The Hindu : Markets and efficient corruption

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Wednesday, Sep 24, 2003

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Markets and efficient corruption

By S.N. Gajanan

All that the state has to do is to allow the market to sort itself out and elicit the palatable corruption level by strategically predetermining the modest wage gains.

SEVERAL STUDIES and other related recommendations from Pay Commissions have indicated that public sector wage levels are low and have not kept pace with inflation. Independently, researchers such as the late Prof. S. Guhan (MIDS) have observed that corruption is rampant in many public enterprises and services. It is natural to connect these two findings, as is usually done in public discourse, to form the logical hypothesis, namely, "low wages leads to high corruption".

Although this logical statement may fit reality rather well, this statement's policy implications are rather shallow. For, the immediate policy prescription to wipe out corruption would be to administer a massive increase in public sector's wages. But I will then release the mother question, "Where will the money come from?", and your first wicket is down. To wit, the only reasonable course to finance this wage increase is a brutish tax increase on everyone. There are at least three problems with this fiscal policy.

First, this is simply a mock redistributive policy, arbitrary and harmful to retirees, fixed-income groups, savers and the unemployed. Secondly, it is necessary that these taxes increase periodically to keep up with inflation, thus maintaining the real wages in this sector. If not, you would be back to square one, and the whole exercise would have been futile. Finally, such massive tax increases in the short run are political blunders, unlikely to be committed by the savvy.

Now suppose you play the devil's advocate with the following alternative, "What if the state is able to finance the whole thing without any tax increases?" Even under such circumstances, I would still maintain that the policy may not work. The reason for this is the presence of what in economics is termed the "moral hazard". That is, it is impossible for the state to monitor all its employees perfectly. This lack of information will provide the employees an incentive to deviate from their required behaviour. Even if all employees maintain the required work ethics, they cannot stop private citizens from bidding for attention. All it takes is for a single household to offer just the right side payment to entice a single employee. This will promptly send the right signal to all workers, who might all end up deviating from the required path. The economic problem arises because the state can never monitor all its employees or its citizens all the time. Therefore, the success of your devilish suggestion hinges on some behavioural disposition on the part of workers and consumers, and this assumption is tenuous at best.

Thus, my mother question still reigns supreme. The state and the treasury are simply forced to back down and attack the problem differently. I illustrate one plausible course of action. The state is aware of several things: the fiscal strains of a tax increase, the moral hazard problem, the monitoring costs, and finally, the presence of a large private sector with varying degrees of urgency, or, what in economics is termed "demand" for public services. Consequently, the state can position itself as a player in the market, which indeed it is, and can act strategically to cut its losses. That is, the state can exploit the virtues of the market to satisfy its own budgetary constraints. The way in which this may be accomplished is captured through the following line of reasoning.

At one extreme the state knows that to fully wipe out corruption (say, a corruption index level of 0) it must impose a massive tax increase, and this is not fiscally or politically credible. To give a zero wage increase is the other extreme, and this option will simply increase corruption to exorbitant levels (say, corruption index level of 100), and once again this is politically inadmissible given the number of strikes and lockouts that this option would generate. Thus, for any wage increase in between these two extremes the state realises that there will be a corruption level that will be induced correspondingly. All that the state has to do now is to settle for an acceptable level of corruption, and in turn implement the required modest wage proposal.

The role of the market in the state's strategic calculation of wages is crucial. That is, once the state announces the wage increase, the employees set their reservation price for supplying their services. Private households, with their urgencies, bid for these services, given their implicit buyer values generated through different urgencies. Clearly, two households that have the same level of sewage blockage may have the same level of urgency, but may differ on their ability to bid successfully for a quick sewage fix. You may wish to replace "urgency" with "ability", but the difference can be conceptualised and whether it is one or the other will be clear from the context. Given ability, households that possess a greater urgency (sewage build-up, telephone hook-up during pregnancies) will have a greater reservation bid, as opposed to those with greater patience. The market for corruptible services will then generate the "palatable corruption index level" for every potentially corruptible service available in this market.

Markets allocate resources "efficiently" if economic agents (demanders and suppliers) are allowed to interact freely. "Efficiency" in this context means that neither "too much" nor "too little" is produced. It also means that competition forces prices to equal average cost, and hence, `efficiency" also implies that what is produced is attained in the cheapest possible manner. Thus, if private consumers and public employees interact then the level of corruption generated must be "efficient" from this standpoint. The state knows this unique aspect of the market and can play the game accordingly. It knows, for example, that for any wage increase the market will sort itself a level of corruption that will satisfy both the suppliers (employees) and the demanders (private consumers) and, consequently, will generate an "efficient" corruption level. All that the state has to do is to allow the market to sort itself out and elicit the palatable corruption level by strategically predetermining the modest wage gains.

Consider an implausible situation where such side payments go on unhindered for a variety of services, and that, the state interprets the situation as a satisfactory market-fix for its employees' low real incomes. This then behoves the state to propose wage gains that are just modest enough to satisfy its budgetary constraints.

It is useless to argue that any corruption is by default inefficient, for this argument fails to recognise the relative nature of the term "efficiency". Indeed, the first-best solution is to aspire for a world with a corruption-index level of 0. But to attain that level of efficiency is prohibitively expensive, as it requires a huge tax increase, huge monitoring costs, without generating cost-push inflation. Thus, we have to look for second-best solutions, which yield "efficiency" levels that are affordable. It is in this second-best sense that an "efficient corruption" level emerges, and all that the state has to do is to induce the markets to work out this level of corruption by proposing the required suitable wage gains. That is, the state can strategically shift the burden of moral hazard and monitoring costs to the market, and still implement a fiscally prudent budget.

The implications of the suggested lines of reasoning through state's strategic behaviour are serious. It throws a wrench in the machine of public policy on anti-corruption. For, if efficient and palatable levels of corruption cause observed wages to be low, then a policy to wipe out corruption through increases in wages is bound to fail. There are other implications as well on the "role of the state" in a market economy. The conventional idea that the state should provide public goods only uncovers part of the story. In a world where access to the very public services itself is bid in the market through the private sector's urgencies, the "publicness" of these goods becomes highly questionable.

Another conventional "role" of the state is to create an environment where there is free flow of information, because "full information" is very crucial in reducing transactions costs and in moving resources to their best possible use. But what if the state in trying to organize its services is itself riddled with informational problems, monitoring costs and moral hazard? Then, the whole notion that the state has the capability to facilitate any information for the benefit of the private sector becomes highly dubious. Consequently, traditional renditions on the role of the state in a market economy are not likely to be realised, because, it is one thing to prescribe what the state "ought to do", and a totally different thing as to what the state actually does.

In the ordinary business of life, then, the proposed strategic behaviour behoves the state to turn a blind eye to glaring side payments, propose piece-meal economic plans, and to embrace markets in the name of reforms. The state has every incentive to behave thus, as long as inefficient provision of public services does not count against it. Such strategic play by the states should be considered as a stiff contender to received renditions and also as an interesting possibility in this world of ideas.

(The writer is Associate Professor of Economics, University of Pittsburgh, Bradford, U.S.)

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