Tax Evasion, Social Customs and Optimal Auditing

Paper number: 95/08

Paper date: May 1995

Year: 1995

Paper Category: Discussion Paper

Authors

Gareth D. Myles
University of Exeter

and

Robin A Naylor
University of Warwick

Abstract

The optimal audit policy is analysed for an independent revenue service when a social custom exists that rewards honest tax-paying. The implication of the existence of the social custom is that in equilibrium the income level of a taxpayer cannot always be inferred exactly from their report. The structure of the optimal audit policy is determined both for a fixed (report-invariant) audit probability and for when the audit probability is a function of the income report. For the constant probability of audit it is shown that an interior solution exists to the decision problem of the revenue service and comparative statics results are given. When the audit probability can vary, the audit function is proved to be a decreasing function of the income report which reaches zero at the highest income report of a tax evader. Increases in the fine for evading and in the tax rate raise the optimal audit probability.

JEL Classification numbers: D82, H26.
Keywords: tax evasion, auditing, social customs.

Acknowledgements: Thanks are due to Ben Lockwood, David de Meza, Jonothan Thomas and participants in seminars at Essex, Exeter, Kent and the Public Finance Weekend at Warwick.

Postal Address: To first author, Department of Economics, University of Exeter, Exeter EX4 4RJ.