TAX LITIGATION, SETTLEMENT, AND TAX REPORTING GAME (AUDIT)

In a setting where tax laws are ambiguous, the resolution of disputes between taxpayers and the tax agency may require litigation. This study investigates (i) how the possibility of litigation influences taxpayers' initial reporting decisions and a tax enforcement agency's audit decision, (ii) how the agency utilizes audit findings to evaluate the hazard of litigation and to make a settlement offer, (iii) how taxpayers respond to the agency's settlement offer, and (iv) how a change in the value of the variables that may induce tax litigation would affect the equilibrium payoffs of taxpayers and the agency.; Several results are derived from the study: (i) an improvement in the agency's ability to assess the litigation hazard may not always increase the agency's expected net revenue; (ii) under a certain condition, we may achieve a Pareto-improvement by enhancing the agency's effectiveness in assessing the litigation hazard; (iii) an improvement in the agency's ability to assess the litigation hazard may have different consequences for individual taxpayers; and (iv) in most cases, tax disputes between the tax agency and taxpayers would be settled instead of being decided by the court.