This paper considers an optimal taxation environment where household income is private information, and the government randomly audits and punishes households found to be underreporting. We prove that the optimal mechanism derived using standard mechanism design techniques has a bad equilibrium (a tax riot) where households underreport their incomes, precisely because other households are expected to do so as well. We then consider three alternative approaches to designing a tax scheme when one is worried about bad equilibria.
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In the mechanism we just constructed, households that report low income have a probability of being audited that is less than π(m). It is immediate to see that the mechanism coincides with one where the probability of being audited isexactlyπ(m),but,afteranaudit,thegovernmentdrawsalotteryandignorestheauditwithprobability1−π(φmF()m). Because of decreasing (and positive) risk aversion, it is possible to repeat the steps of the proof above to construct a new mechanism that gets rid of this unnecessary uncertainty, while preserving expected utility and enhancing incentives to report the truth. ‖ Acknowledgements. We are indebted to Mariacristina De Nardi, Narayana Kocherlakota, Kjetil Storesletten, and three anonymous referees for useful comments, and Roozbeh Hosseini and Vadym Lepetyuk for excellent research assistance. Marco Bassetto thanks the National Science Foundation and the Sloan Foundation for financial support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Banks of Chicago, Minneapolis, or the Federal Reserve System.