WHY IRS AGENTS LINE DANCE: AN AGENCY THEORY MODEL

Carolyn Ann Galantine
Pepperdine University
ABSTRACT
Researchers have previously modeled the relationship between the government and
taxpayers as a two player model with asymmetric information between the government and the
taxpayer. These models delivered useful implications on the impact of audit probability and
penalties on taxpayer compliance treating these variables as exogenous. However, tax researchers
generally did not take into account the very significant problem of the government managing the
auditors. Auditors (and tax collectors in general) have both a distinct set of incentives from the
government and a distinct set of information. These factors are modeled by a three-player game
with asymmetric information between all three players. The model treats the probability of an audit
and the amount collected during examinations as endogenous. Adding the auditor to the model
highlights the known difficulty of motivating an auditor economically to perform consistent with
government goals. The model also demonstrates that the auditor’s utility function interacts with the
taxpayer’s utility function to further complicate the government’s problem. Analysis of the model
shows an effectiveness threshold in both audit probability rates and penalty structure.