63 Pages Posted: 26 May 2006
Date Written: May 2006
This paper considers an optimal taxation environment where household income is private information, and the government randomly audits and punishes households found to be underreporting. We prove that the optimal mechanism derived using standard mechanism design techniques has a bad equilibrium (a tax riot) where households underreport their incomes, precisely because other households are expected to do so as well. We then consider three alternative approaches to designing a tax scheme when one is worried about bad equilibria.
Keywords: multiple equilibria, ex ante incentive compatibility, ex post incentive compatibility, optimal tax mechanism
JEL Classification: H21, H26, E62
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