Tax Evasion and Auditing in a Federal Economy

This paper analyzes the relation between tax auditing and fiscal equalization in the context of fiscal competition. We incorporate a model of tax evasion by firms into a standard tax competition framework where regional governments use their audit rates as a strategic instrument to engage in fiscal competition. It is well known that in such a situation fiscal equalization can mitigate the inefficiencies from tax competition. We compare the regions choice of audit policies for three different cases: A scenario of unconfined competition without interregional transfers, a scenario with a gross revenue equalization scheme and finally, a scenario with net revenue equalization, where not only the revenues from taxation but also the regions auditing costs are shared. We show that fiscal competition leads to audit rates which are inefficiently low from the perspective of total revenue maximization. While in general gross revenue equalization aggravates the inefficiency, net revenue equalization makes the decentralized choice of auditing policies more efficient. JEL-classification code: H26; H71; H77