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We examine the problem of a utilitarian government that sets taxes and fines for evaders but cannot commit to any enforcement policy. Given the tax law, the gov- ernment and taxpayers —some of whom are honest— play an audit-report game that, depending on taxes, fines and audit costs, generates either full evasion and no audits, or partial evasion and random auditing. Anticipating both possibilities, we characterize the optimal tax law. We show that social welfare is non-monotonic in the audit cost. Indeed, it may be optimal for the government not to fi ne evaders as aw ay to commit not to audit.

Optimal Taxes and Penalties When the Government Cannot Commit to Its Audit Policy