How do tax courts affect tax compliance and tax audits? A game-theoretic analysis

We investigate how the possibility to appeal tax audit results in court influences the taxpayer’s income declaration and the tax authority’s auditing process. We employ a game-theoretic model in which the taxpayer’s income declaration may be subject to an audit conducted by a designated auditor on behalf of the tax authority. The taxpayer can challenge audit errors by filing a tax court appeal. We find that in the absence of a tax court, an equilibrium with truthful income declaration can be achieved if tax audit fees are low and penalties for tax evasion are neither too low nor excessively high. If penalties are too high, taxpayers may overstate their income to avoid arbitrary punishment following a negligent tax audit. The possibility of having erroneous tax audits overturned in court incentivizes the tax auditor to increase audit intensity and avoid negligent tax audits. However, the tax authority may reduce its audit frequency in anticipation of audit results being overturned in court. The overall impact of tax courts on tax enforcement is ambiguous and depends crucially on the parameter setting. Generally, tax evasion cannot be meaningfully curbed if tax audits are prohibitively costly or if audit fees are excessively high.