Optimal auditing and insurance in a dynamic model of tax compliance

B. Ravikumar, Yuzhe Zhang

Research output: Contribution to journalArticlepeer-review

9 Scopus citations


We study the optimal auditing of a taxpayer's income in a dynamic principal-agent model of hidden income. Taxpayers in our model initially have low income and stochastically transit to high income that is an absorbing state. A low-income taxpayer who transits to high income can underreport his true income and evade his taxes. With a constant absolute risk-aversion utility function and a costly and imperfect auditing technology, we show that the optimal auditing mechanism in our model consists of cycles. Within each cycle, a low-income taxpayer is initially unaudited, but if the duration of low-income reports exceeds a threshold, then the auditing probability becomes positive. That is, the tax authority guarantees that the taxpayer is not audited until the threshold duration is reached. We also find that auditing becomes less frequent if the auditing cost is higher or if the variance of income is lower.

Original languageEnglish (US)
Pages (from-to)241-282
Number of pages42
JournalTheoretical Economics
Issue number2
StatePublished - May 2012


  • Optimal taxation
  • Stochastic costly state verification
  • Tax auditing
  • Tax compliance

ASJC Scopus subject areas

  • Economics, Econometrics and Finance(all)


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