Firms' Emissions and Self-Reporting Under Competitive Audit Mechanisms

Abstract

Many environmental tax systems rely on self-reported emissions by firms. These emissions reports are verified through costly auditing efforts by regulatory agencies that are constrained in their auditing budgets. The typical finding in the literature is that the agencies allocate the available audit resources purely at random among otherwise identical firms (random audit mechanism). The game-theoretic analysis in this paper shows that the random audit mechanism is not optimal in terms of induced incentives for abating emissions. Instead, the analysis focusses on the incentives induced by endogenous competitive audit mechanisms (CAMs) on firms' emissions and self-reporting behavior. Under CAMs, higher reported emissions by a firm relative to other firms result in a lower audit intensity. This creates a reporting contest between the firms. CAMs have been shown to lead to more truthful reporting when emissions are exogenous to the firms. I endogenize the emissions decisions of the firms and compare the incentives on firms' emissions and self-reporting under two types of CAMs to the random audit mechanism. The two CAMs apply different degrees of competition in reporting. In line with the literature, I find that both CAMs lead to more truthful reporting. Interestingly and novel to the literature, I find that some competition in reporting induces fewer emissions compared with random auditing, while too much competition in reporting induces comparatively higher emissions caused by firms.