Optimal performance reward, tax compliance and enforcement

Abstract

This paper incorporates the incentives of tax inspectors into an equilibrium model of tax compliance and enforcement when the taxpayers’ true income is private information (‘adverse selection’) and the effort of tax inspectors to verify reported income is unobservable (‘moral hazard’). It characterizes the optimal remuneration for tax inspectors, which is a function of discovered tax evasion, paying particular attention to the determinants of the power of incentives and the curvature of the optimal reward scheme. It is shown that the structure of the optimal reward is increasing, and in general non-linear, in the magnitude of discovered tax evasion. The equilibrium characterized has the features that: taxpayers with higher true income underreport less and tax inspectors’ auditing effort, and hence the probability of detecting tax non-compliance, decreases with reported income.