Deterrence vs. gamesmanship: Taxpayer response to targeted audits and endogenous penalties

Taxpayers with large amounts of non-third-party-reported income usually self-report at least a portion of it, an act inconsistent with common theories of compliance. I explain this behavior by generalizing the classical evasion theory to realistically account for the endogeneity of audit and payment rates. These taxpayers refrain from more evasion not due to deterrence, but to tilt the odds and payoffs of the evasion gamble. The introduction of this incentive helps explain many empirical findings that seemingly contradict a more restrictive and unrealistic version of the “deterrence paradigm.” I also estimate feasible structural calibrations, the first based on observed compliance behavior, of taxpayers’ perceptions of the relationship between evasion, audit probabilities, and payment rates.