This paper examines taxpayers' compliance behavior and the tax agency's audit decision in a broader, more realistic, setting. Whereas prior research has taken the taxpayer's prepayment position as exogenous, this study extends the literature by incorporating the estimated tax payment decision into a tax compliance game. A two‐period game‐theoretic model is used to examine the effect that the estimated tax payment rules have on taxpayers' incentives to evade and on the tax agency's audit strategy.
Our primary results are as follows. First, in equilibrium taxpayers' estimated tax payment decision will depend upon the uncertainty about their true tax liability, and the cost from overpayment (the taxpayer's cost of capital) or underpayment (penalty interest) of installments of estimated tax. Second, under reasonable assumptions, high‐type taxpayers who make higher installments of estimated tax are less likely to lie about their level of income than those who make lower installments—that is, taxpayers who pay low are more likely to evade. Third, the tax agency audits taxpayers who have made low reports and low estimated tax payments with a higher probability than those who have made high estimated tax payments. The gain to the tax agency from auditing taxpayers who make lower payments and evade arises not only from the penalties charged for evasion, but also from the interest charged on deficient installments of estimated tax.