Evading, Auditing and Taxing - the Equity Compliance Tradeoff

Tax evasion and auditing are analyzed in a model of linear income taxation. Taxpayers minimize expected tax payments including penalty for underreporting while the tax administration sets its audit policy to maximize expected net revenue under the restriction of only two audit rates per class of taxpayers. Given the reaction of taxpayers and tax administration, we derive the optimal income tax that the government should adopt to maximize social welfare. There are several classes of taxpayers, each characterized by a given distribution of pretax income and specific audit policy parameters