A Theory of Tax Planning

Abstract

I present a model of tax planning in which the deductibility of the taxpayer’s transaction – if challenged – must be deliberated by the tax authority. Even when all facts are known, the outcome of a deliberation remains uncertain, and the only penalty that can be assessed when the tax authority prevails is the loss of the taxpayer’s claimed deduction. The results indicate that tax planning behavior and regulation differ substantially from the theoretical results found in the literature on tax evasion . For example, the tax authority’s implicit commitment to fewer challenges may actually increase net tax collections, while a policy of randomized challenges may not be an equilibrium. The theory of tax planning also suggests that the ‘undersheltering paradox’ is due to emergent shadow standards which create two distinct classes (conservative versus aggressive) of taxpayers.

Keywords: Tax planning, Shadow standard