Related Examinations and Tax Compliance

One of the Internal Revenue Services' methods for audit is to pick individuals engaged in transactions with other taxpayers whose tax returns were selected for audit. Such related examination in the audit procedure introduces an externality where one's actions can potentially harm others. It can induce a different tax compliance behavior compared to the purely random audit mechanism. We propose a Simplified Related Examinations (SRE) audit mechanism and study its effectiveness against the Random Audit (RA) mechanism using a laboratory experiment. Our findings reveal that the SRE treatment significantly increases tax compliance at the extensive margin, effectively encouraging taxpayers to become fully compliant. However, it also leads to a decrease in average tax compliance among persistent tax evaders. We also analyze how varying factors like social distance, group size, and audit rate impact this effect