# Optimal performance reward, tax compliance and enforcement

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## Abstract

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.

## Keywords

Tax administration Tax auditing Tax evasion Tax compliance Multiple inspectors Power of incentives## JEL Classification

H26 D82## Notes

### Acknowledgments

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.

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