Collaborative Research on the Relationship between Income Tax Auditing and Compliance

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Tax noncompliance is widely recognized to be an extremely serious problem. Recent estimates suggest that at least $90 billion of taxable income goes unreported annually--an average of 10 to 15 percent of total taxable income. Concern about declining tax compliance has produced an outburst of policy and academic writing, but both the causes and the appropriate responses remain controversial. Early tax compliance literature treated tax compliance as a "portfolio problem," deriving rules for optimal consumption of the "risky asset" (unreported income) under the assumption that the probability of detection is fixed. These models produced ambiguous results. More recent theoretical innovations have attempted to move out of the decision-theoretic framework to a principal-agent problem and game-theoretic model. In these approaches the Internal Revenue Service (IRS) is allowed to act strategically, conditioning its audit rules on the information it receives from taxpayers. These interactive models, developed by Wilde, Reinganum and Graetz under a previous NSF grant, yield predictions about the nature of the equilibrium audit rule used by the IRS and the equilibrium reporting rule used by taxpayers. The purpose of this research is to test a game-theoretic model and to develop empirical evidence on the relationship between audits and compliance. Three distinct data sets are analyzed: (a) a cross-section data set related to 1969 individual Federal Income Tax returns, which was assembled by the IRS in the seventies; (b) a cross-section, time series data set related to state-level variables for the period 1969-1985; and (c) a data set related to 1979 TCMP individual return items, which was recently assembled by the IRS. The major question to be addressed is whether, and in what fashion, audit rates respond interactively to the compliance behavior of taxpayers. The introduction of IRS as a strategic actor is considered to be a significant improvement in the economic theory of law enforcement generally. The behavioral framework of tax non- compliance makes it an especially appropriate case for an empirical test of the theoretical construct that explicitly takes into account the interactions and responses of the cognizant law enforcement agency. The research is of substantial scientific significance in that it promises not only to offer insights on an important policy issue but also to add powerfully to fundamental knowledge of the conditions that engender conformance to law.