Income tax compliance in a principal-agent framework

Previous analyses have modeled income tax evasion as a 'portfolio problem', deriving the optimal consumption of the 'risky asset' (unreported income) assuming a fixed probability of detection. We compare an alternative audit policy to the standard random audit policy. We focus on an 'audit cutoff' policy, in which an agent triggers an audit if reported income is 'too low', and is not audited if reported income is 'sufficiently high'. We find that random audit rules are weakly dominated by audit cutoff rules. Given lump-sum taxes and fines, audit cutoff rules are the least-cost policies which induce truthful reporting of income.