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Auditing helps to ensure that those who fall under regulatory structures, like taxpayers and banks, are self-reporting their situations accurately. But auditing is often an expensive process, and not every regulatory agency has the ability to perform it well. “This creates an intriguing interaction between weak and strong [auditing] bureaus,” says Richard Zeckhauser, Frank P. Ramsey Professor of Political Economy at Harvard Kennedy School (HKS).
In the Working Paper, “Audits as Signals,” Zeckhauser and his co-authors — Maciej Kotowski, assistant professor of public policy; and David Weisbach at the University of Chicago Law School — argue that this dynamic creates a game between organizations that are subject to audits and the bureaus that perform them.
“Strong bureaus want to signal their distinctive capabilities. That will enable them to deter misreports,” says Zeckhauser. “However, weak bureaus will want to imitate strong bureaus, to, in a sense, borrow their deterrent power. Of course, when such borrowing takes place, the deterrent capability of strong bureaus is diminished.”
“A number of counterintuitive conclusions emerge from the analysis,” argues Zeckhauser. “Here are two: a cap on penalties may actually promote compliance; and audit hit rates – the number of violating agents per audit – may be a very poor indicator of the quality of a bureau.”
Thus, some perceptions about how agents and bureaus will and should behave in such areas could be wrong.
The authors write, “Given constraints on government resources and investigative capabilities, self-reporting audit (SRA) strategies are inevitable. Indeed, many are already in place. Their operation creates a subtle game where agents withhold information from bureaus, some bureaus signal to reveal information, and others mimic to hide it.”
“As nations seek to avoid a repeat of the disaster in the wake of the 2008 financial meltdown, they are well advised to attend to the subtleties of regulations dealing with information disclosure,” says Zeckhauser.
Richard Zeckhauser is the Frank P. Ramsey Professor of Political Economy. Much of his conceptual research examines possibilities for democratic, decentralized allocation procedures. Many of his policy investigations explore ways to promote the health of human beings, to help markets work more effectively, and to foster informed and appropriate choices by individuals and government agencies.
Maciej H. Kotowski completed his PhD in economics at the University of California, Berkeley. His research focuses on microeconomic theory, with emphasis on auctions, mechanism and market design, and game theory.