A General Characterization of Optimal Income Tax Enforcement

Abstract

This paper develops a general approach to characterizing optimal income tax and enforcement schemes. Our analysis clarifies the nature of the interplay between tax rates, audit probabilities and penalties for misreporting. In particular, it is shown that for a variety of objective functions for the principal the optimal tax schedule is in general concave (at least weakly) and monotonic; the marginal tax rates determine the audit probabilities; and less harsh penalties lead to higher enforcement costs. Our results imply that there exists a tradeoff between equity and efficiency considerations in the enforcement context which is similar to that in the moral hazard context for tax policy. It is well accepted by now that informational asymmetries generate important constraints on the formulation of economic policy. An early and classic example is given by Mirrlees (1971), who considers the problem of optimal income taxation when individuals differ in their ability to transform effort into income. It is assumed that ability and effort of an individual cannot be observed at any cost, whereas income, which is the product of these two unobservables, is perfectly and costlessly observable. Taxes can thus depend only on final income. Under these informational conditions the equity-efficiency tradeoffs that constrain the choice of tax policy arise only because of the presence of moral hazard associated with taxation of income. If there were no moral hazard (i.e. individual efforts and therefore incomes were exogenous) the problem of optimal income taxation would be a trivial one since, by assumption, individual incomes are perfectly and costlessly observable. In much of the recent literature on optimal income taxation in the presence of costly enforcement (Reinganum and Wilde (1985), Border and Sobel (1987) and others), on the other hand, individual incomes are treated as exogenous, i.e. there is no moral hazard.' However, informational constraints arise from another important consideration; namely: an individual's income cannot be directly observed; it can only be verified through a costly