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Optimal auditing in a dynamic model of tax compliance

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  • Ravikumar, B
  • Zhang, Yuzhe

Abstract

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.

Suggested Citation

  • Ravikumar, B & Zhang, Yuzhe, 2010. "Optimal auditing in a dynamic model of tax compliance," MPRA Paper 22924, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:22924
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    References listed on IDEAS

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    1. Zhang, Yuzhe, 2009. "Dynamic contracting with persistent shocks," Journal of Economic Theory, Elsevier, vol. 144(2), pages 635-675, March.
    2. 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.
    3. 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.
    4. 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.
    5. 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.
    6. Cheng Wang, 2005. "Dynamic costly state verification," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 25(4), pages 887-916, June.
    7. 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 739-760, October.
    8. Cyril Monnet & Erwan Quintin, 2005. "Optimal contracts in a dynamic costly state verification model," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 26(4), pages 867-885, November.
    9. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
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    Cited by:

    1. Cheng Wang, 2005. "Dynamic costly state verification," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 25(4), pages 887-916, June.
    2. David L. Fuller & B. Ravikumar & Yuzhe Zhang, 2015. "Unemployment Insurance Fraud and Optimal Monitoring," American Economic Journal: Macroeconomics, American Economic Association, vol. 7(2), pages 249-290, April.
    3. Ravikumar, B. & Zhang, Yuzhe, 2012. "Optimal auditing and insurance in a dynamic model of tax compliance," Theoretical Economics, Econometric Society, vol. 7(2), May.

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    More about this item

    Keywords

    Tax compliance; Tax auditing; Stochastic costly state verification;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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