Deterrence Effects of Auditing Rules: An Experimental Study

Tan, Fangfang and Yim, Andrew (2010): Deterrence Effects of Auditing Rules: An Experimental Study.

Abstract

This paper experimentally examines a new auditing rule termed the bounded rule, which takes into account the budget constraint of the auditor (e.g., a tax authority). Compared to a traditional rule that audits income reports with a constant probability, the bounded rule can induce the same deterrence e¤ect with a smaller budget. The basic setting follows a classic tax-compliance game in which each taxpayer receives either high or low income with certain probability. On knowing an auditing rule, the taxpayers have to decide simultaneously and independently whether to report their income truthfully to the auditor. The traditional rule audits every low-income report with a constant probability. The bounded rule audits a randomly selected sample of low-income reports whenever the number of these reports exceeds the maximum number of audits allowed by the budget, or otherwise all of the low-income reports. The experimental evidence suggests that, as predicted, the two auditing rules have the same deterrence e¤ect. The bounded rule needs a smaller budget ex-ante, and conducts fewer audits ex-post. The results provide support for the bounded rule as a more cost-e¤ective alternative to the traditional rule.

• Item Type: MPRA Paper
• Language: English
• Keywords: Audit sampling plan, tax audit, tax compliance, tax evasion, experimental economics.
• Subjects: C - Mathematical and Quantitative Methods > C9 - Design of Experiments; M - Business Administration and Business Economics ; Marketing ; Accounting ; Personnel Economics > M4 - Accounting and Auditing > M42 - Auditing; C - Mathematical and Quantitative Methods > C7 - Game Theory and Bargaining Theory > C72 - Noncooperative Games; H - Public Economics > H2 - Taxation, Subsidies, and Revenue > H26 - Tax Evasion and Avoidance

References

Alm, J., M. B. Cronshaw, and M. McKee (1993). Tax compliance with endogenous audit selection rules. Kyklos 46 (1), 27-45.

Alm, J., B. R. Jackson, and M. McKee (2009, April). Getting the word out: Enforcement information dissemination and compliance behavior. Journal of Public Economics 93 (3-4), 392-402.

Alm, J. and M. McKee (1998, August). Extending the lessons of laboratory experiments on tax compliance to managerial and decision economics. Managerial and Decision Economics 19 (4/5), 259-275.

Alm, J. and M. McKee (2004, July). Tax compliance as a coordination game. Journal of Economic Behavior & Organization 54 (3), 297-312.

Bayer, R. and F. Cowell (2009). Tax compliance and .rms.strategic interdependence. Journal of Public Economics Volume 93, Issues 11-12, 1131-1143.

Blackwell, C. (2007). A meta-analysis of tax compliance experiments. In Martinez-Vazquez and J. Alm (Eds.), Tax Compliance and Evasion, forthcoming.

Boylan, S. J. and G. B. Sprinkle (2001, March). Experimental evidence on the relation between tax rates and compliance: The effect of earned vs. endowed income. Journal of the American Taxation Association 23 (1), 75-90.

Brandenburger, A. (1996, May). Strategic and structural uncertainty in games. In R. J. Zeckhauser, R. L. Keeney, and J. K. Sebenius (Eds.), Wise Choices: Decisions, Games, and Negotiations, pp. 221-232. Harvard Business Press.

Chen, R. and R. M. Johnston (2008). Securities and exchange commission comment letters: Enforcing accounting quality and disclosure. SSRN working paper.

Christie, R. and F. Geis (1970). Studies in Machiavellianism. Academic Press, New York.

Dhami, S. and A. al Nowaihi (2007, September). Why do people pay taxes? prospect theory versus expected utility theory. Journal of Economic Behavior & Organization 64 (1), 171-192.

Dhami, S. and A. Al-Nowaihi (2010, August). Optimal taxation in the presence of tax evasion: Expected utility versus prospect theory. Journal of Economic Behavior & Organization 75 (2), 313-337.

Elffers, H. and D. J. Hessing (1997, April). Influencing the prospects of tax evasion. Journal of Economic Psychology 18 (2-3), 289-304.

Erev, I. and A. Rapoport (1998). Coordination, 'magic,' and reinforcement learning in a market entry game. Games and Economic Behavior 23 (2), 146-175.

Fischbacher, U. (2007). Z-tree - zurich toolbox for readymade economic experiments. Experimental Economics 10(2), 171-178.

Fischbacher, U. and U. Stefani (2007, May). Strategic errors and audit quality: An experimental investigation. The Accounting Review 82 (3), 679.

Graetz, M., J. Reinganum, and L. Wilde (1986). The tax compliance game: Toward an interactive theory of tax enforcement. J. Law Econ. Organ. 2, 1-32.

Heinemann, F., R. Nagel, and P. Ockenfels (2009). Measuring strategic uncertainty in coordination games. Review of Economic Studies 76 (1), 181-221.

Holt, C. A. and S. K. Laury (2002, December). Risk aversion and incentive effects. American Economic Review 92 (5), 1644-1655.

Huyck, J. B. V., R. C. Battalio, and R. O. Beil (Aug., 1991). Strategic uncertainty, equilibrium selection, and coordination failure in average opinion games. The Quarterly Journal of Economics 106 (3), 885-910.

Huyck, J. B. V., R. C. Battalio, and R. O. Beil (Mar., 1990). Tacit coordination games, strategic uncertainty, and coordination failure. The American Economic Review 80 (1), 234-248.

Kahneman, D. and A. Tversky (1979, March). Prospect theory: An analysis of decision under risk. Econometrica 47 (2), 263-91.

Kim, C. K., J. H. Evans, and D. V. Moser (2005, October). Economic and equity effects on tax reporting decisions. Accounting, Organizations and Society 30 (7-8), 609-625.

Kim, C. K. and W. S. Waller (2005). A behavioral accounting study of strategic interaction in a tax compliance game. pp. 35-56.

King, S. and S. Sheffrin (2002, August). Tax evasion and equity theory: An investigative approach. International Tax and Public Finance 9 (4), 505-521.

Lennox, C. and J. Pittman (2010). Auditing the auditors: Evidence on the recent reforms to the external monitoring of audit .rms. Journal of Accounting and Economics 49 (1-2), 84-103.

Loomes, G. (2005, December). Modelling the stochastic component of behaviour in experiments: Some issues for the interpretation of data. Experimental Economics 8 (4), 301.

McFadden, D. (1973). Conditional logit analysis of qualitative choice behavior. Frontiers of Econometrics New York: Academic press.

McFadden, D. (2001, June). Economic choices. The American Economic Review 91 (3), 351-378.

McKelvey, R. D. and T. R. Palfrey (1995, July). Quantal response equilibria for normal form games. Games and Economic Behavior 10 (1), 6-38.

Moser, D. V., J. H. Evans, and C. K. Kim (1995, October). The e.ects of horizontal and exchange inequity on tax reporting decisions. Accounting Review 70 (4), 619-634.

Nelson, M. and H.-T. Tan (2005). Judgment and decision making research in auditing: A task, person, and interpersonal interaction perspective. Auditing: A Journal of Practice & Theory 24, 41-71.

Reinganum, J. F. and L. L. Wilde (1985, February). Income tax compliance in a principal-agent framework. Journal of Public Economics 26 (1), 1-18.

Rieskamp, J. (2008). The probabilistic nature of preferential choice. Journal of Experimental Psychology: Learning, Memory, and Cognition, 1446-1465.

Slemrod, J. and S. Yitzhaki (2002). Tax avoidance, evasion, and administration. 3, 1423-1470.

Starmer, C. and R. Sugden (1991). Does the random-lottery incentive system elicit true preferences? an experimental investigation. The American Economic Review 81 (4), 971-978.

Sundali, J. A., A. Rapoport, and D. A. Seale (1995). Coordination in market entry games with symmetric players. Organizational Behavior and Human Decision Processes 64 (2), 203-218.

Tversky, A. and D. Kahneman (1992, October). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty 5 (4), 297-323.

US Department of the Treasury, U. A. (2006). FY 2007 budget in brief. Washington, DC.

Wilcox, N. T. (2009). "stochastically more risk averse": A contextual theory of stochastic discrete choice under risk. Journal of Econometrics forthcoming.

Yaniv, G. (1999, December). Tax compliance and advance tax payments: a prospect theory analysis. National Tax Journal 52 (4), 753-764.

Yim, A. (2009, December). Efficient committed budget for implementing target audit probability for many inspectees. Management Science 55 (12), 2000-2018.

Zimbelman, M. F. and W. S. Waller (1999). An experimental investigation of Auditor-Auditee interaction under ambiguity. Journal of Accounting Research 37, 135-155.