Optimal Auditing in a Dynamic Model of Tax Compliance

33 Pages Posted: 3 Jun 2010

See all articles by B. Ravikumar

B. Ravikumar

Federal Reserve Bank of Saint Louis

Yuzhe Zhang

Texas A&M University

Date Written: February 24, 2010


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 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 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.

Keywords: Tax Compliance, Tax Auditing, Stochastic Costly State Verification

JEL Classification: D82, D86, J65

Suggested Citation

Ravikumar, B. and Zhang, Yuzhe, Optimal Auditing in a Dynamic Model of Tax Compliance (February 24, 2010). Available at SSRN: https://ssrn.com/abstract=1620044 or http://dx.doi.org/10.2139/ssrn.1620044

B. Ravikumar

Federal Reserve Bank of Saint Louis ( email )

411 Locust St
Saint Louis, MO 63011
United States

Yuzhe Zhang (Contact Author)

Texas A&M University ( email )

Langford Building A
798 Ross St.
College Station, TX 77843-3137
United States

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