Optimal Auditing with Heterogeneous Audit Perceptions

This paper derives a government's optimal tax audit policy when taxpayers hold different beliefs about the likelihood of a tax audit. When audits are inexpensive, differences in perceived audit risk lead to stricter optimal auditing in equilibrium. If audits are relatively costly, heterogeneity in audit perceptions lowers the equilibrium audit intensity. Except when beliefs are near-identical throughout the population, both tax evasion and honest reporting occur in equilibrium. A welfare analysis shows a non-monotonic, U-shaped relationship between perception heterogeneity and social welfare. High levels of social welfare are associated with very homogeneous or very heterogeneous populations. Moderately heterogeneous taxpayer populations are associated with lower levels of social welfare.