Cross-border e-commerce is increasingly important today. Unfortunately, this sector involves widespread under-declaration of goods' valuation (selling price) to avoid import taxes. Customs brokers play a crucial role in this value chain by ensuring proper declarations at customs, and pay stiff penalties if the retailer is caught under-reporting value in an audit. We illuminate the incentives of import tax evasion by developing a theoretical model of an optimal contract between a customs broker (principal) and an overseas retailer (agent) who may expend resources to under-value his goods, but risks getting caught in an audit. We show that fraud is inevitable at all valuations. We further show that increasing audit accuracy lowers fraud but fails to eliminate it. Our model leads to the following policy prescriptions:
(a) higher import duties lead to more fraud, and (b) penalties imposed on the broker are more effective in reducing under-reporting than those imposed on the retailer. Our results can help explain observed trends in cross-border e-commerce.