Optimal Government Regulations and Red Tape in an Economy with Corruption

Abstract

We study an economy where agents are heterogeneous in entrepreneurial ability, and may decide to become workers or entrepreneurs. The government is motivated by a production externality to impose regulations on entrepreneurship, and sets a level of red tape - administered by public officials - to test regulation compliance. In an environment where some officials are corrupt, we study what are the optimal levels of regulations and red tape, and to what extent such policies reduce the welfare losses created by corruption. Under low levels of corruption and externalities, the government sets low levels of regulations and minimal red tape, and with these policies achieves the first best allocation. When externalities and corruption are above a threshold, only a second best allocation can be achieved. For corruption and externalities above a second threshold, mandating higher levels of red tape is a Pareto improving policy.

Keywords: corruption, regulations, red tape