Optimal Government Regulations and Red Tape in an Economy with Corruption

We study an economy where agents are heterogeneous in entrepreneurial ability, and may decide to become workers or entrepreneurs. The government is motivated by a production externality to impose regulations on entrepreneurship, and sets a level of red tape -administered by public officials-to test regulation compliance. In an environment where some officials are corrupt, we study what are the optimal levels of regulations and red tape, and to what extent such policies reduce the welfare losses created by corruption. For each level of externalities, we find that high and low levels of corruption create qualitatively different distortions, which in turn changes the nature and reach of optimal policies. Under low levels of corruption and externalities, the government sets low levels of regulations and minimal red tape, and with these policies achieves the first best allocation. When externalities and corruption are above a threshold, only a second best allocation can be achieved. Moreover, when externalities are large, mandating higher levels of red tape is a Pareto improving policy.