Auditing with Signals

This paper is a first step in the analysis of the use of signals of taxpayer’s incomes by tax audit authorities. In a very simple model, we consider the design of the audit strategy when the tax authority can commit to it and has free access to a signal correlated with the taxpayer’s true income. We discuss the optimal enforcement policy and compare it with the optimal one when only self-reported income is considered. Our main result is that the well-known regressive bias of revenue-maximizing audit rules may be convert in a progressive one when signals are used. Address: Universitat Autonoma de Barcelona. Fac Ciencias Economicas (edicifi B). Departament d'Economia i d'Historia Economica & CODE. 08193 Bellaterra (Barcelona). SPAIN. Fax: 34 93 581 24 61. E-mail: , and . * We thank Pau Olivella for his comments and suggestions. We also thank the Center for Industrial Economics (Institute of Economics, University of Copenhagen), where this research was partially conducted, for its hospitality and financial support. Financial support from the DGES PB97-0181 and the SGR 96-75 is also gratefully acknowledged.