The Cutoff Policy of Taxation when Taxpayers are Risk Averse

Abstract

In this paper we model taxpayers reactions to the possibility of either reporting income as usual and running the risk of an audit or reporting a cutoff income and paying a threshold tax that gives the certainty of not being audited. Models of this kind already discussed in the literature assume that taxpayers are risk neutral. We depart from this stream of research by assuming instead that taxpayers have a Constant Relative Risk Aversion (CRRA) utility function and differ in relative risk aversion coefficient and in income. The government can rely upon a signal in order to assess the income class to which the taxpayer belongs and fix the threshold tax. Our main result is that, within each class, the threshold tax is paid by taxpayers whose relative risk aversion lies in a given interval. Taxpayers with high risk aversion and relatively low income file their report as usual. Unlike analogous models under risk neutrality, relatively rich taxpayers with low risk aversion might not pay the threshold tax as well. An equity problem arises.