Optimal auditing and insurance in a dynamic model of tax compliance

B Ravikumar and Yuzhe Zhang ()

No 2011-020, Working Papers from Federal Reserve Bank of St. Louis

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 underreport his true income and evade his taxes. With a constant absolute risk-aversion utility function and a costly and imperfect auditing technology, we show that the optimal 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 reports 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.

Keywords: Tax auditing; Taxation (search for similar items in EconPapers)
Date: 2011
New Economics Papers: this item is included in nep-acc, nep-cta, nep-dge, nep-ias, nep-iue and nep-pub
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Journal Article: Optimal auditing and insurance in a dynamic model of tax compliance (2012)
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DOI: 10.20955/wp.2011.020

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