Diffusion of Tax Innovation and Post‐Audit Settlement Available to Purchase

This study investigates how a tax agency would assess the liability of a taxpayer who has first adopted a new, controversial tax‐saving scheme, which might be employed by other taxpayers. The tax agency’s post‐audit assessment to the first taxpayer influences whether and how the innovation will diffuse among taxpayers. We find that it is optimal for the tax agency to settle the issue regardless of whether and how fast the innovation diffuses. A trial is too costly an option for the agency: losing in court would make the innovation public knowledge, and other taxpayers would immediately adopt the new scheme. Neither the number of other taxpayers nor the speed of diffusion affects the amount of the optimal post‐audit assessment. These results suggest that a tax practitioner who markets a new tax‐saving scheme need not limit the speed of diffusion for fear of an aggressive response from the agency.