Audits or Distortions: The Optimal Scheme to Enforce Self-Employment Income Taxes

Abstract

I investigate the optimal auditing scheme for a revenue-maximizing tax-collection agency that observes not only reported prots, but also the level of employment at each firm. Each firm is owned by a single entrepreneur whose managerial ability is random. The optimal auditing scheme is discontinuous and non-monotone in ability. In intermediate audit costs, less-productive entrepreneurs face auditing probabilities that increase in ability, whereas the ablest ones are not audited. I argue that if the optimal auditing scheme were adopted in practice, net revenue collected from nonfarm sole proprietors would increase by at least 59 percent.