We consider an economy where contracts are necessary to encourage investments. Contract enforcement requires that a fraction of the agents work in the public sector and do not accept bribes. We find that: (1) It may be optimal to allow some corruption and not enforce property rights fully. (2) Less developed economies may choose lower levels of property right enforcement and more corruption. (3) There may exist a 'free-lunch' such that over a certain range it is possible simultaneously to reduce corruption, increase investment, and achieve a better allocation of talent. Bureaucratic corruption is widespread in many societies. Casual empiricism and case studies suggest that corruption distorts the allocation of resources, and discourages investment and the creation of new firms (e.g. Mydral, 1968, DeSoto, 1989). Cross-country studies also find that countries with high corruption or long bureaucratic delays suffer lower growth (e.g. Mauro, 1996; Sartre, 1997). It is therefore tempting to conclude that government policies and bureaucratic corruption are at least partly responsible for the lack of development or slow growth of many economies (e.g. Shleifer and Vishny, 1993). Nevertheless, governments and bureaucracies do not exist only to seek rents. They perform a number of useful functions, including provision of public goods, correction of market failures, and redistribution. Without understanding why the state exists, it is difficult to assess why corruption arises, what its consequences are, and whether and how it should be prevented. In this paper, we analyse how the employees of the state (bureaucrats) can misuse their power to enforce property rights. The protection of property rights is commonly viewed as one of the most important roles of the state by political philosophers as diverse as David Hume, Karl Marx and Robert Nozick, while a number of social scientists including North and Thomas (1973) and Rosenberg and Bridzell (1989) emphasise the importance of secure property rights in the development of western societies. For the state to have a role in enforcing property rights, some contractual problems must exist between private parties. In our economy, these contractual problems are between entrepreneurs. In particular, production requires two agents, and one of the entrepreneurs needs to undertake an investment, but the returns accrue to the other one. This can be thought as a partnership with the first agent as an upstream supplier providing an input of variable