The effects of IRS audit rates on state individual income tax compliance

Though majority of taxpayers pay their taxes voluntary, the tax gap—taxes legally owed but not paid in full and timely—persists at both federal and state level. The major tool used by tax agencies to reduce the tax gap and ensure high levels of compliance is tax auditing. Through tax audits noncompliant taxpayers are detected and penalized; that produces a deterrent effect on unaudited taxpayers. The research question is weather individual income tax audits conducted at the federal level by the Internal Revenue Service (IRS) have deterrent effects on state individual income tax compliance. In other words, this study attempts to find empirical evidence for spill-over effects of federal auditing activities on states income tax collections. Results of empirical analysis show a positive relationship between federal tax audits and state income tax compliance. Higher federal audit rates translate into higher state income tax collections. This finding confirms the expectation that federal audits have an impact on tax compliance that spills over to state individual income tax collections. The evidence suggests that first, auditing is an effective deterrent of tax evasion. Second, federal-state cooperation in tax administration through sharing of information has the effect of raising effective audit rate for both—federal income and state income—taxes. The findings have policy implications for tax enforcement strategies and national tax reform.