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Feasible Net Income Distributions under Income Tax Evasion: An Equilibrium Analysis

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  • Michael Landsberger
  • Dov Monderer
  • Irit Talmor

Abstract

We investigate how redistribution of income is affected by the fact that income is privately observed and agents may not be truthful in their reports to tax authorities. In response, the government establishes an audit mechanism with penalties. Adhering to a signaling equilibrium concept, we prove that agents resort to mixed strategies, which makes it difficult for tax authorities to identify the true types. The audit strategy has a cutoff property: All income declarations below the pivotal income are audited with a constant probability; other declarations are not audited. In spite of not necessarily being truthful, agents whose true income is below or equal to the pivotal income pay their liability and, consequently, the government is implementing the designated tax schedule for those agents. In equilibrium, penalties and tax corrections equal the audit cost. Consequently, the audit system does not contribute directly to revenues, and its role is restricted to supporting the equilibrium.

Suggested Citation

  • Michael Landsberger & Dov Monderer & Irit Talmor, 2000. "Feasible Net Income Distributions under Income Tax Evasion: An Equilibrium Analysis," Journal of Public Economic Theory, Association for Public Economic Theory, vol. 2(1), pages 135-153, January.
    • Handle: RePEc:bla:jpbect:v:2:y:2000:i:1:p:135-153
    DOI: 10.1111/1097-3923.00032
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    Cited by:

    1. Neumärker, Bernhard & Pech, Gerald, 2010. "Penalties in the theory of equilibrium tax evasion: Solving King John's problem," The Constitutional Economics Network Working Papers 01-2010, University of Freiburg, Department of Economic Policy and Constitutional Economic Theory.
    2. Sebastián Castillo, 2024. "Tax policy design in a hierarchical model with occupational decisions," International Tax and Public Finance, Springer;International Institute of Public Finance, vol. 31(5), pages 1295-1341, October.
    3. Leandro Arozamena & Martin Besfamille & Pablo Sanguinetti, 2010. "Optimal taxes and penalties when the government cannot commit to its audit policy," Department of Economics Working Papers 2010-10, Universidad Torcuato Di Tella.
    4. Bernhard Neumärker & Gerald Pech, 2011. "Penalties in the Theory of Equilibrium Tax Evasion: Solving King John’s Problem," Public Finance Review, , vol. 39(1), pages 5-24, January.

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