Audits as Signals

Those charged with enforcing laws or regulations, or rules of any sort, (collectively “bureaus”) often require regulated entities or individuals (agents) to submit reports on their activities. Bureaus enforce compliance by auditing the reports and imposing punishments when misreporting is identified. For example, a bureau charged with enforcing environmental laws might require polluters to report whether they are in compliance. A bureau charged with enforcing occupational-safety rules might require companies to report accidents. In both cases, it is common practice to audit some fraction of reports and to impose penalties when underreporting is discovered. Similarly, tax administrators rely heavily on self-reporting of tax liability and audit only a fraction of reports. Prosecutors or police regularly ask for selfreports from suspects by asking for a confession. They offer to lower the criminal sanction for a confession. Higher sanctions for failure to confess if guilt is ultimately assessed are akin to sanctions for underreporting. Contracts, commercial relationships, and personal relationships may use similar principles. The apparent purpose of this type of enforcement system, which we will call a self-report audit (SRA) strategy, is to reduce enforcement costs. If only a fraction of reports have to be audited, costs may be lower than the alternative of directly monitoring a population. For this strategy to work, however, agents must have an incentive to send in informative reports. In some settings only biased reports can be expected. Reports of emissions, accidents, and income may be shaved downwards if agents