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Optimal auditing in a dynamic model of tax compliance

  • Ravikumar, B
  • Zhang, Yuzhe

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 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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File URL: https://mpra.ub.uni-muenchen.de/33854/1/MPRA_paper_33854.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 22924.

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Date of creation: Feb 2010
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Handle: RePEc:pra:mprapa:22924
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  1. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  2. Zhang, Yuzhe, 2009. "Dynamic contracting with persistent shocks," Journal of Economic Theory, Elsevier, vol. 144(2), pages 635-675, March.
  3. George J. Stigler, 1974. "The Optimum Enforcement of Laws," NBER Chapters, in: Essays in the Economics of Crime and Punishment, pages 55-67 National Bureau of Economic Research, Inc.
  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. Cheng Wang, . "Dynamic Costly State Verification," GSIA Working Papers 2000-26, Carnegie Mellon University, Tepper School of Business.
  6. Cyril Monnet & Erwan Quintin, 2005. "Optimal contracts in a dynamic costly state verification model," Economic Theory, Springer, vol. 26(4), pages 867-885, November.
  7. 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.
  8. Gary S. Becker, 1974. "Crime and Punishment: An Economic Approach," NBER Chapters, in: Essays in the Economics of Crime and Punishment, pages 1-54 National Bureau of Economic Research, Inc.
  9. Fernandes, Ana & Phelan, Christopher, 2000. "A Recursive Formulation for Repeated Agency with History Dependence," Journal of Economic Theory, Elsevier, vol. 91(2), pages 223-247, April.
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