AN EXPERIMENTAL ANALYSIS OF THE IMPACT OF IMPERFECT AUDITS ON FUTURE TAX COMPLIANCE

The issues of taxpayer noncompliance and the tax authority's ability to impact it through audits have significant policy implications. Audits can potentially have both direct and indirect revenue consequences. Audits may directly generate revenues by targeting noncompliant taxpayers. Audits may also generate revenues indirectly in two ways, through their: (i) subsequent effect, and (ii) ripple effect. The indirect effect of audits has been estimated to be large, dwarfing the direct effect of audits. However, research on the indirect effect of audits is sparse, largely because appropriate data are not readily available.; When audits are imperfect as evidence from the Taxpayer Compliance Measurement Program (TCMP) suggests, and audit quality is uncertain, audits can provide information on audit quality to taxpayers. This study examines the subsequent and ripple effects of imperfect audits in the presence and absence of transfer of information between taxpayers about audit quality and peer reporting behavior. Peer reporting behavior may influence the compliance of taxpayers in a manner contrary to the influence of information about audit quality. To achieve the objectives of this study, an economic model of taxpayer compliance was developed that includes uncertainty about audit quality, and the predictions derived therefrom were tested using the methodology of experimental economics.; The results from this study suggest that increasing audit rate under audit quality uncertainty and certainty may not increase compliance. The results relating to the subsequent effect of audits suggest that compliance may decrease (may not increase) when audit quality is lower (higher) than expected. Therefore, when audit quality is low (high), maintaining uncertainty about audit quality (developing an initially high expectation about audit quality) among taxpayers may maximize compliance. The between-subjects results in this study show that audit quality has a positive impact on compliance under audit quality certainty. The results also suggest that the ripple effect of audits consequent to transfer of information regarding audit quality and peer reporting behavior is positive, i.e., the ripple effect increases compliance, irrespective of audit quality. However, this positive impact of transfer of information on compliance does not appear to be a consequence of peer reporting behavior.