Efficient monitoring of tax avoidance: a Costly State Verification model

Abstract

In this manuscript, the author argues that, starting from the Allingham and Sandmo (1972) and Yitzhaki (1974) frameworks, the traditional models of tax avoidance have paid little attention to the problem of minimising the audit cost faced by the tax administration in assessing the fairness of the taxpayers. The aim of this paper is just to provide new insights on how to efficiently tackle the phenomenon of tax avoidance, addressing the asymmetric information issue and accounting for the expected audit cost borne by tax administration. To accomplish this task, the author proposes a new Costly State Verification model of tax avoidance relying on a few weak assumptions. The solutions of the model suggest that, in equilibrium, the taxpayer’s probability of tax avoidance and level of compliance are constant with respect to both endogenous and exogenous variables, while the tax administration’s audit probability and fine dramatically depend on the taxpayer’s income, tax rate and effective audit cost. The obtained results also give interesting indications on the well-known Yitzhaki puzzle which are in contrast with the established literature on the Prospect theory.