Audit Misperception, Tax Compliance, and Optimal Uncertainty

Abstract

The purpose of this paper is to shed light on the role of taxpayers’ misperceptions in determining compliance behavior. This paper also analyzes the effect of increased randomness on evasion, revenue, and welfare. Whether or not individuals choose to evade taxes depends on the perceived audit probability and on the fraction of honest taxpayers in the population. When individuals know the precise probability of audit, the model becomes in effect a game of coordination, a situation that gives rise to multiple equilibria. This paper incorporates audit misperception by introducing a small amount of uncertainty about the true audit probability. With the introduction of this uncertainty, we verify that there is a unique equilibrium cutoff point, such that each taxpayer evades if and only if his perceived signal falls below this cutoff. It is argued that this unique equilibrium outcome fares better than others in explaining empirical and experimental observations. We also find that, when reducing uncertainty has no cost, the optimal uncertainty is generally indeterminate, even when including zero uncertainty. Finally, we show that, when reducing uncertainty is costly, eliminating all uncertainty can never be optimal. In the limit as this cost vanishes, the optimal uncertainty is unique, meaning that introducing a small amount of enforcement cost resolves the indeterminacy problem.