Taxpayer Self-Inspections, Audits, and Optimal Tax Administration: Evidence from China

Abstract

I document an important tax collection practice that is previously unknown to research on tax administration: mandatory taxpayer self-inspections. The practice emerged spontaneously across China in the 1990s and persists to this day despite having no basis in law. If taxpayers report additional liabilities after self-inspections, no penalties are imposed. Unlike tax amnesties, self-inspections are (i) backed up by the threat of government inspections with a significantly higher-than-normal audit probability, and (ii) used as a basic, routine revenue-generation technique. I show that self-inspections represent roughly 50% of the activity in China’s “tax inspection” (jicha) system and assume even greater importance in the larger “revenue management” (shuiyuan guanli) system. Evidence suggests that self-inspections are much more effective at generating revenue than costlier government inspections. I argue that self-inspections show that the presumed centrality of audits to tax administration cannot rest on audit’s effectiveness in raising revenue. Rather, audits, but not self- inspections or tax amnesties, enforce a social/legal norm of truthful reporting. Audits are important only when the state relies on the norm of truthful reporting. Further, I argue that self-inspections highlight limits to the theory of optimal tax administration: where social norms are relevant, the enforcement elasticity of government interventions may be indeterminate. Finally, I suggest that self-inspections can be usefully classified in a scheme that sort enforcement strategies in terms of whether government interventions are (i) based on directly observable information or (ii) respond to taxpayer disclosure of private information. Recent research on building state capacity in developing countries privileges ex ante interventions afforded by case (i). But in case(ii), where intervention in compliance is necessarily ex post, social norms play a critical role.