A Basic Model of Optimal Tax Enforcement under Liquidity Constraints

Abstract

I design a basic model based on the role of the tax administration as a lender of last resort (Andreoni 1992). If the administration's sole concern is for tax revenues, then it is optimal for it to make taxpayers take an unfair gamble. However, if it also gives some weight to the taxpayers' welfare in its objective function and this is sufficiently large, the situation might be reversed so that the auditing probability is lower and the evasion rate is higher. Under decreasing absolute risk aversion preferences, optimal enforcement is counter-cyclical (that is, greater liquidity constraints imply a higher level of enforcement) unless the administration attaches a considerable amount of weight to taxpayers' utility, which - at least in "normal times" - seems implausible. These theoretical results are complemented with numerical simulations.