Tax Audit Uncertainty and the Work-Versus-Leisure Decision

Abstract

PUBLIC FINANCE REVIEWHorowitz, Horowitz / TAX AUDIT UNCERTAINTY The possibility of being audited provides an incentive for the more larcenous among us to accurately report taxable income when underreporting income carries a penalty. It seems safe to assume that by increasing either the likelihood of an income tax audit or the penalty for underreporting taxable income, the tax authority can reduce the extent to which conscious cheating takes place. That seemingly safe assumption, however, becomes much less so when the linkage between posttax income and the work-versus-leisure decision is taken into account. This article explores the ubiquitous and confounding effects on both reported income and work effort for non-risk-preferring taxpayers of changes in the audit probability, the sanction rate, the tax rate, and taxpayer wealth. It is shown that contrary to intuition and popular wisdom, raising the audit probability or the sanction rate will not necessarily lead to higher reported incomes, and neither increases in the tax rate nor greater taxpayer wealth will necessarily encourage increased leisure.

Income Tax Evasion Responses to Tax Rate and Tax Enforcement Rate

“…Put another way, with Theorem 2, we now can invalidate the perplexing case where the government's improvement of tax enforcement causes tax evasion to increase. Distinct from the previous studies [3][4][5][6][7], the present analysis clearly shows that the effect of an increase in tax enforcement rate on income tax evasion is negative. The factor that enables us to deliver this result is that our model allows individual taxpayers to accurately re-evaluate the price of the income tax evasion gamble when they adjust their tax evasion, according to both (3) and 4, in response to a change in the tax enforcement rate.…”

“…14 Let us now examine the effect on tax evasion behavior of an increase in the probability with which tax evasion is detected and penalized. As noted above, previous studies (e.g., [4][5][6][7]) have shown that an increase in p can decrease or increase tax evasion. The latter is a particularly perplexing result, as it means that enhancing tax enforcement promotes tax evasion.…”

“…As mentioned at the outset, previous studies that discussed how income tax evasion is affected by income tax rate and by tax enforcement rate (e.g., [3][4][5][6][7]) only showed that the effects on tax evasion of tax rate and of tax enforcement rate are ambiguous. We are revisiting the pending questions on tax evasion responses to the two key tax policy variables.…”

“…Notably, for optimally responding to a reform in income tax rate or in tax enforcement rate, taxpayers should accurately reflect a concomitant change in the marginal value of their income tax evasion, which depends on the marginal value of providing their labor to earn the income itself (part of which is to be evaded) because the concurrent change in the marginal value of labor supplies depends on the utility from the income after paying post-reform taxes if the tax evasion is not detected or after paying the penalty if the tax evasion is detected, with post-reform of detecting probability. In this regard, the subsequent studies of Pencavel [4], Baldry [5], and Horowitz and Horowitz [6] have improved upon the model of Allingham and Sandmo [3] by allowing individual taxpayers to jointly decide their labor supply and degree of tax evasion. In spite of this improvement, the latter three papers still failed to resolve the theoretical indeterminateness regarding income tax evasion responses to the tax rate and to the tax enforcement rate, respectively.…”

“…We admit that tax enforcement is costly and imperfect. 6 Namely, p refers to the overall rate of tax enforcement, as the government can surely verify the degree with which individual taxpayers evade their tax liabilities and penalize the tax evasion, with the auditing rate of p. Moreover, the cost for improving the tax enforcement rate p is described by a cost function 1 In addition to choosing p, the government decides penalty rate θ that it charges on unpaid (evaded) tax due when it detects tax evasion. 7 Although legislating penalty rate of θ is an almost costless measure to curb tax evasion, the government cannot legislate θ = ∞ to be in harmony with other penalties on crimes that seriously threaten the society.…”