Auditing with Signals

Abstract

This paper is a first step in analysing the use of statistical information about taxpayers' incomes by tax audit authorities. In a very simple model, we consider the design of the audit strategy when the tax authority can commit to it and has free access to a signal correlated with the taxpayer's true income. We discuss the optimal enforcement policy and compare it with the optimal one when only self-reported income is considered. Our main result postulates that the well-known regressive bias of revenue-maximizing audit rules may be reversed into a progressive one when signals are used.