Academic journal article Economic Inquiry

The Good, the Bad, and the Regulator: An Experimental Test of Two Conditional Audit Schemes

Academic journal article Economic Inquiry

The Good, the Bad, and the Regulator: An Experimental Test of Two Conditional Audit Schemes

Article excerpt


How can a regulatory agency achieve acceptable levels of compliance with its regulations at minimum cost of enforcement? This challenge confronts regulators in areas as diverse as tax collection, policing, customs and immigration, workplace health and safety, and natural resource management. Economists beginning with Becker (1968) have attempted to answer this question using the rational choice framework. Individuals facing a regulation will comply when the expected benefit of doing so exceeds the expected cost, and enforcement mechanisms must be set accordingly. To minimize enforcement costs, economists have proposed simple random audit regimes and, more recently, conditional audit regimes that exploit observable signals about firms or individuals. Unfortunately, it has been difficult to evaluate proposed audit schemes empirically because those who violate regulations tend to conceal their actions.

Although empirical tests have been rare, audit schemes have been tested in a steady stream of laboratory economics experiments (as surveyed in Aim and McKee [1998]). Here subjects either earn or are given increments of income, which they are then asked to disclose in order that some of the money be deducted. Motivated from the tax compliance literature, these experiments have tested the effects on compliance of alternate fines, inspection probabilities, uncertainty as to taxable income, amnesties, tax rates, and many other variables. More recently, experiments have been used to test conditional audit rules, often simple rules of thumb, that make probability of inspection dependent on subject behavior within the experiment. Though always interesting, the conditional audit rules tested have not generally been explicitly derived from theory and so make no claims to having been optimally designed.

This article reports on a laboratory experiment that compares inspection and compliance rates for two "forward-looking" conditional audit rules against a control rule equivalent to simple random auditing. Both rules have been designed to minimize the inspections needed to achieve target rates of compliance when regulators can vary future (as opposed to past) scrutiny of individuals. The two mechanisms are Past-Compliance Targeting (PCT), as proposed by Harrington (1988), and Optimal Targeting (OT), as proposed by Friesen (2003). Both schemes exploit information from current audits to assign individuals to one of two audit pools, which we dub the "green" and the "red". The green audit pool is for "good" firms and imposes a lower fine and probability of audit than the red audit pool for "bad" firms. A regulator using PCT relies on the outcomes of audits to transfer individuals in either direction between audit pools. In contrast, the OT mechanism randomly transfers individuals from the green pool to the red and uses audit outcomes only to enable compliant individuals to escape the red pool and reenter the green.

By using two audit pools, both mechanisms augment the incentives for compliance beyond the avoidance of immediate fines; noncompliance threatens greater future scrutiny, and compliance promises less. Compared to random auditing, both schemes promise to require a lower frequency of inspections to achieve a desired rate of compliance. However Harrington's PCT assumes the rules governing transfer between audit groups, whereas in Friesen's OT the transition rules are derived optimally. Thus for a given target rate of compliance, PCT should require fewer inspections in equilibrium than random auditing, but OT should require fewer still.

We find that both mechanisms do indeed succeed in lowering overall inspection rates, though only Friesen's does so significantly. However, neither mechanism achieves the overall compliance rate achieved by random auditing, and Friesen's in particular is significantly lower. If the ratio of compliance over inspection rate is taken as an ordinal measure of overall efficiency, Harrington's PCT outperforms Friesen's OT, which outperforms random auditing. …

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