Hierarchical design and enforcement of income tax policies

Abstract

A hierarchical model of tax compliance is studied in which the government selects a tax policy and then delegates the responsibility to collect taxes to the IRS. There is a fixed distribution of income in the economy. Individuals differ by their income, which is known neither to the government nor to the IRS. We completely characterize the solution to the IRS’s revenuemaximizing problem. When taxpayers are risk neutral, the optimal auditing policy divides the reported incomes into at most three groups. We show that the government provides a smaller budget to the IRS than the IRS would wish. 1.