33 Pages Posted: 3 Jun 2010
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: 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