A Theory of Auditing and Plunder
Taxpayers know their income but the IRS does not. The IRS can audit taxpayers to discover their true income, but auditing is costly. We characterize optimal policies for the IRS when it is free to choose tax levies, audit probabilities and penalties. The main results are that optimal policies involve taxes which are monotonically increasing in reported incomes and audit probabilities are monotonically decreasing in reported income. In general optimal schemes involve stochastic auditing of reports and rebates for telling the truth. A theory of optimal plundering is described.
Additional InformationWe thank the members of the UCSD and Caltech Theory Workshops for their comments and suggestions. Sobel happily thanks the National Science Foundation for partial support under grant SES-8408655.
Submitted - sswp573.pdf