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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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Author Info
Annamaria Menichini () (CSEF, Università di Salerno)
Peter Simmons () (Department of Economics and Related Studies, University of York)

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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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Publisher 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 Jul 2009
Handle: RePEc:sef:csefwp:201

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Related research
Keywords: contracts; auditing; ex-ante information;

Find related papers by JEL classification:
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information
D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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  1. Cremer, Jacques & Khalil, Fahad & Rochet, Jean-Charles, 1998. "Strategic Information Gathering before a Contract Is Offered," Journal of Economic Theory, Elsevier, vol. 81(1), pages 163-200, July. [Downloadable!] (restricted)
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  2. 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. [Downloadable!] (restricted)
  3. Cremer, Jacques & Khalil, Fahad & Rochet, Jean-Charles, 1998. "Contracts and Productive Information Gathering," Games and Economic Behavior, Elsevier, vol. 25(2), pages 174-193, November. [Downloadable!] (restricted)
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  4. 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.
  5. 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.
  6. Cremer, Jacques & Khalil, Fahad, 1992. "Gathering Information before Signing a Contract," American Economic Review, American Economic Association, vol. 82(3), pages 566-78, June. [Downloadable!] (restricted)
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