Mechanism Design with Auditing and Avoidance: Tax Evasion Story
32 Pages Posted: 30 Sep 2022 Last revised: 30 May 2024
Date Written: September 26, 2022
Abstract
We consider a principal-agent model where the agent is a taxpayer and the principal is a tax authority. The tax authority wants to know the taxpayer's income so that she can then assign an appropriate tax to the taxpayer. It is mandatory for the taxpayer to report his information to the tax authority. Furthermore, the tax authority can investigate whether the taxpayer's report was truthful. If the taxpayer is caught for misreporting, then he is punished by an exogenous fine. We assume that the taxpayer can engage in avoidance activities that undermine the tax authority's audit efforts and, thus, reduce the probability of being caught for lying. We find that whenever avoidance is cheap and efficient, then, in addition to information rent, it is optimal for the tax authority to give the taxpayer avoidance rent.
Keywords: Mechanism Design, Verification, Enforcement, Auditing, Avoidance, Fines, Tax Evasion
JEL Classification: D82, D86, L51
Suggested Citation: Suggested Citation