A Contest with the Taxman: The Impact of Tax Rates on Tax Evasion and Wastefully Invested Resources

We develop a moral hazard model with auditing where both the principal and the agent can influence the probability that the true state of nature is verified. This setting is widely applicable for situations where fraudulent reporting with costly state verification takes place. However, we use the framework to investigate tax evasion. We model tax evasion as a concealment-detection contest between the taxpayer and the authority. We show that higher tax rates cause more evasion and increase the resources wasted in the contest. Additionally, we find conditions under which a government should enforce incentive compatible auditing in order to reduce wasted resources.