Economic Theory Bulletin

, Volume 4, Issue 2, pp 325–345 | Cite as

Optimal performance reward, tax compliance and enforcement

  • Christos Kotsogiannis
  • Konstantinos SerfesEmail author
Research Article


This paper incorporates the incentives of tax inspectors into an equilibrium model of tax compliance and enforcement when the taxpayers’ true income is private information (‘adverse selection’) and the effort of tax inspectors to verify reported income is unobservable (‘moral hazard’). It characterizes the optimal remuneration for tax inspectors, which is a function of discovered tax evasion, paying particular attention to the determinants of the power of incentives and the curvature of the optimal reward scheme. It is shown that the structure of the optimal reward is increasing, and in general non-linear, in the magnitude of discovered tax evasion. The equilibrium characterized has the features that: taxpayers with higher true income underreport less and tax inspectors’ auditing effort, and hence the probability of detecting tax non-compliance, decreases with reported income.


Tax administration Tax auditing Tax evasion Tax compliance Multiple inspectors Power of incentives 

JEL Classification

H26 D82 



Much of this work was completed while Kotsogiannis was a visiting scholar at Drexel University, the hospitality of which is gratefully acknowledged. We also thank Ana Cinta Gonzalez Cabral, Thiess Buettner, Harris Dellas, Gareth Myles, Apostolis Philippopoulos, Matthias Wrede, and seminar participants at the universities of Exeter, FAU Erlangen-Nuremberg, Lugano, and at the 2nd Workshop on Public Sector Reform 2015 for comments. Any remaining errors are ours.


  1. Allingham, M., Sandmo, A.: Income tax evasion: a theoretical analysis. J. Public Econ. 1, 323–338 (1972)CrossRefGoogle Scholar
  2. Andreoni, J., Erard, B., Feinstein, J.: Tax compliance. J. Econ. Lit. 36(2), 818–860 (1998)Google Scholar
  3. Besley, T., McLaren, J.: Taxes and bribery: the role of wage incentives. Econ. J. 103, 119–141 (1993)CrossRefGoogle Scholar
  4. Birkhoff, G., Rota, G.: Ordinary Differential Equations. Wiley, New York (1989)Google Scholar
  5. Cabral, A.C.G., Kotsogiannis, C., Myles, G.: Self-employment underreporting in Great Britain, who and how much? In: TARC Working Paper, pp. 010–14 (2014)Google Scholar
  6. Chander, P., Wilde, L.: A general characterization of optimal income taxation and enforcement. Rev. Econ. Stud. 65, 165–183 (1998)CrossRefGoogle Scholar
  7. Crémer, H., Marchand, M., Pestieau, P.: Evading, auditing and taxing. J. Public Econ. 43, 67–92 (1990)CrossRefGoogle Scholar
  8. Guesnerie, R., Picard, P., Rey, P.: Adverse selection and moral hazard with risk neutral agents. Eur. Econ. Rev. 33, 807–823 (1989)CrossRefGoogle Scholar
  9. Hashimzade, N., Myles, G., Tran-Nam, B.: Application of behavioural economics to tax evasion. J. Econ. Surv. 1–37 (2012)Google Scholar
  10. Hindriks, J., Keen, M., Muthoo, A.: Corruption, extortion and evasion. J. Public Econ. 74, 395–430 (1999)CrossRefGoogle Scholar
  11. Konrad, K.: Strategy and Dynamics in Contests. Oxford University Press, Oxford (2008)Google Scholar
  12. Kotsogiannis, C., Serfes, K.: Optimal performance reward, tax compliance and enforcement. In: TARC Working Paper, pp. 013–15 (2015)Google Scholar
  13. Mookherjee, D., Png, I.: Corruptible law enforcers: how should they be compensated? Econ. J. 105, 145–159 (1995)CrossRefGoogle Scholar
  14. OECD: Tax administration 2013: comparative information on OECD and other advanced and emerging economies. OECD Publishing, Singapore (2013). doi: 10.1787/9789264200814-en
  15. Picard, P.: On the design of incentive schemes under moral hazard and adverse selection. J. Public Econ. 33, 305–331 (1987)CrossRefGoogle Scholar
  16. Reinganum, J., Wilde, L.: Income tax compliance in a principal-agent framework. J. Public Econ. 26, 1–18 (1985)CrossRefGoogle Scholar
  17. Reinganum, J., Wilde, L.: Equilibrium verification and reporting policies in a model of tax compliance. Int. Econ. Rev. 27, 739–760 (1986)CrossRefGoogle Scholar
  18. Slemrod, J., Yitzhaki, S.: Tax avoidance, evasion, and administration. In: Handbook of Public Economics, 1st edn, vol. 3, chap. 22, pp. 1423–1470. Elsevier, London (2002)Google Scholar
  19. Yitzhaki, S.: A note on income tax evasion: a theoretical analysis. J. Public Econ. 3, 201–202 (1974)CrossRefGoogle Scholar

Copyright information

© Society for the Advancement of Economic Theory 2016

Authors and Affiliations

  1. 1.Department of Economics, TARCUniversity of Exeter Business SchoolExeterEngland, UK
  2. 2.CESIfoMunichGermany
  3. 3.School of Economics, LeBow College of BusinessDrexel UniversityPhiladelphiaUSA

Personalised recommendations