Risk-Averse Taxpayers and the Allocation of Tax Enforcement Effort: Law Enforcement or Leviathan? Some Empirical Evidence

Abstract

Agencies charged with collecting taxes and enforcing the tax code generally use information provided by taxpayers to decide whether to subject individual returns to a variety of review procedures. One consequence of such conditional screening is the creation of incentives for strategic income reporting by individuals who wish to avoid the inconvenience and penalties associated with audits. Because taxpayers differ with respect to risk aversion, individuals in identical fiscal circumstances tend to report different income levels and pay different taxes. In turn, a tax agency may allocate its enforcement effort in a manner that systematically takes account of differences in taxpayer risk aversion. Three models are developed and tested in this article. Empirical evidence suggests that risk aversion affects both taxpayer behavior and the allocation of audit efforts by the Internal Revenue Service of the United States, although not in the manner predicted by the Leviathan model.