Only the Carrot, Not the Stick: Incorporating Trust into the Enforcement of Regulation

Abstract

New enforcement strategies allow agents to gain the regulator's trust and consequently face a lower audit probability. Prior research suggests that, in order to prevent lower compliance, a reduction in the audit probability (the "carrot") must be compensated with the introduction of a higher penalty for non-compliance (the "stick"). However, such carrot-and-stick strategies reflect neither the concept of trust nor the strategies observed in practice. In response to this, we define trust-based regulation as a strategy that incorporates rules that allow trust to develop, and using a generic (non-cooperative) game of tax compliance, we examine whether trust-based regulation is feasible (i.e., whether, in equilibrium, a reduction in the audit probability, without ever increasing the penalty for non-compliance, does not lead to reduced compliance). The model shows that trust-based regulation is feasible when the agent sufficiently values the future. In line with the concept of trust, this strategy is feasible when the regulator is uncertain about the agent's intentions. Moreover, the model shows that (i) introducing higher penalties makes trust-based regulation less feasible, and (ii) combining trust and forgiveness can lead to a lower audit probability for both trusted and distrusted agents. Policy recommendations often point toward increasing deterrence. This model shows that the opposite can be optimal.