Tax Riots

63 Pages Posted: 26 May 2006

See all articles by Marco Bassetto

Marco Bassetto

Federal Reserve Bank of Chicago

Christopher Phelan

Federal Reserve Bank of Minneapolis

Date Written: May 2006

Abstract

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

Suggested Citation

Bassetto, Marco and Phelan, Christopher J., Tax Riots (May 2006). FRB of Chicago Working Paper No. 2006-04, Available at SSRN: https://ssrn.com/abstract=904664 or http://dx.doi.org/10.2139/ssrn.904664

Marco Bassetto (Contact Author)

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States

Christopher J. Phelan

Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States
612-204-5615 (Phone)

HOME PAGE: http://phelan.mpls.frb.fed.us

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