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An Equilibrium Model of Tax Compliance with a Bayesian Auditor and some 'Honest' Taxpayers.
Paper Number: 506
Date: 06/01/1984
Abstract:

Empirical work on  tax compliance has yielded conservative estimates of unreported taxable income in  the U.S. that average 10 to 15 percent of  total taxable income for recent years. Moreover, it is held by  many that the rate of  noncompliance has been growing dramatically. This problem is  widely perceived as  one of  eroding ethics - more and more people are ceasing to comply voluntarily and are instead acting "strategically" in  response to  the structure of  the U.S. income tax laws. We  propose a  simple model of  tax compliance in  which an  exogenously given fraction of  taxpayers comply voluntarily, while the remainder behave strategically. We  distinguish between a  general decision to act strategically and  a  specific decision not to  report honestly. This is  done in  an  equilibrium setting where the IRS is  allowed to adjust its audit policy in  response to  taxpayer  behavior. Because the audit policy of  the IRS is  endogenous and thus co-determined with the reporting behavior of  potential noncompliers,  several non-intuitive results emerge. In particular, we  find that an  increase in  the fraction of  strategic taxpayers decreases the likelihood  that a  given strategic taxpayer fails to  comply. In fact, the decrease in  the likelihood of  underreporting exactly offsets the increase in  the fraction of  strategic taxpayers, so  that aggregate compliance (and net tax revenues) are unaffected.

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Paper: sswp506.pdf