AMBIGUITY ABOUT AUDIT PROBABILITY, TAX COMPLIANCE, AND TAXPAYER WELFARE ARTHUR SNOW and RONALD S. WARREN JR. * We show that an increase in uncertainty about the probability of being audited (ambiguity) increases tax compliance for ambiguity-averse taxpayers but reduces compliance for ambiguity lovers. Because experimental evidence reveals considerable heterogeneity with respect to ambiguity preferences, we conclude that fostering uncertainty about the probability of being audited may not be an effective policy for increasing taxpayer compliance. Moreover, because the tax authority can neither categorize nor screen taxpayers on the basis of their preferences for ambiguity, it is not likely to be either a useful or a desirable instrument for increasing taxpayer welfare. (JEL H26, D81) I. INTRODUCTION To encourage voluntary compliance with the tax code, the U.S. Internal Revenue Service (IRS) relies heavily on a policy of auditing tax returns and levying penalties when undeclared income is detected, with penalties linked to the amount of tax evasion discovered. The selection of returns for auditing is based on both strategic and random procedures. Strategic audits are determined by a closely guarded formula for choosing specific tax returns that exceed certain thresholds for reported income, deductions, and credits. After a decade-long hiatus, the IRS recently revived a program of random audits to measure tax compliance and update the formula for triggering strategic audits. 1 The IRS has testified to the importance of both the randomness and secrecy of its audit policies as instruments for increasing taxpayer compliance, because auditing all returns is not cost-effective. 2 However, the relatively small penalties levied for detected evasion, combined with the low probability of an audit, would seem to provide taxpayers with a strong in- centive to engage in rational evasion behavior. Indeed, the commissioner of the IRS has esti- mated that the amount of federal tax evaded annually exceeds 10% of the total revenue ac- tually collected. 3 Experimental analyses of the compliance decision have supported the IRS view that tax evasion is reduced by uncertainty about or up- ward bias in perceptions of the probability *We thank three anonymous referees for their helpful comments on an earlier version of this paper. Warren gratefully acknowledges financial support from a Terry- Sanford Research Award. Snow: Professor, Department of Economics, Terry Col- lege of Business, University of Georgia, Athens, GA 30602. Phone 1-706-542-3693, Fax 1-706-542-3376, E-mail snow@terry.uga.edu Warren: Associate Professor, Department of Economics, Terry College of Business, University of Georgia, Athens, GA 30602. Phone 1-706-542-3693, Fax 1-706-542-3376, E-mail warren@terry.uga.edu 1. See IRS News Release IR-2002-05, January 16, 2002. 2. See Roberts v. Internal Revenue Service, 584 Federal Supplement 1241 (Eastern District, Michigan), 1984. ABBREVIATIONS IRS: Internal Revenue Service SOP: Second-Order Probability 3. See IRS News Release IR-2002-05. As Andreoni et al. (1998, p. 821) observe, extensive reporting require- ments for institutions that pay out either labor or capital income limit opportunities for many individuals to evade their tax liabilities, particularly those who take the stan- dard deduction. Andreoni et al. (1998, p. 850) also point out that some individuals have a moral compulsion to re- port their taxable incomes to the IRS honestly. However, individuals who are both able and willing to evade face a low probability of being detected and a relatively small penalty if they are detected. For fiscal year 2002, the IRS audited fewer than 0.6% of individual income-tax returns, as reported at www.irs.gov/taxstats. Andreoni et al. (1998, p. 820) report that taxpayers face gross penalty rates rang- ing from 1.2 for negligent understatement of liabilities to 1.75 for intentional fraud. The substantial amount of eva- sion estimated by the IRS indicates that many individuals who are able and willing to evade do so. It is these indi- viduals who are the targets of IRS audits, and it is their behavior that the IRS intends to affect through policies aimed at discouraging noncompliance. Economic Inquiry doi:10.1093/ei/cbi066 (ISSN 0095-2583) Advance Access publication August 10, 2005 Vol. 43, No. 4, October 2005, 865–871 Ó Western Economic Association International 865