Income Tax Compliance in a Principal-Agent Framework

Abstract

Previous analyses have modeled income tax evasion as a "portfolio problem," deriving the optimal consumption of the "risky asset" (unreported income) under the assumption of a fixed probability of detection, The purpose of this paper is to examine some of these issues in tax compliance starting from a different set of assumptions. In particular, we compare alternative audit policies to the standard random audit policy. We focus on an "audit cutoff" policy, in which an agent triggers an audit if his or her reported income is "too low," and is not audited if reported income is "sufficiently high." This paper establishes two major results. First, random audit rules are weakly dominated by audit cutoff rules. It can be shown, given lump-sum taxes and fines, that these audit cutoff rules are the least-cost policies which induce truthful reporting of income. Second, the dominance of audit cutoff rules over random audit rules holds for "lump-sum" as well as proportional taxation—in fact, the equilibrium consequences of the two are equivalent.

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