Taxes and Bribery: The Role of Wage Incentives

Abstract

This paper presents a simple model to evaluate alternative payment schemes for tax inspectors in the presence of corruption. We consider problems of both moral hazard, which arises because taking bribes cannot be observed without costly monitoring, and adverse selection, since not all potential tax inspectors can be identified as being honest or dishonest. We identify three wage regimes. First, one could pay the same wage that a tax inspector could earn elsewhere - his reservation wage. Second, one could pay a wage which solves the moral hazard problem, i.e. deters bribery. This we call an efficiency wage, by analogy with recent models examined i n macro economics. Third, the government could pay a wage below the reservation wage, at which only the dishonest become tax inspectors - the capitulation wage. We make precise the conditions under which each yields the greatest amount o f tax revenues, net o f administrative costs. Many countries in the developing world are undergoing structural adjustment programmes which require fundamental fiscal changes. Outside agencies advise restoration of budget balance, a task which involves expenditure cuts and tax increases. The treatment of public employee pay scales often poses a particular dilemma i n this process. Wages and salaries are a significant component of government expenditures and one important question concerns the extent to which wages rather than employment cuts should be used to save money. There is sometimes a reluctance to advocate wage cuts, stemming in part from a feeling that this might impair the performance of the public sector. Hence, Tanzi (1990) argues that a policy of wage cutting ' is likely to increase the inefficiency of public sector employees, especially at a time when the public sector is expected to play a larger role in restructuring the economy' (p. 16). In the context of tax collection the issue is particularly pressing, given the need to raise more tax revenues. A reduction in efficiency in this branch of the government i s likely t o mean that fewer returns are processed and when individuals' living standards are squeezed, their incentive to accept bribes in lieu o f collecting taxes i s increased.^ O n this count, i t i s even sometimes suggested that wages of tax inspectors should be increased to aid the effort to * The comments of Henry Bienen, John Hey and two anonymous referees have been helpful in revising this paper. The authors are also grateful t o the John M . Olin Program for the Study o f Economic Organization and Public Policy at Princeton University and the Pew Charitable Trusts for financial support. McLaren also acknowledges support from the International Finance Section of Princeton University. None of the above should be implicated in any way. ' See, for example, Goode (1984) chapter 1 3 and Gould and Amaro-Reyes (1983).