Tax Compliance Game Research Articles

Information Sharing between Tax and Statutory Auditors: Implications for Tax Audit Efficiency

ABSTRACT We examine whether tax audits become more efficient if tax auditors have access to information about statutory audit adjustments. To this end, we extend the standard tax compliance game by including a statutory auditor and analyze the strategic interactions among a firm issuing financial and tax reports, a statutory auditor, and a tax auditor. We show that granting the tax auditor access to information on statutory audit adjustments can, in some cases, increase tax revenues while simultaneously decreasing tax audit frequency. Thus, more information sharing between statutory and tax auditors could be a policy instrument to combat tax evasion and increase tax audit efficiency. However, the tax audit efficiency enhancing effect comes at the cost of a reduction in financial statement quality as the probability of overstated financial assets increases. Moreover, depending on the importance of firms' financial statement valuation, the additional information may also reduce tax revenues. The regulator must, therefore, carefully weigh the potential efficiency gains from information sharing on statutory audit adjustments that are derived in this study against the potential efficiency losses.

When do firms use one set of books in an international tax compliance game?

This study examines how a strategic tax auditor affects a multinational firm’s transfer pricing in a tax compliance game. Our model uses a divisionalized firm, in both a low-tax and a high-tax country, that decides to implement a transfer-pricing regime with either one or two sets of books. After observing its unit costs, the firm reports a compliant or noncompliant tax transfer price. In a regime with one set of books, the single transfer price coordinates the quantity decision and determines the tax payments. In a regime with two sets, different transfer prices serve those tasks. In contrast to previous studies, our analysis incorporates a strategic tax auditor, who observes the tax transfer price and decides whether to audit the firm. Real-world regulations suggest larger penalties for detected noncompliance under a two-sets-of-books transfer-pricing regime. Our analysis identifies the mixed strategy equilibria and examines how variations in the tax regulation—the tax rate difference and the penalty difference—affect the firm’s tax aggressiveness. We show that a firm acts less tax aggressively with a higher tax rate difference. Additionally, the model predicts that the firm either increases or decreases the probability of keeping one set of books for a smaller penalty difference.

Estimating Income in a Tax Compliance Game. A Bayesian Persuasion Approach

Estimating Income in a Tax Compliance Game. A Bayesian Persuasion Approach

Internet Appendix for: 'When Do Firms Use One Set of Books in an International Tax Compliance Game?'

The Internet Appendix includes formal claims and proofs for the alternative sequence section. The original paper `When do firms use one set of books in an international tax compliance game?' is available at the following URL: https://ssrn.com/abstract=3012231,

Strategic Interactions Between Tax and Statutory Auditors and Different Information Regimes: Implications for Tax Audit Efficiency

We examine whether tax audit regimes become more efficient if (i) there are audited financial statements and (ii) tax auditors have access to the internal statutory audit report revealing information about statutory audit adjustments. Our analysis is based on a standard tax compliance game that we extend to model the strategic interaction among a firm issuing financial and tax reports, a statutory auditor, and a tax auditor. We find that the efficiency effects of additional information depend on the strength of tax auditor incentives and the weight that firms place on book income. For high-powered tax auditor incentives, we obtain no information effect on our efficiency measures. For low-powered tax auditor incentives, we find an ambiguous effect, and for mediumpowered tax auditor incentives and firms that place a high weight on book income, tax audit efficiency increases if the tax auditor has access to additional information. In the latter case, we find that granting the tax auditor access to the internal statutory audit report increases firms' tax compliance, raises tax revenues, and decreases tax audit frequency.

More bang for your buck: tax compliance in the United States and Italy

AbstractI investigate the relationship between perception of public institutions and tax compliance using a large tax compliance laboratory experiment conducted in Italy and the United States. In the first test, I conduct a simple tax compliance game to uncover that given the exact same decisions, contributions to the public good do not differ between Italy and the United States. Second, I ask participants to pay taxes to their national government, pension fund and fire department. In these rounds, behaviours diverge with Italian participants complying significantly less than Americans. Theoretically, I provide evidence demonstrating that how individuals perceive their institutions is a crucial component of the tax compliance decision. Methodologically, I provide a unique experiment, which can help us to better explain crosscountry variation in tax compliance, by asking subjects to make country-specific tax decisions.

The Audit of Deferred Taxes as a Signal for Tax Auditors: Tax Compliance Implications For Private and Public Firms

Using a tax compliance game, we study whether the observability of the taxpayer’s financial accounting information and the statutory auditor’s report affects the tax compliance. We find that firms’ responses differ significantly between private and public firms. Private firms compensate for the reported signals by understating both book and tax valuations. We find that introducing the informative signals does not necessarily increase efficiency. In fact, for private firms, it may also lead to lower tax revenues. For public firms, however, the positive effect of using the informative signals on tax compliance is much more pronounced. The usage of audit reports in addition to financial accounting statements always increases tax revenues from public firms. Regarding changes in book-tax conformity, we find that higher book-tax conformity can lead to higher tax revenues from public firms; however, tax revenues from private firms decrease with higher book-tax conformity.

Auditor’s cognitive bias in tax auditing decision: An experimental evidence

A well known game-theoretic model of tax compliance developed by Graetz et al.(1986) predicts the optimal equilibrium strategies of taxpayers and tax auditors when a common knowledge assumption of individual rationality is applied to game participants. Previous experimental evidence in tax compliance game setting, however, shows that decision makers face cognitive limitations. That is, tax auditors and taxpayers adjust their strategy based on a belief about the opponent’s response to parametric change, but do not correctly recognize that their opponent does likewise(Kim 2011). The hypotheses in this study assume that the auditor with limited rationality is sensitive to both the proportion of unethical taxpayers and uncertainty about the proportion. To represent limited rationality, this study proposes that the auditor makes the audit strategy choice through an anchoring and adjustment process. The anchor is a function of the factors that directly affect the auditor, such as the audit cost. The adjustment is a function of the auditor’s expectation about the taxpayer’s reporting strategy. The experiment in this study operationalizes the game-theoretic model of Graetz, et al.(1986) to examine how the auditor with limited rationality responds to the variation in the proportion of unethical taxpayers and uncertainty about the proportion of unethical taxpayers. The experimental results show a significantly positive relationship between the level of unethical taxpayers and the audit probability. The results show that the auditors used the level of unethical taxpayers as a cue for setting an anchor for the audit rate. The auditors who know the level of unethical taxpayers increase the audit probability as the level increases. When the level of unethical taxpayers is common knowledge, the auditors respond to normatively irrelevant variation in the level of unethical taxpayers, reflecting non-strategic or simple strategic thinking. The experiment also shows how to eliminate the auditors’ strategic decision bias by suppressing normatively irrelevant information, given the previous experimental results showing that humans normally cannot work through the higher levels of strategic thinking as predicted by game-theoretic models. When the auditors know the level of unethical taxpayers in each round, they commit the bias of under-auditing when the level is low. However, when the auditors know only the uniform distribution over possible levels of unethical taxpayers, the tendency to under-audit disappears. A counterintuitive policy implication for auditors is to ignore variation in the proportion of unethical taxpayers unless the variation is a private information. A key element in the hypothesis development and experimental design is the players’ formation of a belief about their opponent’s strategy and incorporation of this belief into their own strategy choice. Future research might further examine the belief formation process and its impact on strategy choice, in two ways. One way is to elaborate the subjects’ task. A future experiment additionally might collect the subjects’ estimates of their opponent’s estimate of their own strategy. The extra data would clarify how the subjects make belief-based adjustments in their strategy choice. The other way is to simplify the taxpayers’ reasoning process by informing the audit probability before they state their under-reporting probability.

One Set or Two Sets of Books: The Impact of a Strategic Tax Auditor

This study examines how a strategic tax auditor affects a multinational firm’s transfer pricing in a tax compliance game. Our model uses a divisionalized firm, in both a low-taxand a high-tax country, that decides to implement a transfer-pricing regime with either one or two sets of books. After observing its unit costs, the firm reports a compliant or non-compliant tax transfer price. In a regime with one set of books, the single transferprice coordinates the quantity decision and determines the tax payments. In a regime with two sets, different transfer prices serve those tasks. In contrast to previous studies, our analysis incorporates a strategic tax auditor, who observes the tax transfer price and decides whether to audit the firm. Real-world regulations suggest larger penalties for detected non-compliance under a two-sets-of-books transfer-pricing regime. Our analysis identifies the mixed strategy equilibria and examines how variations in the tax regulation—the tax rate difference and the penalty difference—affect the firm’s tax aggressiveness. We show that a firm acts less tax aggressively with a higher tax rate difference. Additionally, the model predicts that the firm either increases or decreases the probability of keeping one set of books for a smaller penalty difference.

The Effect of Tax Privacy on Tax Compliance – An Experimental Investigation

In this paper, we use a tax compliance game with a public good to investigate the impact of public disclosure on tax evasion behavior experimentally. Three different types of tax privacy are tested, ranging from complete privacy to full disclosure. We expect two different effects: first, a contagion effect, arising when an individual observes non-compliance of other individuals and therefore reduces her own tax compliance; second, a shame effect of increased tax compliance due to the anticipated shame of being declared a tax evader. Both these effects are supported by the experimental results. However, the shame effect reduces tax evasion only in the short run. The influence of shame diminishes over the course of the experiment with subjects observing the non-compliance of other participants. Thus, our results indicate that when the contagion and the shame effect are present the latter is not strong enough to override the former in the long run. Furthermore, disclosing tax information anonymously increases tax evasion compared to providing no information on tax evasion behavior. These observations are of particular importance for tax policy because public disclosure may lead to more evasion instead of less when supporting a crowding-out of the tax morale.

Alchian and Allen visit the IRS: costly audits and taxpayer compliance

This article reports on the results from a small-scale investigation of the compliance effects of a costly pre-audit on tax compliance. The tax compliance game is modelled in three parts: a declaration phase, a pre-selection phase with a cost for taxpayers and an audit selection phase where all evaded income is discovered. While the theoretical predictions are ambiguous, the data from a series of laboratory experiments demonstrate that the presence of pre-audit costs leads to lower tax compliance.

Combining Psychology and Economics in the Analysis of Compliance: From Enforcement to Cooperation

In tax compliance research, there has been a significant shift in research paradigms, from an emphasis on enforcement to approaches that stress cooperation. In this paper, we trace this shift. We first describe the major “actors” in the tax compliance game and their complex interactions. Second, we examine various perspectives on the compliance decisions of individuals, starting with “economic” factors and then moving to factors based more on “psychology”, like social norms, fairness, and social interactions. Third, we present the “slippery slope framework” as a unifying framework. We conclude with recommendations based on this framework that have been shown to improve compliance.

Alchian and Allen Visit the IRS: Costly Audits and Taxpayer Compliance

This note reports on the results from a small scale investigation of the compliance effects of a costly pre-audit on tax compliance. The tax compliance game is modeled in three parts: a declaration phase, a pre-selection phase with a cost for taxpayers, and an audit selection phase where all evaded income is discovered. While the theoretical predictions are ambiguous, the data from a series of laboratory experiments demonstrate that the presence of pre-audit costs leads to lower tax compliance.

Conformity or Decoupling: A Comparative Analysis of Different Tax Regimes

This paper analyzes a tax compliance game to examine how the degree of conformity in tax systems affects the value relevance of accounting information. The parallel settings in the book-tax conformity case and the decoupling case, and their solutions are compared to obtain comparative results. In the conformity case, the firm must report its earnings that are equal to its taxable income. On the other hand, the firm can report its accounting earnings and its taxable income differently. However, the tax authority conducts a tax audit based on the book-tax difference. The analysis shows that the value relevance in the conformity model is strictly higher than that in the decoupling model. Although this result is somewhat counterintuitive, it is consistent with some empirical studies.

Discussion of The Interrelationship between Estimated Tax Payments and Taxpayer Compliance

CONTRIBUTION Feltham and Paquette (2002) (hereafter the paper) examine the effect of a taxpayer’s prepayment position on the taxpayer’s reporting strategy and the government’s auditing strategy in a tax compliance game. Chang and Schultz (1990) find a positive association between noncompliance and an underpayment position. Dusenbury (1994) asserts, ‘‘The prepayment level determines the additional payment due or the refund available, but logically should not influence the reported tax liability.’’ Dusenbury (1994) goes on to argue that the link between noncompliance and prepayment position can be explained using prospect theory. This paper offers a competing explanation. The authors argue that because a taxpayer’s prepayment position is endogenously determined, the prepayment itself provides information regarding the taxpayer’s true tax liability to the tax authority, which in turn affects the strategic interaction in the tax compliance game. It shows that behavior that appears to be illogical when tax compliance is framed as a single-person decision theory problem is optimal if one assumes that tax compliance is a multiplayer, strategic game.

The Interrelationship between Estimated Tax Payments and Taxpayer Compliance

This paper examines taxpayers' compliance behavior and the tax agency's audit decision in a broader, more realistic, setting. Whereas prior research has taken the taxpayer's prepayment position as exogenous, this study extends the literature by incorporating the estimated tax payment decision into a tax compliance game. A two-period game-theoretic model is used to examine the effect that the estimated tax payment rules have on taxpayers' incentives to evade and on the tax agency's audit strategy. Our primary results are as follows. First, in equilibrium taxpayers' estimated tax payment decision will depend upon the uncertainty about their true tax liability, and the cost from overpayment (the taxpayer's cost of capital) or underpayment (penalty interest) of installments of estimated tax. Second, under reasonable assumptions, high-type taxpayers who make higher installments of estimated tax are less likely to lie about their level of income than those who make lower installments—that is, taxpayers who pay low are more likely to evade. Third, the tax agency audits taxpayers who have made low reports and low estimated tax payments with a higher probability than those who have made high estimated tax payments. The gain to the tax agency from auditing taxpayers who make lower payments and evade arises not only from the penalties charged for evasion, but also from the interest charged on deficient installments of estimated tax.

Honesty and Evasion in the Tax Compliance Game

Conventional models of tax compliance emphasize that taxpayers make strategic tax reports, underreporting income to the extent that this behavior is functionally rewarded. In contrast to this view, considerable empirical evidence suggests that many taxpayers are inherently honest, reporting truthfully regardless of the incentive to cheat. In this article we build a game-theoretic model of tax compliance that includes both honest and potentially dishonest taxpayers. We show that including honest taxpayers significantly alters the model, leading to much improved empirical predictions and somewhat different and novel policy implications.

Audit selection and income tax underreporting in the tax compliance game

This paper uses a game-theoretic model of the tax compliance game to estimate a model of audit selection and income tax underreporting in Jamaica. The empirical analysis make use of audited tax returns for individual taxpayers, and a random sample of tax returns for the population from which the audited returns are selected. The estimation results strongly indicate a nonrandom audit strategy, and thus provide support for the game-theoretic approach. The results also indicate that the probability of underreporting and the level of underreporting are positively related to the marginal tax rate and to income, and negatively related to marginal payroll tax benefits; in general, the underreporting elasticities are small.

Tax Base Erosion in Developing Countries

It is widely believed that the tax base in most developing countries has been severely eroded by legal tax avoidance and illegal tax evasion, brought about largely by poor' tax administration.1 This erosion, it is thought, has had a variety of fiscal effects: tax revenues are lost and the growth of the tax base is dampened, the progressivity implied by the statutory rate structure is not achieved, the costs of tax administration are increased, and horizontal and vertical equity suffer because the effective tax rates faced by individuals depend largely upon their success in playing the tax compliance game. It is not surprising, therefore, that virtually all fiscal reform programs in developing countries start with the promise to improve administration. Better administration is a discretionary government action that at once can lower the tax rate, increase revenues, slow capital flight, and improve the fairness of the system. Yet tax base erosion in developing countries is something about which precious little is known, and, in particular, the empirical evidence about the severity and the nature of the problem is all but nonexistent.2 Why do we know so little about the dimensions of the evasionavoidance problem? One reason is conceptual problems in measuring erosion of the tax base. For example, how does one estimate the substitution of nontaxable for taxable compensation in response to the tax structure, or the extent to which a higher marginal tax rate has induced individuals to report less of their taxable income? Another reason is the problem of comparability across countries. The many legal and

The Tax Compliance Game: Toward an Interactive Theory of Law Enforcement

The existing paradigm for the economic analysis of tax compliance provides an inadequate theory of the revenue collection process. Even as a purely economic model, its exclusive focus on individual taxpayers' decision-making promotes an unduly restrictive vision of the compliance problem and potential responses to it. In this paper we outline a more comprehensive theoretical basis for analyzing tax compliance, and illustrate it with a simple model. We believe our approach to be a significant improvement in the economic theory of law enforcement because it views the noncompliance problem as an interactive system. In our theoretical construct, individual decision-making not only depends upon and responds to the detection and punishment structure, but, unlike prior models, we also explicitly include the law enforcement agency--in this case the Internal Revenue Service--as an important interactive element. Initially we outline our general approach and its differences from the existing economic law enforcement paradigm. We then detail a simple model and its results and compare these results both to the prior literature and to some of our ongoing research in an effort to illustrate how our theoretical construct may affect predictions. Finally, we describe potential extensions of the model, examine its robustness with respect to various underlying assumptions and offer suggestions for further research, including possible applications to other law enforcement contexts.