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Sorting the Good Guys from Bad: On the Optimality of Deterministic Audit with Ex-Ante Information Acquisition

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Abstract

In a costly state verification setup, a principal entering a contract with an ex-post informed agent, as well as auditing, has the option of acquiring costly imperfect information about future revenues either before or after the contract is agreed. If acquired, information immediately becomes public. We find that it may be optimal to gather information either for sure or randomly but only after the contract. When acquired, information improves targeting of audit reducing the inefficiencies associated with it. This is obtained by auditing deterministically after favourable signal realisations and never after unfavourable ones. When no signal is collected as a result of randomisation in information acquisition, audits either occur deterministically or never, depending on whether the principal breaks even upon signal acquisition. Interpreted in the context of tax auditing, the results provide a rationale for the tax agencies widespread reliance on presumptive taxation methods.

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Bibliographic Info

Paper provided by Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy in its series CSEF Working Papers with number 201.

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Date of creation: 15 Jul 2008
Date of revision: 27 Oct 2012
Handle: RePEc:sef:csefwp:201

Note: A previous version has been circulated under the title “The Strategic and Social Power of Signal Acquisition".
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Keywords: contracts; auditing; ex-ante information;

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  1. Cremer, J. & Khalil, F & Rochet, J.-C., 1996. "Strategic Information Gathering Before a Contract is Offered," Papers 976.425, Toulouse - GREMAQ.
  2. Cremer, J. & Khalil, F. & Rochet, J-C., 1997. "Contracts and productive information gathering," Discussion Paper Series In Economics And Econometrics 9707, Economics Division, School of Social Sciences, University of Southampton.
  3. Crémer, Jacques & Khalil, Fahad, 1991. "Gathering Information before Signing a Contract," IDEI Working Papers 5, Institut d'Économie Industrielle (IDEI), Toulouse.
  4. Cremer, Jacques & Khalil, Fahad, 1994. "Gathering information before the contract is offered: The case with two states of nature," European Economic Review, Elsevier, vol. 38(3-4), pages 675-682, April.
  5. Alberto Bennardo, 2008. "Information Gathering, Disclosure and Contracting in Competitive Markets," CSEF Working Papers 190, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  6. Lewis, Tracy R & Sappington, David E M, 1997. "Information Management in Incentive Problems," Journal of Political Economy, University of Chicago Press, vol. 105(4), pages 796-821, August.
  7. Khalil, Fahad & Parigi, Bruno M, 1998. "Loan Size as a Commitment Device," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 39(1), pages 135-50, February.
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