Misreporting in the Value-Added Tax and the Optimal Enforcement

A common fraud by registered traders in the value-added tax system is under-reporting sales and over-reporting purchases. This paper models this problem by linking the level of misreporting to the risk-aversion of taxpayers and the level of transactions with final consumers. In addition, it analyses the enforcement consequences of the new developments in information reporting and electronic invoicing, which enable the tax authority to randomly cross-check the invoices. The results highlight the importance of taxpayer’s subjective beliefs in shaping audit policy of the tax authority. The optimal audit rate for risk-neutral firms is an increasing function of transaction with final consumers, but this relationship may turn to be negative for risk-averse taxpayers. Moreover, the optimal level of invoice cross-checking on transactions of each commodity is positively associated with the number of trading firms.