intrinsically honest with some probability and show that a small change in this probability has significant effects on reporting behaviour, audit policy and expected revenue.
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