Ending Wasteful Year-End Spending: On Optimal Budget Rules in Organizations

What can organizations do to minimize wasteful year-end spending before the annual budget expires? I introduce a two-period model to derive the optimal budget rollover and audit rules. A principal tasks an agent with using their budget to fulfill the organization's spending needs, which are private information of the agent. The agent can misuse funds for private benefit at the principal's expense. The principal decides upfront which share of unused funds the agent can roll over to next year, and which spending amounts to audit in order to punish fund misuse. The optimal rules are to allow the agent to roll-over a share of the unused funds, but not necessarily the full share, in most cases to audit only suffciently large spending, and to exert maximum punishment if fund misuse is detected. An extension with endogenous budget levels shows that strategically underfunding the agent can be optimal.