Income tax evasion and audits under common and idiosyncratic shocks

Common shocks affect the profits of ex ante identical self-employed entrepreneurs. From aggregate tax return data or other industry expertise, the tax collection agency can better estimate the common shock. With three profit realizations, high, medium, or low, it is shown that this information asymmetry results in taxpayers engaging in at most one-step underreporting compared to a maximal two-step underreporting when the agency does not know the common shock. The evasion behavior also varies with profit levels: for high penalties, only high profit earners evade, whereas for moderate penalties, medium profit earners evade more often. In addition, the tax authorities audit low returns more intensively than they do medium returns when the common shock is favorable, and sometimes do not audit at all when the common shock is unfavorable. Finally, when idiosyncratic shocks depend on the abilities of the entrepreneurs, high-ability entrepreneurs will be more prone to underreporting.