The Tax Compliance and Audit Policy Implications of Costly False Detection Errors

Abstract

In July 1996, Congress passed the Taxpayer Bill of Rights 2 (T2). T2 resulted from a series of initiatives aimed at protecting honest taxpayers, particularly those affected by IRS enforcement actions. This study incorporates taxpayer rights considerations into a strategic model of tax reporting and auditing, and examines the impact of false detection and costly error correction on taxpayer equity, tax evasion, and revenue collections. The model also considers proposals to shift honest taxpayer costs to the tax authority. The study finds that: (1) tax evasion can be deterred completely, but only at honest taxpayers' expense, (2) costly false detection errors increase tax authority revenue collections in some cases, and (3) although tax authority reimbursement of honest taxpayer costs can restore equity, it may also increase evasion, producing additional revenue loss. These results highlight the trade-off between detecting tax evasion and protecting taxpayers' rights.