Finding Out Who the Crooks Are - Tax Evasion with Sequential Auditing

This paper investigates multi-item moral hazard with auditing contests. Although the presented model is widely applicable, we choose tax evasion as an exemplary application. We introduce a tax-evasion model where tax authority and taxpayer invest in detection and concealment. The taxpayers have multiple potential income sources and are heterogeneous with respect to their evasion scruples. The tax authority - unable to commit to an audit strategy - observes a tax declaration and chooses its auditing efforts. We show that a tax inspector prefers to audit source by source until he finds evidence for evasion to conduct a full-scale audit thereafter.