Content area
Full text
Luciana Echazu, Department of Economics, Clarkson University, Potsdam, NY 13699, USA; [email protected]; corresponding author
Pinaki Bose, Department of Economics, Fogelman College of Business and Economics, University of Memphis, Memphis, TN 38152, USA; [email protected]
[Acknowledgment]
We would like to thank the participants at the 2006 Southern Economic Association Conference, NEUDC 2006, and two anonymous referees for their many useful comments on this paper.
1. Introduction
Bureaucratic corruption and a high incidence of unregulated, and often illegal, productive activities in what is conventionally denoted as the shadow economy, are two features that characterize many developing economies.1 The interrelations between them have been examined in numerous studies.2 These studies typically analyze the equilibrium incidence of bribery in the formal (or the regulated or legal) sector when the informal or shadow sector provides an avenue of escape from predatory bureaucratic demands. But bureaucratic corruption exists in the informal sector as well--in the form of extortions by enforcement officials in charge of apprehending illegal firms. While this aspect is relatively understudied in the literature, it can, as this paper shows, complicate the sectoral interactions sufficiently to invalidate established results in two areas of the literature on corruption. In the area of the "industrial organization of corruption," our analysis generates very different conclusions concerning the benefit of bureaucratic centralization.3 The same analysis also shows that the complementary relationship between the sizes of the formal sector and the shadow economy may no longer be valid when the informal sector is corrupt and characterized by less productive firms.
Shleifer and Vishny (1993) examine the impact of the structural organization of bureaucracy on official corruption and find that a centralized bureaucracy results in lower bribes than a decentralized one. The intuition behind their result is that when permits are issued by different officials, bureaucrats do not take into consideration the negative impact of their independent decisions on the corrupt incomes of other officials. A centralized bureaucracy that maximizes total bribes internalizes this external effect of one official's action on another, thereby lowering corruption. Because higher bribes reduce the viability of otherwise profitable firms, a decentralized bureaucracy results in a lower level of both economic activity and social welfare than a centralized one.
We find that this result loses its general...