Optimal self-employment income tax enforcement

Most models of optimal income tax enforcement assume that income is either random or solely remunerates labor, neglecting that auditing strategies may depend on observable inputs. This paper outlines a model to optimally monitor self-employed entrepreneurs when, in addition to reported profits, the tax collection agency also observes the number of workers employed (or any other input variable) at each firm. We show that, by conditioning the monitoring strategy only on labor input, it is optimal for the IRS to audit firms in a way that generates some empirical regularities, like the missing middle. We also show that the optimal direct mechanism can be implemented by an indirect monitoring strategy that is consistent with actual IRS practices. In particular, the IRS calculates inputted income as function of labor. Whenever an entrepreneur reports profits that are lower than inputted income, she is randomly monitored. Finally, we formalize a model of optimal presumption taxation, in which inputted income is the tax base, to compare revenue collection across tax systems.