Thinking and Learning in the Tax Evasion Game

Abstract

Equilibrium behaviour is one of the fundamental concepts of economics: that each player's strategy is a best response to their beliefs about other players' strategies (and that these beliefs are realised). It is therefore striking that one of the most utilised economic models of tax compliance (Allingham and Sandmo, 1972) lacks this property as random audit selection is not a best response for the tax administration. The game theory literature of tax compliance has solved the equilibrium under assumptions of perfect information, full rationality and representative agents (Reinganum and Wilde, 1986; Erard and Feinstein, 1994). The recent application of behavioural economics to tax compliance (Hashimzade et al., 2014) allows richer assumptions such as heterogeneity and asymmetric information to be included in agent-based models. This paper investigates the tax administration's best-response audit strategy with heterogeneous taxpayers, imperfect information and evolutionary survival of taxpayers. It finds that, under these conditions, the tax administration's best-response audit strategy is an adaptive learning approach and not a well-defined audit function. This fits with actual practice of ‘predictive analytics’ by OECD tax administrations. Behavioural game theory also predicts that when actors are information rich, adaptive learning will dominate abstract thinking.