An optimal tax audit mechanism: models and some evidences

Abstract

Since tax evasion, a moral hazard rooted in information asymmetry, causes inefficiency as well as distorting income distribution, conscious policies are needed to abate its harm. However, policy measures are limited-the penalty for tax evasion is bounded above and monitoring resources are constrained. Focusing on the selfemployed, we thus explore how to design a socially optimal tax audit mechanism. With the 1989 Korean 'Family Income and Expenditure Survey,' we also examine: (1) tax payment factors; (2) the income tax gap between self-employed (SELF) households (HHs) and 'pay-as-you-earn' (PAYE) employee HHs; and (3) the effect of the tax audit rule on compliance. Though it saves audit resources and seizes evaders' risk premium, cutoff audit-currently adopted in Korea featuring 'reporting guidelines'-is shown to lower social welfare due to its built-in regressive bias. The line drawing hinders self-compliance as well. Endogenous audit with the audit chance declining in reported income without truncation is desirable for inequality-averse society. At least, the cutoff must be kept secret to taxpayers. The empirical analysis shows: (1) One-third of SELF HHs and 90% of temporary employees in the nonfarm sector are beyond tax enforcement; (2) SELF HHs pay less income tax than PAYE HHs by 46-60%, ceteris paribus, amounting to 18-30% of income tax collection. The tax gap widens with income.; (3) The elasticity of income tax payment to income is less than one for SELF HHs, conflicting with progressive taxation; (4) SELF HHs' elasticity is lower around their mean income than at tails. This reflects the adverse effect of cutoff audit; and (5) Tax enforcement is ineffective to capital income.