Sample-Audit Tax Assessment for Businesses: What's Fair?

Abstract

How should a revenue agency assess a business taxpayer's income on the basis of a sample audit of transactions? The agency would like to maximize revenue while minimizing the risk that the taxpayer will be assessed more than he really owes. The taxpayer reasons that overassessment is worse than underassessment, as far as he is concerned, and therefore the taxpayer might reasonably argue that the lower bound of a one-sided confidence interval should be used by the assessor. The revenue agency might understandably take a different point of view. The revenue agency might argue that overassessment is really no worse than underassessment, from its point of view, so the midpoint of such a confidence interval should be used. In fact, it is this latter position that is currently in use most commonly by state agencies, but such practice is being challenged. The courts will have to make a decision.

KEY WORDS:

• Bayes
• Credibility interval
• Law
• Loss functions
• Lower bounds