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Corruption Under Moral Hazard (WPS 2204)

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by G. S. Eskeland and H. Thiele (1999)

Some corruption of employees will exist when managers are constrained in setting rewards and penalties. Attempts to reduce corruption need to address these constraints. Raising salaries without raising expected penalties will have higher costs than benefits.

In this theoretical analysis, the "principal" can be the head of the tax collection agency (or "government" or even citizens), the "supervisor" can be the tax collector, and the "agent" can be the taxpayer.

The principal, interested in controlling an agent's socially costly activity ("cheating"), hires the supervisor to save on monitoring costs. The agent may bribe the tax collector to suppress reporting, but bribery can be eliminated by the agency head if he institutes enough investigations and sets rewards high enough and penalties steep enough. When penalties and rewards are constrained, some corruption will exist even under a rational approach to pursuing the agency's objectives. Anticorruption efforts will have higher costs than benefits unless they successfully address these constraints.

The agency's implementation costs, and thus the scope for corruption, are defined by constraints on penalties and rewards relative to costs of monitoring and investigation. For example, if the agency head is extremely handicapped in his ability to detect bribery (by a high burden of proof and cost of investigation, and a civil service pay scale that is too flat and rigid), he cannot really reward good employees or make dishonest employees suffer.

The analysis assumes that the principal can commit in advance to a certain likelihood of being caught engaging in bribery. Creating an independent anticorruption commission (like those in Hong Kong and New South Wales) may be interpreted as a way of making such a commitment. In Hong Kong two-thirds of reports to the commission are made in full name, an indication that it has attained a reputation for independence and efficiency. The "whistleblower act" in the United States (promising rewards and protection for informants), as well as separation of powers and independent courts, also function as commitment.

Corruption exists not only in poorly designed but also in sophisticated systems. It can profitably be reduced only by improving general incentives. Advances in courts, investigations, freedom of the press, and flow of information can allow more performance-based rewards and penalties.

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