Do Government Wage Cuts Close Budget Deficits? Costs of Corruption

Real wage declines have been common in the public sector in many countries over substantial periods of time. In several cases, such wage reductions have coincided with declines in the efficiency of the public sector. In a simple analytical framework, it is shown that higher wage levels alter the incentive-compatible equilibrium by attracting relatively skilled human capital to the government sector, which raises the quality of public output—tax revenue collection in this paper, increases in wages should complement appropriate monitoring and penalty rates for effective tax administration; prescriptions of raising the statutory tax rate alone, however, may not increase revenue collection.

Abstract

Real wage declines have been common in the public sector in many countries over substantial periods of time. In several cases, such wage reductions have coincided with declines in the efficiency of the public sector. In a simple analytical framework, it is shown that higher wage levels alter the incentive-compatible equilibrium by attracting relatively skilled human capital to the government sector, which raises the quality of public output—tax revenue collection in this paper, increases in wages should complement appropriate monitoring and penalty rates for effective tax administration; prescriptions of raising the statutory tax rate alone, however, may not increase revenue collection.

The commitment to reform cannot long survive, unless government provides adequate pay, recognition For jobs well done, accessible training, and decent working conditions.

-The Volcker Commission (1990)

Widespread tax evasion and underground activities undermine fiscal revenues and raise equity issues (in transition economies).

-World Economic Outlook (May 1995)

Beset by macroeconomic problems, developing countries and transition economies adopt adjustment programs from time to time to get their houses in order. Because most problems are rooted in lax budgetary policies, general government budgets are usually the focal point for corrective measures. A common advice given to governments, particularly by International institutions and donor groups, is to cut “excessive” expenditure items. As public investment expenditures are generally viewed favorably in light of economic growth objectives, the natural targets are current expenditures, particularly government wages. A common rule of thumb that is often employed is to cut (or maintain) the wage bill in real (or even nominal) terms. Governments in most developing countries have generally been reluctant to shed labor, given relatively high unemployment rates and poorly developed social safety nets. In these circumstances, a real reduction in government salaries is among the common austerity measures taken.

Despite the complexities involved in determining the appropriate salary levels for civil servants, there can be little disagreement that paying salaries that ensure public administrative efficiency is important for several reasons. First, the pervasive nature of government activity in developing countries and transition economies creates vast opportunities for bureaucratic discretion. Unless the right incentives, of which adequate pay is an integral part, are set for government employees, public resources are likely to be misallocated. Second, the civil servants in these economies are expected to play a crucial role in helping transform underdeveloped economic structures and rudimentary institutions into advanced, market-based ones; to facilitate the process quickly and efficiently, governments must attract skilled human capital by compensating workers adequately. Underpaid civil servants have been known to illegally spend a substantial part of their office time on rent-seeking activities, thus diminishing civil service productivity.1 Finally, with the recent liberalization of economic regimes in several countries and the growth of the private sector, wages in the private sector are likely to rise rapidly. To preclude mass exodus of skilled government employees to the private sector, government pay scales, especially of those holding key positions in the government, must rise in tandem with the trends in the private sector.2

Given the strong complementarities between public administration and private sector activities, it is surprising to see that mainstream economics has paid little attention to this issue. While much anecdotal evidence on public administration inefficiency and corruption in developing countries and transition economies exists (reported in Section I), there is a dearth of formal analysis in the current literature of the macroeconomic relationships among public wage policy, public administration, and private sector activity. This paper is intended to fill this gap. A model of public administration is developed to understand better the links between government wage policy and administrative efficiency. Specifically, we investigate these issues in the area of revenue collection to see how different public policies and institutional settings affect the fiscal deficit. The model that we develop can be generalized to study other aspects of public administration as well, such as public procurement of goods and banking supervision.

The analytical results in the tax administration model developed in this paper show that, as expected, levels of tax evasion and bribes are high when penalty rates on the private sector and tax collectors are low and when the probability of detection is low.3 More important, we establish a clear link between low civil service salaries and high levels of tax evasion. We also show that raising statutory tax rates, ceteris paribus, may not increase tax collection. Macroeconomic policy implications for optimal tax and wage rates are derived. One important result is that cutting wages could actually lead to an increase in the budget deficit. Thus, a government wage policy that attracts quality human capital is viewed as an important component of the larger set of policies and institutional mechanisms that make for efficient governments.4

The rest of the paper is organized as follows. Section I motivates the paper by reviewing past trends in public wages and citing anecdotal evidence that sheds some light on public administrative efficiency in developing countries and transition economies. In Section II, a model of revenue collection is developed to analyze the impact of wage policy on public administrative efficiency. In the two subsequent sections, this model is used to investigate the conditions under which tax evasion and corruption emerge and to derive the macroeconomic implications for incentive-compatible tax and wage policies. The last section summarizes the main results.

I. Incentive Myopia: Wage Cuts for Fiscal Needs

In a provocative paper, Klitgaard (1989) charges governments in developing countries with “incentive myopia,” a term used to describe the shortsightedness of policymakers in attempting to close budget deficits by cutting real wages in the public sector. Klitgaard argues that such an approach leads to a collapse of incentives in the public sector. Despite the evidence on incentive myopia presented in several anecdotal studies, there has been little economic analysis or systematic empirical investigation of the phenomenon. In particular, no attempts have been made to link public wage policy with the quality of output in public administration. A genuine problem, of course, is that reliable and consistent time-series data, even on the structure of public sector wage and employment, are not available for most countries. Some studies (such as those by the World Bank and the International Labor Organization) provide snapshots of key issues on the basis of sparse and disjointed databases. These studies are important in that they demonstrate the nature of problems in the public sector. Unfortunately, despite the authors’ attempts, a consistent panel of information about public wages and public sector inefficiency cannot be developed from these studies to pursue a comprehensive econometric investigation at this time. However, the available evidence presented below sheds some light on the problems associated with real wage declines in the public sector.

Long-Term Decline in Real Public Wages

Evidence from a number of developing countries suggests that real wage levels for public sector employees have been declining over long periods of time.5 Table 1 presents the trend growth in real wage levels in the general government for selected developing countries. Our estimates are for all the countries for which time-series data were available and for as many years as the data permitted. The trend regressions indicate that real wage levels in the general government declined for 13 out of the 21 countries. In the eight countries that registered positive growth rates, Ghana had the highest growth, with an annual rate of 4.4 percent. For the sample as a whole, real wages declined annually by about 1.4 percent.6

Table 1.

Selected Developing Countries: Trends in Real Wages in General Government

(Annual percent change)

article image
Source: National authorities.

Estimated from a fixed-effects pooled regression of the countries listed. The coefficient is significant at the 5 percent level.

In transition economies, large-scale liberalization of prices, accompanied by wage controls, led to declines in real wages in the public sector, particularly during the initial stages.7 Table 1 also reports declines in real wages in the public sector for five Eastern European countries during 1989–92. A similar pattern, but characterized by even sharper declines, is evident in the former U.S.S.R, countries. Table 2 shows that, with the exception of Latvia and Estonia (the two countries that reformed earlier than others), real wages declined in all of the former U.S.S.R. countries. Thus, during the initial transition years, falls in real wages were common in the transition economies.

Table 2.

Selected Former U.S.S.R. Countries: Real Public Wage Indices

(1992= 100)

article image
Sources: National authorities; and IMF staff estimates.

Real wage declines in the public sector are a frequent consequence of fiscal adjustments in stabilization programs of developing countries (Kraay and Van Rijckeghem, 1995). Such programs appear to protect employment at the expense of reducing real wages (Hewitt and Van Rijckeghem, 1995).

Evidence on Wage Differentials in the Public and Private Sectors

Evidence on government wages relative to the private sector was reported in a fairly comprehensive cross-country study by Heller and Tait (1984). Several measures of wage differentials indicate that, in general, public wages relative to private sector wages were lower in developing countries than in industrial countries during the late 1970s and the early 1980s. Declining trends in real wage differentials over a longer time period in countries for which data were available are presented in Table 3. To control for changes in the structure of wages in the government and in the private sector, Chaudhry, Reid, and Malik (1994) focus on wages at the highest and the lowest grades at comparable levels in the government and the private sector. They find that, in most cases, public wages were lower than private sector wages at both grade levels, particularly at the highest grade levels.

Comparable data on public and private sector wages are not yet available for the transition economies, with the exception of the Czech Republic. In a rare study that compares public sector to private sector wages in the Czech Republic, Flanagan (1995) finds that full-time employees in the private sector earn considerably more than their counterparts in the state sector. After controlling for schooling and potential experience, survey results show that workers (owners) in new private firms earn 18 (43) percent more than those in current or former state enterprises.

Table 3.

Selected Developing Countries: Trends in the Ratio of Government to Private Sector Average Wages

(Annual percent change)

article image
Source: National authorities.

Public Wages, Corruption, and Misallocation of Resources

The limited recorded evidence suggests that corruption is quite pervasive in developing countries and transition economies, and that it imposes significant economic costs.8 While arguments supporting corruption have been made by Leff (1964) and others, who claim that it cuts red tape and undermines rigid and unjustified regulations, Gould and Amaro-Reyes (1983) find that the practice of giving “speed money” was actually the cause of administrative delays because civil servants developed the habit of slowing paperwork until some kind of payment was made to them. Shortages in the supply of critical government-controlled inputs (such as electricity, transportation services, and imported inputs) have also created rent-seeking opportunities and led firms to create wasteful excess capacity to get higher allocations of inputs (Sahay, 1990 and 1991). Mauro (1995) uses qualitative measures of corruption to test its effects on economic growth and finds a significant negative relationship between corruption and growth for a number of developing countries.9

One of the most comprehensive projects on tax evasion and bribes was funded during 1975–78 by the International Development Research Center (IDRC) of Canada (Alfiler, 1986).10 The IDRC found that under Nepal’s dasturi system monthly average bribes for customs officials ranged from 50 percent to 200 percent of the staff’s monthly pay.11 Officers administrating revenues estimated that 20–30 percent of Nepal’s targeted revenue was “lost” on account of bribes. With respect to other countries covered in the project, an ex-prime minister in Thailand was quoted as stating that the country could collect about 47 percent more revenue if there were no corruption and tax evasion, particularly in the Bangkok region. Also, only 15 percent of the total tax revenue due in the timber industry in Malaysia was collected by the state during 1964–74. At the other end of the spectrum, bribe taking was found to be a high-risk activity in Singapore because penalties were high and anticorruption measures strictly enforced.12 In Hong Kong, corruption was lucrative in the 1960s, but this situation changed in the 1970s when the Independent Commission Against Corruption was established.

A recent econometric study by Van Rijckeghem and Weder (1996) provides direct evidence of the negative relationship between public wages and corruption. Using a panel data estimation procedure for a sample of 20 countries over the 1982–94 period, they find that the ratio of civil service wages to manufacturing wages was a significant determinant of the corruption index. In the countries studied, the simple correlation between these relative wages and the corruption index was more than 0.8.

Tanzi (1994) argues that less-developed countries may be more prone to corruption than industrial countries because of differences in “cultural factors.” However, as the evidence documented above indicates, corruption appears to be more common in these countries because the administrative system and institutions are poorly developed and government wages are low. While it is true that, with the passage of time, corruption can become institutionalized in any country and may appear to be more characteristic of developing countries, it is not obvious that these are cultural factors per se. In fact, because there is greater impartiality and competence in the public order in industrial countries, migrant societies in industrial countries do not appear to engage in the corrupt behavior that is prevalent in their own countries.

II. An Analytical Framework

To analyze the efficiency of public administration, the model developed in this section allows for bureaucratic corruption.13 Empirical studies of bureaucratic corruption point to three main factors that determine the extent of corruption: opportunities (the size of government à la Tanzi, 1994), low salaries, and poor policing. We address the last two factors in the analysis presented below. We recognize that a distinction can be made between bureaucratic corruption (characterized by bribes) and bureaucratic inefficiency (owing to low levels of skills and mismanagement), although the two may observationally be the same (for example, resulting in low rates of tax collection). This distinction falls out fairly neatly in the model presented here.

Related Work

Well-known models of tax evasion (Allingham and Sandmo, 1972; and Srinivasan, 1973) are based on asymmetric honesty between taxpayers (who could be dishonest) and tax collectors (who are honest by assumption). Although this scenario is likely in industrial countries, it is not a reasonable assumption in most developing countries.

Our model allows for the possibility that both tax collectors and taxpayers are corrupt. Virmani (1987) also allows for symmetric dishonesty and considers different bureaucratic regimes (honest or dishonest, depending on what he calls a social weakness factor) that are independent of the incentive scheme for tax collectors. Within the dishonest regimes, he determines optimal incentive schemes that ensure the honesty of bureaucrats in “corruption-deterring” societies and “weak” societies. He shows how, if bribes exist, evasion does not increase in a corruption-deterring society when penalties are raised: the larger penalties merely lead to transfers of rent from payer to collector. In a weak society, however, larger penalties lead to increased evasion. The intuition for the latter outcome is that, if penalties are increased, it becomes more profitable for the tax evader and collector to collude.

In contrast to Virmani’s model, our model does not assume a priori that some regimes are more corruptible than others; the emergence of corruption is simply a result of the incentive mechanisms in the administrative system.

Following Becker and Stigler (1974). Rose-Ackerman (1975), Klitgaard (1989 and 1995), Basu, Bhattacharaya, and Mishra (1992), and Mookherjee and Png (1995), our model also focuses on the principal-agent problem of corruption. The model presented below analyzes the interaction between the government (the principal), on the one hand, and the tax collector and the private sector firm (the agents), on the other, to determine how statutory taxes, penalties, and public wage policy determine the level of tax evasion and bribes. In addition to examining ways of motivating the agent to be honest, we derive macroeconomic budgetary implications of alternative wage and tax policies.14 While Shleifer and Vishny (199.1) also derive the consequences of corruption for resource allocation, they take the principal-agent solution as given.

The Model

The model basically consists of four sets of players: the government, the auditors (or the monitors), the tax collectors, and the private sector firms. The private sector firm produces output, yi, on which the government imposes a uniform statutory tax rate, t, across all firms such that total taxes in the economy that are due to the government are T= tY= ΣTi = tΣyi, where Y is the aggregate output in the economy, Ti are total taxes due by each firm i, and yi is the output of firm i. It is assumed that the government knows aggregate output, y (and, therefore, T), in the economy perfectly.15 However, taxes due by each firm, Ti = tyi, can be observed only imperfectly by the government and the auditors, who monitor the tax collectors and the private firms. The government (the principal) collects taxes through its agents, the tax collectors.

Collusion and Asymmetric Information

In the model, there is perfect information between the government and the auditors but imperfect information between the auditors and the tax collectors. The tax collector observes the firm’s output perfectly (and, hence, the firm’s tax liability), but the government and the auditors do not. Thus, the extent of tax evasion or the presence of side deals between the private sector and the tax collector are not fully observed by the government and the auditors. The assumptions on information flows among the various players are illustrated in Figure 1.

Figure 1.
Figure 1.

Description of Information Content and Flows

Citation: IMF Staff Papers 1996, 004; 10.5089/9781451930931.024.A004

Since the government and the auditors cannot fully observe the activities of the tax collector and the firm, the collector and the firm can potentially cheat the government of taxes. We assume that, if tax evasion occurs, the tax collector and the firm play a cooperative game to determine τi = μTi, where 0 ≤ μ ≤ 1 and τi is the total tax declared by firm i and collected by the government. The firm pays the lax collector a bribe, bi, and reduces its tax liability by Ti - τi.16 Because the firm and the bureaucrat share in the gains from collusion, biTii.

Institutional Setup: Monitoring and Penalties

The government is aware of the potential for collusion between the firms and tax collectors to cheat it of tax revenues. In response, it sets up institutional arrangements to monitor their activity. Specifically, the government hires auditors who discover evasion with a finite probability P, where 0≤P≤ 1 and P is directly proportional to the auditors’ ability to detect cheating. The auditors’ actions are fully observable by the government. An auditor’s ability to detect cheating depends on her skills, which are a function of the wage that she receives. Her skill level is, therefore, assumed to be directly proportional to the public sector wage (wg) relative to the wage in the private sector (wp); as both wg and wp can be observed, the level of her skill is an observable.17 The underlying assumption is that a higher relative wage in the public sector, represented by = = wg/wp, allows better human capital to flow into the government sector.18 Thus, the probability of being caught is proportional to α because α determines the auditors’ ability to detect cheating. In addition, we assume that the probability of getting caught increases as tax evasion increases. The probability of getting caught is

p=p(α,T,τ),(1)
A04lev3sec10

where TTi and τ = Στi are aggregate taxes due and collected in the economy and are, therefore, observable to the government and the auditors. The function p is assumed to be differentiable, increasing, and convex in both arguments. It is also assumed that each firm’s decision to cheat or not affects x since τ = Στi. Thus, P is, in part, a choice variable for the firm.

If corruption is discovered, both the firm and the tax collector are fined such that they individually pay penalties that are larger than the amount that is cheated. Thus, the firm pays a penalty that is a multiple of the level of tax evasion, that is, δp(Ti - τi), with δp > 1. Similarly, in the event of detection, the collector will pay δg(Ti - τi), where δg > 1.

III. Corruption and Tax Evasion

Given the public policy variables T, α, δg,. and δp in the tax administration model, the collector and the firm collectively decide whether or not to evade taxes. Tax evasion and bribes emerge if the payoffs to the collector and the firm from cheating are larger than from not cheating the government.

The Payoffs

We assume that all parties are risk neutral. If no evasion occurs, neither the firm nor the collector gains or loses anything. The payoffs, as well as the structure of the game, are summarized in Figure 2 and described below.

Figure 2.
Figure 2.

Payoff Functions of Tax Collector and Private Firm

Citation: IMF Staff Papers 1996, 004; 10.5089/9781451930931.024.A004

The Firm

If evasion occurs and is not discovered by the auditors, the firm’s payoff is

Tibiτj.(2)
A04lev4sec13

If auditors discover the evasion, the firm pays a penalty, δp on the tax evaded, as described in the previous section. Thus, when tax evasion occurs and is discovered by the auditors, the firm’s payoff is

Tibiτiδp(Tiτi).(3)
A04lev4sec13

The total expected payoff to the firm for participating in the evasion game is simply the probability-weighted sum of equations (2) and (3):

p[(Tibiτi)δp(Tiτi)]+(1p)(Tibiτi),(4)
A04lev4sec13

which simplifies to

(Tiτi)(1pδp)bi.(5)
A04lev4sec13
The Tax Collector

The net payoff to the tax collector (net of the wages received) when he is not discovered by the auditor is bi. As discovery of cheating leads to a penalty assessment of δg on the amount of tax that was evaded, the net gain to the collector when he is discovered is bi - δg(Tii).19 The total expected payoff of the collector is, therefore,

p[biδg(Tiτi)]+(1p)(bi),(6)
A04lev2sec14

which simplifies to

bipδg(Tiτi).(7)
A04lev2sec14
The Existence of Bribes

The choice between cheating the government of its tax revenues or not will depend on whether the expected payoffs to the tax collector and the firm are more if they cheat than if they do not. A necessary and sufficient condition for the existence of bribes and tax evasion in equilibrium is that each of the two players gains. This condition is satisfied if expressions (5) and (7) are each greater than zero. Alternatively, the conditions can be collapsed into

(Tiτi)(1pδg)bi0,(8)
A04lev4sec15

and

bipδg(Tiτi)0,(9)
A04lev4sec15

A necessary condition for the nonnegativity conditions in equations (8) and (9) to be satisfied such that Ti - τi is strictly positive is

p(δp+δg)1.(10)
A04lev4sec15

The economic interpretation of equation (10) is that bribes and tax evasion will exist only if the monitoring arrangements are weak (that is, if p is small) and penalties for such activities (that is, δp and δg) are small. Alternatively, weak institutional setups raise the payoffs for corrupt and illegal activities.20

Optimal Level of Tax Evasion

If the condition specified in equation (10) is met, the tax collector and the firm bargain to determine the optimal levels of tax evasion and bribes. We solve the problem in two stages. In the first stage, the firm and the collector determine τi (the taxes declared) to maximize their joint net payoffs (that is, they maximize the size of the total pie). In the second stage, they bargain to divide the gains from evasion (that is, they determine how to split the pie). This process determines the bribe that the collector receives. We basically follow Mookherjee and Png (1995) in taking this approach. A simple Nash bargaining technique is used to find a solution to this second stage of the problem.

In the first stage, then, the sum of equations (5) and (7) with respect to τi is maximized as follows:

maxτi(Tiτi)[1p(δp+δg)].(11)
A04lev3sec16

The first-order condition is

Tiτi+(1(δp+δg)p)(δp+δg)pτi=0.(12)
A04lev3sec16

Given that ∂p/∂τi is negative (from equation (1)), if equation (10) holds, Ti > τi (that is, taxes are evaded).21 Given equations (10) and (12), the following proposition can be established:

Proposition I: Tax evasion occurs when institutional arrangements are weak, that is. when there is a low probability of detection and punishment in the event of conviction is relatively minor.

We can obtain τi (the tax that the government actually collects) as a function of the policy variables of the government. Thus,

τi=τi(α,δp,δg,Ti).(13)
A04lev3sec16

Using the optimality conditions, the qualitative effects of changes in the policy variables on revenue collection can be derived.

Under fairly reasonable assumptions,22 the total derivatives of τi with respect to α, δp, and δg are positive. That is, when civil service wages and penalty rates are raised, tax collection increases. The intuition is that, as wages increase, the quality of auditors improves, raising the probability of detection, which, in turn, deters tax evasion. Also, raising penalty rates on either the tax collector or the private sector firm deters tax evasion. However, raising the statutory rate of taxation, Ti, does not guarantee an increase in tax collection. Under certain conditions, it is possible to show that raising the statutory lax rate may actually lead to a decline in collection.23 This can be summarized in the following proposition:

Proposition 2: Tax collection rises unambiguously when penalty rates on private sector firms or tax collectors are raised, or when government wages are raised. Raising the statutory tax rate may or may not increase revenue collection.

So far. we have not differentiated between the effects of raising the wages of tax collectors and of auditors. Assume that α1 and α2 are the relative wages of the tax collectors and the auditors, respectively. Then, in equation (13), we can see that τ* = τ*(T, α2. δp, δg). Consequently, increasing the salaries of tax collectors (α1) only has no effect on the level of tax evasion. The intuition is fairly clear: as all players, including tax collectors, are assumed risk neutral, higher expected remunerations (either from wages or from bribes) are always preferred to lower, for given probability of detection and penalty rates. Thus, even if their wages are raised, there is no incentive on the part of tax collectors not to cheat unless the government takes complementary measures to improve tax administration (that is, to raise δg and p). Proposition 3 follows:

Proposition 3: Ceteris paribus, raising auditors’ wages reduces tax evasion; however, raising only the tax collectors’ wages has no effect on tax evasion.

Of course, proposition 3 holds under the assumption that tax collectors are risk neutral. If tax collectors were risk averse, it can be shown that an increase in their wages would also lead to a reduction in tax evasion. Propositions 1–3 point to the importance of setting the right incentives in government institutions to raise the efficiency of public services. While setting the right wage rates attracts better human capital into tax administration, other supporting measures, such as effective penalty rates, are also required to deter evasion.

Optimal Level of Bribes

We use a simple Nash bargaining solution to determine how the total gains from tax evasion are divided between the tax collector and the private firm. We assume in this simple framework that there is one tax collector for each firm and that the two have equal bargaining power. Equal bargaining power in this Nash bargaining game would imply that the two players agree to equalize their expected payoffs ex ante.24 Setting the net expected gains of the two players equal to each other, we can obtain the optimal level of the bribe:25

bi=(Tiτi)1p(δpδg)2=γ(Tiτi).(14)
A04lev3sec17

The term γ can be interpreted as the “share” parameter that determines the split of the tax evasion pie. Bribes emerge only when γ and Ti - τi are strictly positive and γ is strictly less than one.26 These conditions are satisfied when

1>p(δgδp)>1.(15)
A04lev3sec17

It can be shown that if equation (10) holds the restrictions imposed by equation (15) are satisfied.

The effect of exogenous changes in the policy variables (δp, δg, α, and T) on bribes in equation (14) arises from two distinct channels: the direct effect of the policy variables on the amount evaded, Ti - τi, and their indirect effect on the share parameter, γ. Since ∂bi/∂τi = − γ in equation (14), a one-unit increase in the revenue collection leads to a decline in bi by the extent of the share parameter, γ. The effect of increasing penalties on bribes depends on whether δp, or δg. is raised. We have shown in the previous section that, as penalties rise, revenue collection increases and tax evasion (Ti - τi) falls. An increase in δp, reduces the share parameter (as the firm has a higher cost of cheating), while an increase in δg raises the share parameter (as the collector faces a higher cost of cheating). A one-unit increase in both δp and δg leaves γ unchanged as the costs borne by both parties rise by equivalent proportions. Thus, when δp, is raised, bi falls unambiguously while, if δg is raised, Ti - τi falls but γ increases, leaving the net effect on bribes ambiguous. We find then that raising the penalties on civil servants alone may not be sufficient to reduce the emergence of bribes.

A general increase in wage rates in tax administration has an unambiguously negative effect on bribes because of the rise in the auditors’ wages (α2). As α2 rises, the level of bribes falls through two channels: directly, because γ declines as the probability of an audit (p) increases; and indirectly, because an increase in p reduces tax evasion (T-τ).

Finally, the effect of an increase in the statutory tax rate on bribes is ambiguous. As the tax rate rises, the level of bribes increases because ∂γ/∂T>0 at a given level of γ. However, the probability of detection,p (see equation (1)), increases as T - τ increases and the share parameter, γ declines. Hence, the level of bribes could fall at higher rates of taxation. The effect of exogenous changes in the policy variables on bribes can be summarized in the following proposition:

Proposition 4: The level of bribes falls unambiguously when wages of auditors or penalty rates on private firms are raised. However, raising the statutory tax rate or increasing the penalty rates on tax collectors has an ambiguous effect on bribes. In addition, a ceteris paribus increase in the wages of the tax collectors only has no effect on bribes.

IV. Incentive-Compatible Public Policies

Policy implications derived from a general equilibrium analysis of bureaucratic corruption have received little attention in the design of public policies. Corruption-related activities have traditionally been viewed as reflecting declines in the “moral fiber” of the society, and several schemes are typically set up to avowedly eradicate their occurrence. Frequently adopted approaches to dealing with these problems are ones that set up elaborate mechanisms (and, therefore, spend more public money), such as oversight committees and onetime asset declaration schemes.27 The model developed in this paper suggests that, in view of the asymmetric information in government production (or revenue collection, in our example), there is a need to design incentive-compatible policies and institutional arrangements to achieve the objective of increasing efficiency in government services.

To determine optimal public policies and institutional arrangements (that is, T, ∂p, ∂g, and α) in the framework developed in the previous sections, we will assume in this paper that the objective of the government is simply to maximize its revenues net of expenditures. The government chooses the punishment levels, δp and δg, the wage rate, wg, and the appropriate taxes due, T, such that they are incentive compatible with the behavior of private firms and tax collectors. Because the effects of increasing penalty rates on tax evasion are clear (they lead to less tax evasion), we will concentrate only on determining optimal levels of T and α (or wg, given wp).28 Thus, given the optimality conditions for tax evasion and bribes, as well as δp. and δg, the government chooses wg and T to maximize net revenues.

The only sources of revenues for the government are (1) tax collections, which amount to τ; (2) penalties (δp(T - τ) imposed on private firms in the event of detection; and (3) penalties (δg(T - τ)) imposed on tax collectors when cheating is detected. For simplicity, we normalize the number of auditors, tax collectors, and private sector firms to be each equal to one.29

Expenditures consist of (1) administrative costs associated with the primary function of the government, which is tax collection: and (2) wages paid to the tax collectors and auditors, wg = wpα. The expenditure function can be written as

E(T,wpα).(16)
A04lev2sec18

We assume that E is strictly increasing and convex in both arguments. This is a reasonable assumption because increases in the statutory tax raise collection costs and hiring better skilled workers increases overhead costs (because of, say, the need for a better office environment).

To determine optimal wage and tax policies, the government maximizes its net revenues with respect to T and α, given the optimal tax collection function τ* (equation (13)) derived from the Nash bargaining problem of the tax collector and the firm.30 The net revenue function can, therefore, be written as

maxτ*(T,δp,δg,α)+p[α,Tτ*(T,δp,δg,α)](δp+δg)T,α(Tτ*(T,δp,δg,α))E(T,wpα)(17)
A04lev2sec18

To simplify the algebra, we use an explicit functional form for the probability of detection (equation (1)). Let

p(α,Tτ)=α(1τT)(18)
A04lev2sec18

This equation satisfies all the conditions required of p that are derived in Section III. Using this function, the level of revenue collection from the optimization problem of the firm can be derived as follows:

τ*=(112α(δp+δg))T.(19)
A04lev2sec18

Substituting equations (18) and (19) into equation (17) and defining δp + δg = δ, we can rewrite the government’s objective function (equation (17)) as follows:

maxT,αR=T(114αδ)E(T,wp,α),(20)
A04lev2sec18

where R is the fiscal balance of the government. The solution to this problem yields optimum values of T and a that maximize net revenues of the government. The first-order conditions are

ETEα=(4αδ1)wpα.(21)
A04lev2sec18

Equation (21) can be interpreted as showing that the marginal rate of substitution of the cost of tax collection for wage expenditure equals the net additional revenue gain in equilibrium. The convexity of the expenditure function ensures the conditions required for an interior maximum to derive the incentive-compatible policy vector (T*, α*), A Laffer curve is thus derived not only for the well-known relationship between tax revenue collections and statutory tax rates but also between revenue collection and government wage rates. Such a three-way relationship is illustrated in Figure 3. Proposition 5 follows:

Figure 3.
Figure 3.

Laffer Curve in Tax and Wage Rates

Citation: IMF Staff Papers 1996, 004; 10.5089/9781451930931.024.A004

Proposition 5: There exists an optimal mix of statutory tax and wage rates that maximizes the net revenues of the government. Thus, expenditure cuts on government wages can lead to a decline in the government’s net revenues if government wages are lower than the optimum.

Using the first-and second-order conditions, we can determine the effects of changes in the parameters of our model (wp, δp, δg) on the optimal policy vector (T*, α*). Totally differentiating wg and T with respect to the wage rate in the private sector, wp, we get

dwgdwp>0;dTdwp<0.(22)
A04lev2sec18

These results show the importance of keeping public sector wage developments in line with those in the private sector. Specifically, if private sector wages increase, civil service wages should be raised to prevent an increase in tax evasion and corruption. Equation (22) also cautions against the raising of statutory tax rates only when private sector wages are rising.

Differentiating wg and T with respect to the two penalty variables, we get

dwgdδj<0;dTdδj<0;j=p,g.(23)
A04lev2sec18

This result suggests that maximizing output and efficiency in tax administration would depend on an appropriate combination of penalty rates, statutory tax rates, and relative civil service wage rates. The analysis also suggests that an optima! mix of policies exists in equilibrium that maximizes the net revenue of the government.

V. Conclusion

Adjustment programs often necessitate fiscal correction. In an attempt to reduce expenditures, governments frequently choose to cut wage rates to protect employment in the government sector. Evidence from several developing countries shows that government wages are low relative to the private sector and that real wage declines have been common in the public sector over substantial periods of time. Low wages and weak monitoring systems have given rise to bureaucratic corruption, particularly in the revenue-raising branches of governments.

Using a tax administration model, this paper analyzes the relationship between public wages and tax policy, on the one hand, and public sector efficiency and corruption, on the other. We find that low government wages lead to a decline in public sector productivity (reflected in low tax collection rates) and a rise in corruption. Corruption occurs because under imperfect information firms are able to collude with tax collectors at a price (bribe) to cheat the government of its taxes. We show that it is possible to increase tax collection by raising the wages of the auditors, as higher wages attract better human capital to the government sector.

From a macroeconomic perspective, we find that the government can maximize its net revenue by designing incentive-compatible tax and wage policies that take into account potential for collusion between private firms and tax collectors. Thus, any deviation from the optimum combination of tax and wage rate would result in a deterioration of the fiscal balance. While cutting wages may be more feasible politically than reducing employment in the public sector, our analysis suggests that cutting wages to close the budget deficit could worsen the fiscal balance. Moreover, in an environment in which the institutional arrangements are weak, as evidenced by poor monitoring and small penalties, raising the statutory tax rates alone is unlikely to raise revenue collection.

REFERENCES

  • Alam, M. Shahid, 1989, “Anatomy of Corruption: An Approach to the Political Economy of Underdevelopment,” American Journal of Economics and Sociology, Vol. 48 (October), pp. 44156.

    • Search Google Scholar
    • Export Citation
  • Alfiler, Maria Concepcion P., 1986, “The Process of Bureaucratic Corruption in Asia: Emerging Patterns,” in Bureaucratic Corruption in Asia: Causes, Consequences and Controls, ed. by Ledivina V. Cariño (Quezon City. Philippines: JMC Press), pp. 1568.

    • Search Google Scholar
    • Export Citation
  • Allingham, Michael G., and Agriar Sandmo, 1972, “Income Tax Evasion: A Theoretical Analysis,” Journal of Public Economics, Vol. 1 (November). pp. 32338.

    • Search Google Scholar
    • Export Citation
  • Basu, Paushik, Sudipta Bhattacharaya, and Ajit Mishra, 1992, “Notes on Bribery and the Control of Corruption,” Journal of Public Economics, Vol. 48 (August), pp. 34959.

    • Search Google Scholar
    • Export Citation
  • Becker, Gary S., and George J. Stigler, 1974, “Law Enforcement, Malfeasance, and Compensation of Enforcers.” Journal of Legal Studies. Vol. 3 (January). pp. 118.

    • Search Google Scholar
    • Export Citation
  • Besley, Timothy, and John McLaren, 1993, “Taxes and Bribery: The Role of Wage Incentives,” Economic Journal, Vol. 103 (January), pp. 11941.

    • Search Google Scholar
    • Export Citation
  • Bhagwati, Jagdish N., 1982, “Directly Unproductive, Profit-seeking (DUP) Activities,” Journal of Political Economy, Vol. 90 (October), pp. 9881002.

    • Search Google Scholar
    • Export Citation
  • Chaudhry, Shahid A., Gary J., Reid, and Waleed H. Malik, eds., 1994, Civil Service Reform in Latin America and the Caribbean: Proceedings of a Conference, World Bank Technical Paper No. 259 (Washington: World Bank).

    • Search Google Scholar
    • Export Citation
  • Flanagan, Robert J., 1995, “Wage Structures in the Transition of the Czech Economy,” Staff Papers. International Monetary Fund, Vol. 42 (December), pp. 83654.

    • Search Google Scholar
    • Export Citation
  • Gould, David J., and José A. Amaro-Reyes, 1983, “The Effects of Corruption on Administrative Performance: Illustrations from Developing Countries,” World Bank Staff Working Papers. No. 580, Management and Development Series, No. 7 (Washington: World Bank).

    • Search Google Scholar
    • Export Citation
  • Haque, Nadeem Ul, and Se-Jik Kim, 1995, “‘Human Capital Flight’: Impact of Migration on Income and Growth.” Staff Papers, International Monetary Fund, Vol. 42 (September), pp. 577607.

    • Search Google Scholar
    • Export Citation
  • Heller, Peter S., and Alan A. Tait, 1984, Government Employment and Pay: Some International Comparisons, IMF Occasional Paper No. 24 (Washington: International Monetary Fund. rev. ed.).

    • Search Google Scholar
    • Export Citation
  • Hewitt, Daniel, and Caroline Van, Rijckcghem, 1995, “Wage Expenditures of Central Governments,” IMF Working Paper 95/11 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Klitgaard, Robert, 1989, “Incentive Myopia,” World Development, Vol. 17 (April), pp. 44759.

  • Klitgaard, Robert, 1991, Adjusting to Reality: Beyond “State vs. Market” in Economic Development (San Francisco: International Center for Economic Growth Press).

    • Search Google Scholar
    • Export Citation
  • Klitgaard, Robert, 1995, “Institutional Adjustment and Adjusting to Institutions,” World Bank Discussion Papers, No. 303 (Washington: World Bank).

    • Search Google Scholar
    • Export Citation
  • Kraay, Aart, and Caroline Van Rijckeghem, 1995, “Employment and Wages in the Public Sector: A Cross-Country Study,” IMF Working Paper 95/70 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Krueger, F. 1974, “The Politicai Economy of the Rent-Seeking Society,” American Economic Review, Vol. 64 (June), pp. 291303.

  • Leff, Nathaniel H., 1964, “Economic Development through Bureaucratic Corruption,” American Behavioral Scientist, Vol. 8 (November), pp. 814.

    • Search Google Scholar
    • Export Citation
  • Lindauer, David L., and Barbara Numberg, eds., 1994, Rehabilitating Government: Pay and Employment Reform in Africa (Washington: World Bank).

    • Search Google Scholar
    • Export Citation
  • Mauro, Paulo, 1995, “Corruption and Growth,” Quarterly Journal of Economics, Vol. 110 (August), pp. 681712.

  • Mauro, Paulo, 1996, “The Effects of Corruption on Growth, Investment, and Government Expenditure,” IMF Working Paper 96/98 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Mookherjee, Dilip, and I.P.L. Png, 1995, “Corruptible Law Enforcers: How Should They Be Compensated?” Economic Journal, Vol. 105 (January), pp. 14559.

    • Search Google Scholar
    • Export Citation
  • Rose-Aekerman, Susan, 1975, “The Economics of Corruption,” Journal of Public Economics, Vol. 4 (February), pp. 187203.

  • Sahay, Ratna, 1990, “Trade Policy and Excess Capacity in Developing Countries,” Staff Papers, International Monetary Fund, Vol. 37 (September), pp. 486508.

    • Search Google Scholar
    • Export Citation
  • Sahay, Ratna, 1991, “Input Shortages in Mixed Economies: An Application to Indian Manufacturing Industries,” IMF Working Paper 91/56 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Samad, Abdus, 1993, Governance, Economic Policy, and Reform in Pakistan: Essays in Political Economy (Lahore, Pakistan: Vanguard Books).

    • Search Google Scholar
    • Export Citation
  • Shapiro, Carl, and Joseph E. Stiglitz, 1984, “Equilibrium Unemployment as a Worker Discipline Device,” American Economic Review, Vol. 74 (June), pp. 43344.

    • Search Google Scholar
    • Export Citation
  • Shleifer, Andrei, and Robert W. Vishny, 1993, “Corruption,” Quarterly Journal of Economics, Vol. 108 (August), pp. 599617.

  • Srinivasan, T.N., 1973, “Tax Evasion: A Model,” Journal of Public Economies, Vol. 2 (November), pp. 33946.

  • Tanzi, Vito, 1994, “Corruption, Governmental Activities, and Markets,” IMF Working Paper 94/99 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Tanzi, Vito, and Anthony J. Pellechio, 1995, “The Reform of Tax Administration,” IMF Working Paper 95/22 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • van Ginneken, Wouter, ed., 1991, Government and Its Employees: Case Studies of Developing Countries (Aldershot, England: Avebury Press).

    • Search Google Scholar
    • Export Citation
  • Van Rijckeghem, Caroline, and Beatrice S. Weder, 1996, “Wage Policy in the Civil Service: Do Low Wages Cause Corruption?” (unpublished; Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Virmani, Arvind, 1987, “Tax Evasion, Corruption, and Administration: Monitoring the People’s Agents under Symmetric Dishonesty,” World Bank Development Research Department Discussion Paper No. 271 (Washington: World Bank).

    • Search Google Scholar
    • Export Citation
  • Wade, Robert, 1982, “The System of Administrative and Political Corruption: Canal Irrigation in South India,” Journal of Development Studies, Vol. 18 (April), pp. 287328.

    • Search Google Scholar
    • Export Citation
  • World Bank, 1992, Governance and Development (Washington: World Bank).

*

Nadeem Ul Haque is Deputy Division Chief in the IMF’s Research Department. He obtained his first degree from the London School of Economics and a Ph.D. from the University of Chicago. Ratna Sahay, who has a doctorate from New York University, is a Senior Economist in the Research Department. The authors are grateful to Gary Becker, Robert Klitgaard, Donald J. Mathieson, Gian Maria Milesi-Ferretti, Peter Montiel. Assaf Razin, Caroline Van Rijckeghem, and Vito Tanzi for several insightful comments, and to Manzoor Gill and Ravina Malkani for excellent research assistance.

2

Those who frequently interact with senior government officials in economies undergoing rapid structural reforms arc familiar with the high turnover rates in government jobs.

3

For more information on experience with tax administration, see Tanzi and Pellechio (1995).

4

In the context of a growth model. Haque and Kim (1995) show that perverse incentives in domestic markets can lead to human capital flight abroad and retard economic growth.

5

In Gould and Amaro-Reyes’s(1983) study of the salary structure of middle- and low-level civil servants in Africa and Latin America, they find that the salaries were, at times, so low that officials could not even afford balanced diets. Lindauer and Nunberg (1994) and Chaudhry, Reid, and Malik (1994) also document low and declining wages in the public sector in Africa and Latin America in the 1980s.

6

Because trends in average wages abstract from changes in the structure of wages, they could present a misleading time-series picture. Van Ginneken (1991), however, confirms that, even after controlling for the structure of wages, real wages declined in virtually all African countries over the 1975–85 period. It is also revealing that the erosion was higher at the highest grade level than at the lowest grade level in nearly all cases. The latter fact assumes significance because it (arguably) reflects the extent to which the quality of the top bureaucrats, the key implemcntcrs of public policy, may have declined in these countries.

7

Newspaper reports and anecdotal evidence suggest that, in transition economics, wages in the government sector have declined more sharply than wages for the public sector as a whole. Protests and demands for higher wages from civil servants in education, health, and public administration are often headline news in transition economies.

9

In a recent paper, Mauro (1996) explores the links between different types of government expenditures and corruption.

10

Twenty-two case studies were prepared by research teams from seven Asian countries—Hong Kong, Korea. Malaysia, Nepal, the Philippines, Singapore, and Thailand. Information was based on journalistic sources, government commission reports, and personal interviews.

11

Dasiuri means periodic payment for “services” rendered.

12

For example, a messenger of the Port of Singapore Authority paid a fine of S$l,500 for accepting bribes of S$2 and S$5 for twice leaking confidential in formation.

13

While political corruption can also decrease the efficiency of the public sector, this paper focuses only on bureaucratic corruption.

14

Becker and Stigler (1974) argue for efficiency wages to motivate the agent to be honest, while Klitgaard (1991) makes a case for indoctrination.

15

Output yi is assumed to be exogenous and fixed in this model. It will, therefore, be ignored from now on, and the model will concern itself only with Ti and T. Thus, a higher Ti simply implies that the lax rate has gone up for the same level of yi.

16

It is assumed that the penalties on the tax collector are sufficiently large to ensure that he will not overreport and that the costs to the private sector of appealing an excessive report are sufficiently low such that τ <T.

17

For simplicity, we also assume that the tax collectors receive the same wages as the auditors. We relax this assumption later lo see whether it leads to a different outcome.

18

The variable α is, for analytical simplicity, normalized such that it is bounded between 0 and 1. It is also plausible to expect that the government would at best pay the auditors and collectors no more than their opportunity costs in the private sector.

19

The penalty on the collector will be levied because he failed to perform his duties, irrespective of whether he took a bribe or not. The analysis does not change qualitatively if we assume that a penalty on the collector is levied only when he accepts the bribe.

20

Examples in Samad (1993) and Klitgaard (1989) substantiate this result.

21

The second-order conditions are satisfied if the probability function is either linear or convex in τi, which is assumed here.

22

The partial cross derivative, pτα, should be ≤ 0. No restrictions on pτT are required.

23

Revenue collection declines if pτiTi ≥ 0 and Tii ≤(pTi-Pτi)/pτiTi.

24

It is possible to complicate the problem by endogenously determining the bargaining strength of the two players by altering the game between them. However, we avoid this exercise for two reasons: first, it is difficult to come up with closed-form solutions with general functional forms; and second, the exact share of the tax evasion pie is not of consequence to the main problem that we are addressing, which is how to design appropriate incentives in government institutions. See also Mookherjee and Png (1995).

25
The optimal bribe is obtained when equations (5) and (7) are set equal to each other. This results in the following equation being solved for bi:
(Tiτi)(1pδp)bi=bipδg(Tiτi).
article image
26

Because the gain from tax evasion has to be split between the firm and the collector, it must be the case that γ < 1.

27

See Samad (1993) and Klitgaard (1989) for examples and some discussion of the processes that are often used to reduce corruption.

28

Alternatively, we could assume that the maximum possible (or politically feasible) penalty has already been imposed.

29

Assuming different numbers of firms, tax collectors, and monitors does not change the qualitative results. It is also possible to endogenize these numbers to see how many firms survive and what are the optimal number of tax collectors and monitors that the government should hire. While the latter exercise may yield interesting results, it is beyond the scope of the objectives of this paper.

30

The approach used here is also similar to the “efficiency wage” model, in which workers caught performing at less than par are fired (see Shapiro and Stiglitz, 1984).

IMF Staff papers: Volume 43 No. 4
Author: International Monetary Fund. Research Dept.