Abstract
The optimal enforcement policy when households are heterogeneous, with respect to both income level and to income source, leads to more intense income auditing for easy-to-monitor sources. We obtain the common result that within each income source any taxpayer reporting less than a predetermined cut-off level will be audited, while taxpayers reporting at least this level will never be audited. However, this audit policy leads to very different reporting behavior depending on the income source. The Internal Revenue Service does not audit only honest taxpayers, and an increase in the audit budget may lead to a larger segment of full evaders.
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