Do Government Wage Cuts Close Budget Deficits? : Costs of Corruption

This paper examines the question of government wage policy as an instrument for improving public sector management and, therefore, the fiscal balance. Evidence from several countries shows that real wage declines have been widely experienced in the public sector in many countries over substantial periods of time. In a model of tax revenue collection under imperfect observability, we investigate the impact of the low and/or declining real government wages on incentives to work and on corruption. We show that public sector output (revenue collection in the paper) could improve with higher wages since it alters the incentive compatible equilibrium and attracts more skilled human capital to flow to the government sector. However, an increase in wages has to be complemented with appropriate monitoring and penalty rates for effective tax administration. The usual prescription of raising the statutory tax rate alone, however, may not increase revenue collection. We show that there is a combination of statutory tax rates and wage policy which maximizes government's net revenues