Tax Audit Uncertainty and the Work-Versus-Leisure Decision

Abstract

The possibility of being audited provides an incentive for the more larcenous among us to accurately report taxable income when underreporting income carries a penalty. It seems safe to assume that by increasing either the likelihood of an income tax audit or the penalty for underreporting taxable income, the tax authority can reduce the extent to which conscious cheating takes place. That seemingly safe assumption, however, becomes much less so when the linkage between posttax income and the work-versus-leisure decision is taken into account. This article explores the ubiquitous and confounding effects on both reported income and work effort for non-risk-preferring taxpayers of changes in the audit probability, the sanction rate, the tax rate, and taxpayer wealth. It is shown that contrary to intuition and popular wisdom, raising the audit probability or the sanction rate will not necessarily lead to higher reported incomes, and neither increases in the tax rate nor greater taxpayer wealth will necessarily encourage increased leisure.