Decentralizing Deterrence, with an Application to Labor Tax Auditing

Deterrence of illegal activities is frequently carried out by many atomistic auditors (tax auditors, law enforcement agents, etc.). Not much is known either normatively about the best way to incentivize the auditors, nor positively about what these incentives look like in real world organizations. This paper focuses on the positive question. It proposes a game-theoretic model of decentralized deterrence and an empirical test, based on the equilibrium of the model, to identify the incentives of individual auditors. In the special (but important) case of tax enforcement, the paper fully characterizes the equilibrium of a strategic auditing game and provides a method to calibrate its parameters based on audit data. Applying the model and method to Italian auditing data provides “proof of concept:” the methods are practical and tractable. We are able to provide an estimate of tax evasion based on (non-random) audit data alone. Counterfactual simulation of the model quanti…es the costs and bene…ts of alternative auditing policies. We compare decentralized enforcement with a counterfactual “commitment policy,” and compute the loss from the former. Thus we are able to quantify the costs of decentralizing enforcement. We thank Dan Silverman and Joel Slemrod for useful comments.