The optimality of punishing only the innocent: The case of tax evasion

We study the effects on tax enforcement and tax policy of unintentional compliance errors by taxpayers and administrative errors by tax auditors. The government can impose both penalties for misreporting and rewards for honest reporting. Maximal sanctions will not be applied because errors are possible, so evasion cannot be eliminated costlessly. Under optimal policy intentional evasion can be deterred, but innocent tax evaders must be penalized whether they have unintentionally evaded or have been mistakenly convicted. This deters intentional evasion, but limits redistribution. Without rewards for honest reporting, the revelation principle need not apply, so intentional evasion can occur.