VI. Incentive Payments for Civil Servants - 2

Suppose the regulator can directly
control neither the inspector’s monitoring
effort nor his underreporting of the
factory’s pollution for which he gets
bribed, a double moral hazard problem
in a principal-agent model. The regulator
has three instruments: a rate of reward
r for the inspector (a percentage
commission based on the fines for pollution
collected from the factory), a
penalty p (depending on the amount of
underreporting of pollution) on the inspector
when corruption is discovered,
and a penalty q (a mark-up over the
usual fine for the evaded pollution ) on
the factory for bribing the inspector.
The probability that the inspector will
unearth the factory’s true pollution
level (assuming, of course, that he will
not overreport) depends on the monitoring
effort exerted by the inspector.
There is also an exogenous probability
that the inspector’s underreporting and
the bribe paid are discovered by the
regulator. Given the regulator’s policy
package (r, p, q), the factory and the
inspector simultaneously choose the
pollution level and the monitoring intensity
respectively. The two parties
(assumed risk-neutral) then jointly determine
the bribe, if any, as part of a
Nash bargaining solution.
Suppose the factory has polluted and
the inspector has found out about it. If
bribery is going on, then small increases
in r or p may merely raise the level of
the bribe: a compensation policy
whereby the larger reward for the inspector
or a higher penalty for taking a
bribe, raises the cost borne by the inspector
for underreporting pollution,
and so the inspector demands and receives
a larger bribe, and corruption increases.
Mookherjee and Png show that
it takes a sufficiently large, discrete, increase
in the reward or the penalty to
eliminate corruption (when the inspector’s
demand for bribe rises beyond the
factory’s willingness to pay). One way to
reduce the bribe, however, is to raise q,
the penalty on the bribe-giver (making
bribing more costly for him), while reducing
the penalty p for the bribe-taker
(so that the latter does not demand a
larger bribe): this contrasts with the
typical practice of punishing bribe-givers
less severely than bribe-takers.
What effect does the compensation
policy have from the point of view of
the primary objective of regulating pollution?
A small increase in the reward
rate r, by raising the bribe and hence
the price of pollution will lower the incentive
for the factory to pollute. The
larger bribe will increase the inspector’s
incentive to monitor, further deterring
the factory. The reduction in pollution,
on the other hand, will discourage the
inspector from monitoring. In equilibrium
the net effect is to reduce pollution.
By contrast, when the regulator
raises the penalty rate p on the inspector,
this will reduce his incentive to
monitor; the reduction in monitoring
can reduce the expected penalty for
pollution for the factory, and hence the
result may be more pollution. Thus although
the inspector is risk-neutral, the
carrot (reward for reporting pollution)
and the stick (penalty for taking a
bribe) can have opposite effects on the
level of pollution. All this is not to discourage
a suitable incentive payment
system in the context of corruption but
to point to the nature of complexities
involved.16 The analysis also suggests.