Agency Budgets, Cost Information, and Auditing

Abstract

A model of legislature-agency interaction is analyzed where the agency possesses an informational advantage in that only it knows the cost of its services. The legislature has the ability to audit the agency, where auditing is a costly means of verifying the agency's information. Two different procedures are analyzed for determining the agency's budget: in one, the agency makes a budget request, after which the legislature can either accept or reject the request, or audit the agency and impose a budget equal to the true cost of services. In the other procedure, the legislature can follow a request with a counterproposal to the agency, which can then either accept or reject. Since under both procedures auditing is costly, it will be optimal for the legislature to refrain from auditing a request if the perceived benefits do not outweigh this cost. At issue is the ability of the legislature to impose discipline on the agency's request and final budget through an optimal choice of audit and counterproposal strategies, the extent of the information transmitted through the agency's budget request, and the efficiency of the resulting outcomes. A refinement of the sequential equilibrium concept provides the behavioral predictions for the procedures.