Taxpayers' Reporting Decisions and Auditing Under Information Asymmetry.

Abstract ABSTRACT: This study examines the effects of uncertainty on taxpayers' reporting decisions in conjunction with economic factors. Previous research is extended by (1) simultaneously modelling taxpayers' reporting decisions and the tax agency's audit policies, (2) incorporating taxpayers' uncertainty about the tax agency's audit costs and uncertainty about their tax liabilities, and (3) investigating the effects of both transferable monetary and nontransferable penalties for underpayment of taxes. The analysis shows that tax liability uncertainty can have different effects upon taxpayers' reporting decisions than uncertainty about the audit cutoff point. Furthermore, these specific effects will depend upon the presence or absence of monetary penalties and the anticipated audit probability in the initial equilibrium which, in turn, depends upon the penalty and tax rates. Specifically, increased tax liability uncertainty will induce more taxpayers to report a high level of income under proportional monetary penalties, but sometimes can have the opposite consequences under fixed, nontransferable penalties. Similar results also hold with respect to tax rate changes. The findings have direct implications for experimental studies of taxpayers' reporting behavior and potential policy implications for the effects of changes in the tax laws and reduction in tax and penalty complexity both of which would likely affect taxpayers' uncertainty.