Feasible Net Income Distributions Under Income Tax Evasion: An Equilibrium Analysis

We investigate how redistribution of income is affected by the fact that income is privately observed and agents may not be truthful in their reports to the tax authorities. In response, the government establishes an audit mechanism with penalties. Adhering to a signaling equilibrium concept, we prove that agents resort to mixed strategies, which makes it difficult for tax authorities to identify the true types. The audit strategy has a cut-off property: all income declarations below the pivotal income are audited with a constant probability. Other declarations are not audited. In spite of not being necessarily truthful, agents whose true income is below or equal the pivotal income, pay their liability and consequently, the government is implementing the designated tax schedule for these agents. Any effective tax schedule can be implemented by pushing the pivotal income upward, by setting a sufficiently high penalty on underreporting. In such a case, the effect of private information is only in reducing government revenues. In equilibrium, penalties and tax corrections equal the audit cost. Consequently, the audit system does not contribute directly to revenues, and its role is restricted to supporting the equilibrium. ∗We are grateful to the Associate Editor and two referees for helpful comments.