The deterrence effect of real-world operational tax audits on self-employed taxpayers: evidence from Italy

International Tax and Public Finance https://doi.org/10.1007/s10797-021-09707-9 The deterrence effect of real‑world operational tax audits on self‑employed taxpayers: evidence from Italy Gabriele Mazzolini1 · Laura Pagani2 · Alessandro Santoro2 Accepted: 29 September 2021 © The Author(s) 2021 Abstract We use a large administrative tax-returns panel dataset merged with a tax audit database to estimate the effect of real-world operational tax audits on subsequent tax behavior of a large sample of Italian self-employed taxpayers. Results from operational audits do not suffer from the fact that taxpayers are aware that they have been randomly selected for research purposes and, then, such audits are viewed as more of a signal about true audit rates by the taxpayer. Our empirical approach relies on fixed-effects difference-in-difference comparisons with an ex-ante matched sample of non-audited taxpayers. To address concerns about the endogenous selection into audit, we provide evidence for the common trends assumption. We find a positive and lasting effect of audits on subsequent reported income. However, in line with theoretical predictions, taxpayers do not increase tax compliance when the tax authority does not assess a positive additional income. Our results are robust to a variety of specifications and samples. Keywords Tax compliance · Administrative panel data · Tax audits JEL Classification H26 · C23 · C55 * Laura Pagani Gabriele Mazzolini Alessandro Santoro 1 Italian Revenue Agency, Rome, Italy 2 Department of Economics, Management and Statistics (DEMS), Università di Milano-Bicocca, Milan, Italy 13 Vol.:(0123456789) G. Mazzolini et al. 1 Introduction In the benchmark economic model of tax-compliance, utility maximizing taxpayers decide the level of income to report considering the private costs and benefits of evasion. Compliance depends on evasion detection probability and on related penalties (Allingham & Sandmo, 1972). Tax audits are the main evasion deterrence instrument. They produce two effects on tax compliance (Gemmel & Ratto, 2012). First, when taxpayers are subject to an audit, the tax authority could detect noncompliance and force compliance, raising an additional tax yield. Second, taxpayers experiencing an audit are likely to increase their perceived probability of detection (Kleven et al., 2011). In the expected utility maximizing model of tax-compliance, this probability update will lead to an increase in their future reporting.1 In this paper, we study audits’ effect on subsequent tax reporting of audited taxpayers focusing in particular on those audits conducted by revenue agencies during their customary auditing activity and which, following Slemrod (2016), we call ‘real-world operational audits.’ We use a large administrative tax-returns panel dataset of Italian taxpayers whose income is obtained from self-employment and from sole proprietorships merged with a tax audit database, both made available by the Italian revenue agency. Thanks to the recent wider availability of confidential taxpayers’ administrative datasets and to the willingness of some revenue authorities to conduct field experiments to evaluate the effect of audits, there is a growing body of literature that uses randomized audits to analyze the causal effects of audits on deterrence and taxpayers’ behavior. Overall, this literature has found a positive and significant effect of audits on subsequent tax compliance, although the magnitude is both heterogeneous across income types and time-variant. Kleven et al. (2011) conducted a tax-enforcement field experiment in Denmark and found that the overall effect of audits on total net income is positive but quite modest and driven entirely by self-reported income. DeBacker et al. (2018) used IRS data and found that on average audits cause a 0.4% increase of reported wage income over three years after the audit. The effect is much higher when considering self-employment income (7.5%). Advani et al. (2019) used random audits in the United Kingdom. They found a large and persistent impact of audits on reported tax liability that reached a remarkable 26% increase four years after the audit. The previous studies of tax audits on individuals are based on random audits. These latter have undoubtedly the methodological advantage over real-world operational audits that derives from the randomness of treatment assignment. Then, the internal validity of these studies cannot be questioned. However, the use of random audits generally implies that taxpayers are aware that they have been randomly selected to be audited for research reasons, and such awareness may imply that they revise the audit risk differently from the case in which they have been chosen by the tax authority for an operational audit (Slemrod, 2016). This argument applies to De 1 Audits may also produce spillovers to non-audited taxpayers. 13 The deterrence effect of real‑world operational tax audits… Backer et al. (2018) and to Advani et al. (2019), as well as to other studies using random audits with the exception of Kleven et al. (2011).2 The study of audits’ effect using operational audits allows to determine more realistically the costs and benefits of audit policies and, overall, the policy relevance of results obtained using realworld tax audits may be larger compared to random audits. There are few studies focusing on real-world operational audits.3 D’Agosto et al. (2018) study operational audits’ effect using our same data source in the 2004–2009 period and find a positive deterrence effect of tax audits. However, they use a difference-in-difference model without taking explicitly into account individual time invariant unobserved heterogeneity, contrary to what we do in this paper using individual fixed effects. Moreover, with respect to the previous study, in our paper we enrich the analysis of audits’ effect, exploring heterogeneity across different audit outcomes. Specifically, we exploit unique information available in our data on ‘nulloutcome’ audits, namely cases when the revenue agency recognizes that it has mistakenly claimed additional taxes and cancels the preliminary adjustment, and we look at differential audits’ effects for null and non-null audit outcomes. An additional study using operational audits is Løyland et al. (2019), who analyze compliance effect of risk-based tax audit in Norway. Differently from our study, however, they exclude self-employed taxpayers and use self-reported deductions among wage earners and transfer recipients as outcome. They find a positive effect of audits on future compliance in terms of a fall in self-reported deductions. Our paper analyses the impact of real-world operational audits on high-risk taxpayers. The outcome we consider is total personal income from self-employment and sole proprietorship as reported on taxpayers’ tax returns. Taxes on this type of income are clearly more subject to evasion throug (...truncated)