The Optimal Deterrence of Tax Evasion: The Trade-off Between Information Reporting and Audits

Despite the widespread recognition of the effectiveness of information reporting to increase tax compliance, existing tax theory considers tax audits to be the only tool to prevent evasion. This paper extends tax theory by modeling information reporting as an additional enforcement instrument that allows a tax authority to acquire signals about taxpayers' income. The paper rigorously characterizes the optimal strategy to maximize tax revenue when enforcement resources are limited. It determines the optimal allocation of resources between audits and information reporting, which is governed by how effectively the signals facilitate audit targeting. The model demonstrates that the value of information repotting declines with audit coverage because of the corresponding decline in the value of audit targeting. The optimal level of information reporting is an inverse U-shaped function of the budget allocated to enforcement, while the optimal audit coverage always increases with the budget. This finding implies that at some point it may not be optimal to expand information reporting. (C) 2016 Elsevier B.V. All rights reserved.