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.

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