Optimal taxes and penalties when the government cannot commit to its audit policy

LEANDRO AROZAMENA; MARTÍN BESFAMILLE; PABLO SANGUINETTI

San Pablo

Seminario; Sao Paulo School of Economics - Economics Seminar; 2013

Escola de Economía de Sao Paulo, Fundaçao Getulio Vargas

We examine the problem of a utilitarian government that sets taxes and fines for evaders but cannot commit to its enforcement policy, which is delegated to a net-revenue maximizing tax administration. Given the tax law, the tax administration and taxpayers -some of whom are honest- play a report-audit game that, depending on taxes, fines and audit costs, generates either full evasion and no audits, or partial evasion and random auditing. Anticipating both possibilities, we characterize the optimal tax law. We show that it may be optimal for the government not to fine evaders as a way to commit not to audit. Moreover, social welfare may be nonmonotonic in the audit cost.