Who is audited? Experimental study on rule-based tax auditing schemes

In this study, we employ a game theoretic framework to formulate and analyze tax audit schemes. We test the theoretical predictions in a laboratory experiment. We compare audit schemes based on three audit rules: random audit rule, cut-off audit rule, and lowest income reporter audited rule (LIRA). While the cut-off audit rule is known to be optimal in theory, it has not been examined in a controlled laboratory experimental setting. The primary experimental finding is that LIRA rule yields the highest degree of truthful reporting among the rules, contrary to the theory. Moreover, the regression analysis shows that individual social norms regarding tax payment as well as the cut-off rule and the LIRA significantly increase the degree of truthful reporting. Our experimental finding that the LIRA yields the highest degree of truthful reporting is practically important because the tax authority in most countries assigns higher priority for enhancing tax compliance.