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An Experimental Study of Compliance and Leverage in Auditing and Regulatory Enforcement

  • Timothy N. Cason
  • Lata Gangadharan

Evidence suggests that a large majority of firms and individuals comply with regulations and tax laws even though the frequency of inspections and audits is often low. Moreover, fines for noncompliance are also typically low when regulatory violations are discovered. These observations are not consistent with static compliance models. Harrington (1988) modified these static models by specifying a dynamic game in which some agents have an incentive to comply even when the cost of compliance each period is greater than the expected penalty. This paper reports a laboratory experiment based on the Harrington model framework, in which subjects move between two inspection groups that differ in the probability of inspection and severity of fine. Subjects decide to comply or not in the presence of low, medium or high compliance costs. Enforcement leverage arises in the Harrington model from movement between the inspection groups based on previous observed compliance and noncompliance. Our results indicate that consistent with the model, violation rates increase when compliance costs become higher and as the probability of switching groups becomes lower. Behavior does not change as sharply as the model predicts, however, since violation rates do not jump from 0 to 1 as parameters vary across critical thresholds. A simple model of bounded rationality explains these deviations from optimal behavior.

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Paper provided by The University of Melbourne in its series Department of Economics - Working Papers Series with number 918.

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Length: 35 pages
Date of creation: 2004
Date of revision:
Handle: RePEc:mlb:wpaper:918
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  1. Timothy N. Cason & Lata Gangadharan, 2004. "Emissions Variability in Tradable Permit Markets with Imperfect Enforcement and Banking," Department of Economics - Working Papers Series 917, The University of Melbourne.
  2. Alm, James & Cronshaw, Mark B & McKee, Michael, 1993. "Tax Compliance with Endogenous Audit Selection Rules," Kyklos, Wiley Blackwell, vol. 46(1), pages 27-45.
  3. Philip A. Haile & Ali Hortacsu & Grigory Kosenok, 2003. "On the Empirical Content of Quantal Response Equilibrium," Levine's Bibliography 666156000000000215, UCLA Department of Economics.
  4. Eckert, Heather, 2004. "Inspections, warnings, and compliance: the case of petroleum storage regulation," Journal of Environmental Economics and Management, Elsevier, vol. 47(2), pages 232-259, March.
  5. Alm, James & Jackson, Betty & McKee, Michael, 1992. "Institutional Uncertainty and Taxpayer Compliance," American Economic Review, American Economic Association, vol. 82(4), pages 1018-26, September.
  6. Harrington, Winston, 1988. "Enforcement leverage when penalties are restricted," Journal of Public Economics, Elsevier, vol. 37(1), pages 29-53, October.
  7. Urs Fischbacher, 2007. "z-Tree: Zurich toolbox for ready-made economic experiments," Experimental Economics, Springer, vol. 10(2), pages 171-178, June.
  8. Richard Mckelvey & Thomas Palfrey, 1998. "Quantal Response Equilibria for Extensive Form Games," Experimental Economics, Springer, vol. 1(1), pages 9-41, June.
  9. Oljaca, Neda & Keeler, Andrew G & Dorfman, Jeffrey, 1998. "Penalty Functions for Environmental Violations: Evidence from Water Quality Enforcement," Journal of Regulatory Economics, Springer, vol. 14(3), pages 255-64, November.
  10. Friesen, Lana, 2001. "Targeting Enforcement to Improve Compliance with Environmental Regulations," 2001 Conference (45th), January 23-25, 2001, Adelaide 125634, Australian Agricultural and Resource Economics Society.
  11. Landsberger, Michael & Meilijson, Isaac, 1982. "Incentive generating state dependent penalty system : The case of income tax evasion," Journal of Public Economics, Elsevier, vol. 19(3), pages 333-352, December.
  12. Jeremy Clark & Lana Friesen & Andrew Muller, 2004. "The Good, the Bad, and the Regulator: An Experimental Test of Two Conditional Audit Schemes," Economic Inquiry, Western Economic Association International, vol. 42(1), pages 69-87, January.
  13. Storey, D J & McCabe, P J, 1980. "The Criminal Waste Discharger," Scottish Journal of Political Economy, Scottish Economic Society, vol. 27(1), pages 30-40, February.
  14. Torgler, Benno, 2002. " Speaking to Theorists and Searching for Facts: Tax Morale and Tax Compliance in Experiments," Journal of Economic Surveys, Wiley Blackwell, vol. 16(5), pages 657-83, December.
  15. Harford, Jon D., 1978. "Firm behavior under imperfectly enforceable pollution standards and taxes," Journal of Environmental Economics and Management, Elsevier, vol. 5(1), pages 26-43, March.
  16. James Alm & Michael McKee, 1998. "Extending the lessons of laboratory experiments on tax compliance to managerial and decision economics," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 19(4-5), pages 259-275.
  17. Salop, Steven C & Scheffman, David T, 1983. "Raising Rivals' Costs," American Economic Review, American Economic Association, vol. 73(2), pages 267-71, May.
  18. Linder, Stephen H. & McBride, Mark E., 1984. "Enforcement costs and regulatory reform: The agency and firm response," Journal of Environmental Economics and Management, Elsevier, vol. 11(4), pages 327-346, December.
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