The Red–Green Channel Dilemma: Customs Declaration and Optimal Inspection Policy

Despite the evolvement of an extensive literature on the economics of smuggling, the evasion of customs duties under the common red–green channel system has failed to attract any theoretical attention. The present paper develops a simple three‐passenger‐type model to examine the passenger's decision of whether to pass through the green or red channel, as well as to derive the optimal inspection policy for a revenue‐maximizing customs authority. The analysis reveals that if net revenue collection when inducing truthful declaration is positive, it is never optimal for the customs authority to provide incentives for passing through the green channel, although it may be optimal to provide incentives for cheating at the red channel. However, if the penalty for evasion is large enough to wipe out passengers' income, providing incentives for passing through the green channel may be the optimal policy.