A mechanism is incentive compatible if it provides an incentive for economic agents to truthfully reveal private information. Consider the implementation of an income tax system. The private information of an individual worker is the level of skill, or productivity, in employment. The public information is the observed income of the individual which is the product of skill and the number of hours worked. The optimum allocation for the economy is defined by an income and consumption level for each level of skill. An income tax system is incentive compatible if it provides an incentive for every individual to earn the income the government desires for their skill level. By earning the required income each individual is implicitly revealing the unobservable level of skill. Incentive compatibility is imposed as a condition that any incentive contract must satisfy.
Reference: Oxford Press Dictonary of Economics, 5th edt.
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