The bomb-crater effect of tax audits: Beyond the misperception of chance

The experimental literature has identified the Bomb Crater Effect (BoCE), i.e., the fact that tax compliance drops immediately after a taxpayer is audited. From a theoretical perspective, BoCE has been explained either by the misperception of chance, also known as the gambler's fallacy, or by the loss repair effect. The aim of this paper is to look more closely at the former. We run a laboratory experiment in which the information set is relatively rich but the implementation of the Bayesian updating process is fairly simple. By doing so, we are able to elicit a range of consistent but heterogeneous probability beliefs and to distinguish between Bayesian and non-Bayesian subjects. We obtain two major results concerning Bayesian subjects. First, they exhibit a strong and robust short-run BoCE. Second, they are seemingly not affected by the audits of other taxpayers in their compliance decision. These results are robust to different definitions of Bayesianity as well as to different specifications and conflict with the evidence that Bayesian agents correctly perceive the chance of being audited. In turn, these findings suggest that the existing explanations of the BoCE are not satisfactory and that alternative theories are needed.