Consider the optimal audit strategy of a tax authority. All taxpayers have either a low income YL or a high income YH, with YL H. They file a tax return, but the rich taxpayers may attempt to underreport. The proportions of taxpayers with high and low incomes are known, but a personal tax return can only be verified through an audit that costs c. There is a constant tax rate on income t and a fine consisting of a surcharge F on any underpaid tax. The parameters c, t, and F are not chosen by the tax authority.
a. Suppose that the tax authority can pre-commit to its audit polity. What is the optimal audit strategy for the tax authority? Is such a policy credible? Why or why not?
b. If there is a fixed fraction of high-income taxpayers who are known to report truthfully, what could be a credible audit strategy?
What is the impact on the equilibrium audit strategy of an increase in the cost of auditing?