Tax evasion, informants, and optimal auditing policy

We analyze the interaction between the tax authority, tax payers, and potential informants in a game theoretic framework. The tax authority gives monetary incentives to informants, and conducts random tax audits. The probability of a tax payer being audited depends on whether the tax authority received a tip about him from an informant or not. In subgame perfect equilibrium tax payers are divided into (at most) two groups. Those with income up to a certain level evade a small amount of taxes to assure that potential informants do not have sufficient incentives to report, and those with high incomes choose to declare zero income knowing that they will be reported by informants. The tax authority chooses the probabilities of the two types of audits, under a budget constraint. In many cases the probabilities are chosen in a way that no informant actually reported, and in some cases the tax authority does not conduct any audits.