The double dividend of relative auditing—Theory and experiments on corporate tax enforcement

• Published date: 01 December 2022
• Author: Ralph‐C. Bayer
• Date: 01 December 2022
• DOI: http://doi.org/10.1111/jpet.12587

Received: 9 February 2021

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Accepted: 4 March 2022

DOI: 10.1111/jpet.12587

ORIGINAL ARTICLE

The double dividend of relative

auditing—Theory and experiments

on corporate tax enforcement

Ralph‐C. Bayer

School of Economics and Public Policy,

University of Adelaide, Adelaide,

South Australia, Australia

Correspondence

Ralph‐C. Bayer, School of Economics and

Public Policy, University of Adelaide,

Adelaide, SA, Australia.

Email: ralph.bayer@adelaide.edu.au

Funding information

Australian Research Council,

Grant/Award Number: Discovery Project

DP12010183

Abstract

In this paper, we present and extend previous

theoretical results that show that tax authorities can

at the same time reduce tax evasion and boost output

with clever audit behavior. We argue that randomized

controlled trials or field experiments are impractical for

empirical testing in this context. Instead, we turn to

laboratory experiments and test if humans follow the

theoretical mechanisms underlying the theory. We find

that both dividends, less evasion, and higher output,

materialize in the laboratory. We show in additional

experiments that the behavioral mechanism generating

the higher output differs from the theoretical driver.

1|INTRODUCTION

In the last decade, around the world, concerns about large firms avoiding or evading their taxes

have gained in prominence. In response, governments have tightened the rules and have

bolstered enforcement. The European Union, for example, adopted “The Anti Tax Avoidance

Directive”in 2016. The UK parliament passed the “Criminal Finances Act,”which increases

the liability of firms for criminal activities (such as evasion) of their employees. The Australian

Government recently gave their tax authority (ATO) new powers and introduced a 40% tax

penalty on firms found breaking the rules. Beside these institutional changes, governments and

tax authorities around the world have also been working on improving the information

gathering process that leads to audits. In 2014 more than 60 countries have agreed to

J Public Econ Theory. 2022;24:1433–1462. wileyonlinelibrary.com/journal/jpet

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This is an open access article under the terms of the Creative Commons Attribution‐NonCommercial License, which permits use,

distribution and reproduction in any medium, provided the original work is properly cited and is not used for commercial purposes.

© 2022 The Authors. Journal of Public Economic Theory published by Wiley Periodicals LLC.

automatically exchange bank account information of individuals and firms. Moreover, tax

authorities around the world use analytical tools that calculate risk scores for individuals and

firms (e.g., the Discriminant Inventory Function in the United States).

The main focus of the push against corporate‐tax avoidance has been the development of

enforcement techniques that catch more evaders and avoiders. Much less attention has been paid to

firms' likely tax planning reactions to these new measures. Here, the potential deterrence effect of the

new measures received the most attention. In all this, the question if and how these new ways of

enforcing corporate taxes might impact market outcomes have been widely neglected.

The idea that corporate tax enforcement can have an impact on market outcomes has only

recently been introduced to the literature. Some theory papers have shown that the way how tax

authorities go about enforcing corporate tax compliance can cause distortions in goods markets.

Bayer and Cowell (2009,2016) investigate audit rules that allocate a higher auditing effort to a firm

that declares a low profit relative to its competitors. They find that these rules create an externality

in the goods market that increases output and therefore social welfare. A similar effect can be

theoretically achieved with relative enforcement rules of environmental regulation (Oestreich,

2014). Many tax authorities implicitly—or even explicitly—use audit rules that have a relative

component. Examples are the use of the Discriminatory Inventory Function (DIF) by the IRS in

the United States or the Risk Differentiation Framework (RDF) by the Australian Taxation Office.

Whenever the likelihood or the thoroughness of an audit or an investigation depends on the degree

of suspicion, then this necessarily results in a relative rule in the sense of the theory, as a company

that reports a low profit compared to their competitors looks suspicious to the authorities.

This paper empirically tests if the incentives created by relative rules actually work as

predicted by theory. For this purpose, we build the simplest theoretical environment where it is

possible to show the benefits relative audit rules can theoretically provide. We look at relative

rules where the detection probability for a company smoothly increases with the difference

between its own and the competitor's declaration but also consider the more extreme jump

rule, where the detection probability only depends on whether a firms declares more, less or the

same profit as it's competitor. The former set of rules was first introduced and analyzed by

Bayer and Cowell (2009,2016), the latter by Oestreich (2014).

For our empirical tests, we take the different rules to the laboratory. Ideally, for an

empirical test we would like to randomly assign different audit rules to otherwise identical

industries in the field and then compare taxes evaded and output decisions. This is highly

impractical for a variety of reasons. First, no two identical industries exist. Second, randomizing

audit rules across industries in a country is difficult to achieve. Moreover, the multinational

nature of firms in many oligopolies adds a dimension that is likely to confound the audit‐rule

effect. Finally, tax evasion is not directly observable, and using audit results as measure

provides a selected sample. For these reasons, we conclude that using laboratory experiments is

the preferred second‐best methodology for an empirical test. Note that our laboratory

experiments are not designed with the aim of perfectly replicating the situation a company

finds itself in. Instead of building an environment that looks as similar to the real world as

possible, we use an extremely stylized game, which provides a minimum working example for

the mechanism underlying the theoretical double dividend.

1

This allows us to cleanly test if the

incentive mechanism generated by relative audit rules works as predicted by theory if an

1

See Brandts and Potters (2018), Holt (1995), and Plott (1982) for discussions of the value of experimental methods in

Industrial Organisation.

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BAYER