University of Tel Aviv Buchman Faculty of Law Law and Economic Development Prof. Hans-Bernd Schäfer Dec. 2012

Exam Proposed Solution

The Question

The economist Kaushik Basu has recently made a proposal to check low-level forms of corruption (specifically, payment to government officials in exchange for a service that citizens are legally entitled to):

1. making it legal for the citizen (but not for the official) to pay a bribe to the public official in such cases; and 2. entitling the citizen to reclaim the bribe money (or even twice the bribe money according to a similar proposal) from the government, if he or she reports and proves the bribe payment to a government authority made in charge.

This proposal has been widely discussed, especially in India. Discuss whether or not, and under what conditions this proposal could work and what might be its strengths and weaknesses from an economic and from a rule of law point of view.

Proposed Solution

 Note- this is the suggested outline for analyzing Basu's proposal. Obviously, each essay can approach the proposal in an individual manner and the grading has taken that into account. Full points can be received for a clear, elaborate and thoughtful analysis.

 Introduction – Corruption and Economic Development

- Basu's proposal is aimed at minimizing corruption, which weakens the legal, physical, and social foundation of economic development. There is a general correlation between the perception of corruption and the country's GDI: observers tend to perceive low corruption in high-income countries, medium corruption in middle-income countries, and high corruption in low-income countries. - Bribery can be generally categorized according to the rank of the official demanding the bribe: centralized bribery refers to bribery given to and controlled by top officials, whereas decentralized bribery is controlled by regional administrators. Even in a system of decentralized bribery, the top officials find a way to get their cut. Instead of reigning in lower-ranking officials, the top officials turn a blind eye in exchange for a cut of the bribery proceeds. If the bribing entity is lucky, the top official will wield his power in order to protect it from extortion by others. - The relative stability of the political elite affects the prevalence of corruption. Politicians that are secure in their power will prefer that corruption levels do not hamper economic growth. Their ability to collect bribes from successful businesses in the long run outweighs benefits of short term extortions that stifle economic success. Conversely, unstable politicians are unable to discount future dealings and prefer to extort as much as possible in the short- term. - With regard to Basu's proposal, it should be noted that weak central authority provides an opportunity for corruption to proliferate among minor officials. In India, Shah and Sane found that licensing requirements are so difficult to meet that their only rationale seems to be the extraction of bribes for inspectors and the police. It is against this backdrop that we must weigh the relative merits of the proposed law.

 Basu's Proposal – Strengths

- A bribe is essentially a specific type of contract: one person provides a service (the legal entitlement) in exchange for a payment. Under current contract law regime, this is an illegal contract. Once it is found out, the bribe-giver will have to return the entitlement he received as a result of the bribe. Thus, the two parties essentially entered into a prisoner's dilemma: the optimal result for both of them will occur if neither of them reports the bribe. The optimal result (through the eyes of the bribe-taker and bribe-giver) rests on the mutual trust that exists between them; if one side suspects the other will go to the police or otherwise renege on the agreement, the bribe contract would never have been formulated in the first place.

On this understanding lays the strength of Basu's proposal. Under the current regime, bribes are unenforceable by the courts and therefore rely on the mutual trust between the bribe-giver and bribe-taker. By offering a reward to the bribe-giver and promising not to take away his entitlement, the proposal changes the dynamic of the prisoner's dilemma: the optimal result for the bribe-giver will occur if he goes to the authorities and reports the bribe! This change in pay-offs damages the trust between the bribe-giver and bribe-taker and dissuades the bribe-giver from entering the relationship in the first place.

- Basu's proposal should be analyzed within the formula that measures corruption's net cost to society:

(net social cost of corruption) = (harm) + (prevention) - (benefit).

The net social cost of corruption is the harm that corruption causes to society minus the cost of preventing it. Law and public policies that minimize this cost create "optimal" levels of corruption. While Basu's proposal on its face does not entail an enormous cost (recouping the bribe-givers payment and giving him a reward), it could still raise the net social cost of corruption if improperly implemented. This is because in certain situations, preventing bribery might create a net loss to society. Bribery can be beneficial to society when it allows citizens to circumvent "bad laws" that impede instead of help the economy (an example of this can be a monopoly given to a strong interest group or political crony). Therefore, although counter-intuitive, successful implementation of Basu's proposal should include a loophole that does not apply a bribery that undermines "bad laws".

 Basu's Proposal – Weaknesses

- Analysis of the proposal's weaknesses should focus on the feasibility of implementation. Recall that the proposal aims at shifting the dynamic of the prisoner's dilemma in a way that motivates the bribe-giver to report the bribe. Objective real-world obstacles stand between theory and implementation.

- One of the impediments to the proposal's success is the efficiency of the judiciary. If the bribe-giver is forced to wait an extremely long time and overcome expensive legal hurdles in order to prove his claim, the basic prisoner's dilemma is unchanged and will not motivate the bribe-giver to turn in the bribe-taker.

- Another weakness in the proposal is the assumption the bribe-giver and bribe- taker are involved in a one-off relationship that coincides neatly with the matrix of the prisoner's dilemma. This assumption can be undermined for a variety of reasons. Some bribe-givers enter into many transactions with elected officials and should be categorized as repeat players. The repeat player takes part in an enduring relationship with the officials and actually benefits from the ability to bribe them. In order to motivate the serial bribe-giver to turn in the bribe-taker, the reward needs to compensate him for the long-run benefits that he can obtain from the relationship.

Similarly, the basic matrix of the prisoner's dilemma does not take into account societal concerns that effect the bribe-giver's motivation. We know that in certain cases, community and kinship can overcome the trust problem and help enforce otherwise unenforceable contracts. If the bribe-giver and bribe-taker belong to a defined group or caste, even the offer of a substantial reward will not cause the bribe-giver to turn in his kinsman. Loyalty to a group and fear of "group sanctions" (such as ostracism) outweigh simple monetary considerations. Sowing distrust in this environment is very difficult and can hamper the effectiveness of the proposal. For the proposal to work, a strong civil service might have to rotate officials around so as to distance the official from the community with which he has to deal.

- Another obstacle for the successful implementation of the proposal is the culture of the country. Studies have shown that culture affects behavior. Black letter law's ability to change the culture is not understood.

- It is imperative we take into account the proposal's effect on the informal sector when we tally up the harms and benefits. In poor countries, the informal sector occupies a large fraction of the economy. One of the reasons that the informal sector flourishes is the high cost of adherence to regulation. Even after accounting for a potential reward, a bribe-giver that is part of the informal sector will hesitate to turn in a bribe-taker. This hesitation stems from fear of the regulatory spotlight; a member of the informal sector that seeks judicial help is now on the radar of all other government agencies. The one- time reward of turning in a bribe-taker is offset by enhanced regulatory fees. Consequently, for this proposal to work in the informal sector the state needs to be able to commit to leniency with regard to the bribe-giver from the informal sector.

 How the Many Can Overcome the Few

- Can we offer an alternative proposal with that has a better chance of eradicating? The problem with effective reforms is that they harm the interest of those who have the power to initiate and carry them through. In our case, the group that will be disadvantaged by an effective reform is the civil sector that receives the bribes.

- As the proposal stands, and assuming its' feasibility, the civil service is a net- loser of the proposal. We can assume that the reduction of bribes in the society benefits all citizens and that this off-sets the harm done to the civil service. Therefore, the proposal constitutes a net gain in the cost-benefit analysis and should be carried out.

Since the civil service will be harmed by the proposal, it stands to reason that they will mobilize and resist. Effective legal reform can be categorized into three categories. Since we know who bear the civil service will bear the cost of successful implementation of the reform, the veil of ignorance analogy does not apply. However, the remaining two strategies are still feasible: diffusing the cost of the reforms between larger groups, not only the civil sector. By spreading the cost over multiple groups, it is possible to dilute the opposition afforded by each group. Second, and more important, a successful reformer will buy off the opposition by giving them a share of the surplus from growth (with regard to the civil service, a share of the surplus entails raising their salary and other benefits). This ensures that the reform is a Pareto gain (no group is worse off) and accepted by all.

- The other prong of a successful reform is a credible commitment by the reformers. The group that is being made worse off will only agree to the new Pareto distribution if it has faith in its' implementation.