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Bureaucrats, Businessmen, and Middlemen: Who Gains and

Who Loses?1

Leonid Polishchuk2

IRIS Center at the University of Maryland at College Park

Abstract

When government is corrupt, intermediary firms that help their clients meet official
regulatory and reporting requirements, are involved in passing bribes. Such firms still cut
the costs of compliance with government rules and regulations, but in addition facilitate
reaching an illicit agreement with a corrupt official, and protect the latter from the threat
of exposure by the victims of corruption. This could lead to higher bribes, leaving private
sector agents worse-off. It is shown in the paper that such an outcome is likelier in the
wake of a government reform that aims to curb red tape and improve transparency and
accountability of civil service.

Keywords: corruption, intermediary firms, government accountability

1
Prepared for delivery at the 2004 Annual Meeting of the American Political Science Association,
September 2 – September 5, 2004. Copyright by the American Political Science Association.
2
E-mail lpol@iris.econ.umd.edu The author is grateful to Omar Azfar, Victor Buev, Oleg Eismont,
Anthony Lanyi and Clifford Zinnes for useful discussions of this paper.
1. Introduction

Corruption in government agencies affects the performance and impact of conventional


economic institutions. An institution that enhances economic efficiency when corruption
is absent could cause private sector losses in a corrupt environment. A case in point is the
middlemen who mediate interactions of private firms and individuals with government
agencies. Such intermediaries – individual consultants or consultancies – handle their
clients’ taxes, offer legal advice, assist in meeting reporting and regulatory requirements,
passing inspections and audits, obtaining licenses, permits, registrations, travel
documents, etc.

Intermediary services are mushrooming in many developing and transition economies,


which in part can be explained by excessive red tape and a cumbersome, non-transparent
and rapidly evolving regulatory environment that is difficult to navigate without
professional help. Another explanation is that consultancies assume additional functions
of brokering and passing bribes. Empirical evidence supporting this claim remains
patchy, but business surveys conducted in Russia indicate that intermediaries indeed
commonly resort to bribery to facilitate their clients’ cases3. Indirect evidence of bribery
can be found in the promises by intermediaries to expedite the case on a priority basis and
settle it at a time that would be inconceivably short if conventional channels were used.
Competition spreads corruption through the sector of intermediaries the same way it does
elsewhere in the economy (Shleifer, Vishny, 1993): consultancies that refrain from
bribery lose out to the competitors that serve their clients better by dealing in bribes.

The institution of intermediaries comes into being spontaneously in response to market


demand, but does it make private sector agents better off? Clearly without corruption the
answer is positive: the mantle of intermediaries grows around the government to lower
the costs of compliance with official rules through specialization and economies of scale.
Middlemen share these savings with their clients – otherwise the latter would not seek the
help of intermediaries and would instead deal with government agencies directly. This
revealed preferences-type argument shows that under normal circumstances
intermediaries indeed benefit private sector.

The above conclusion, however, doesn’t hold when bureaucracy is opportunistic and
corrupt, and therefore controls in its own interests the costs of meeting government
requirements, and adjusts such costs, inclusive of bribes, to the presence of
intermediaries. To find out whether under corruption intermediaries play a positive or
negative role from the private sector’s point of view, one has to compare the equilibria
that occur with or without intermediaries, but with corruption present in both cases. Such
analysis also provides an assessment of the impact of intermediaries on corrupt

3
See e.g. Survey of Administrative Costs in Russian Regions, Information and Consulting Center
“Business-Thesaurus”, 2002 (in Russian); Olimpieva, I., O. Panchenkov, and E. Nikiforova, ‘Middle
Layer’, Expert North-West, 2004, No. 4 (in Russian).

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bureaucracy, and thus reveals stakeholders’ preferences over the institution of middlemen
that resort to bribery.

The existing literature on corrupt intermediaries is scarce. A case study reported in


(Oldenburg, 1987) shows that intermediaries could draw illicit gains from the perception
that government is corrupt even when the government officials immediately involved are
by and large honest. In this case middlemen live off the poor collective reputation of
public servants, and have a stake in preserving such reputation, which leads to a self-
fulfilling equilibrium (Bardhan, 1997). The present paper is concerned with the situation
when bureaucrats en masse live up to their negative reputation and indeed commonly
resort to corruption, in which case intermediaries are “vertically integrated” with corrupt
officials, passing bribes upstream and delivering government services, permits etc.
downstream (on “industrial organization” of corruption see e.g. Shleifer, Vishny, op.cit.;
Waller, Verdier, Gardner, 2002).

The paper is organized as follows. Section 2 disaggregates the impact of intermediaries


into three effects, two of which produce efficiency gains for all sides involved, and the
third one is a transfer of wealth from the private sector to the bureaucracy. Section 3
presents a model for analysis of the above effects. Section 4 describes the behavior of a
private sector agent in dealing with a corrupt official. Conditions when intermediaries
allow corrupt bureaucracy to increase bribes are obtained in Section 5. Section 6 provides
an assessment of the impact of intermediaries on the private sector. Section 7 discusses
implications of government reform for the intermediaries sector; this analysis continues
in section 8 with application to so-called “one-stop shops”. Section 9 concludes.

2. Impact of corrupt intermediaries: three effects

Intermediary firms could possess specific assets, such as specialized professional


knowledge, connections to government agencies, etc., in which case they enjoy certain
market power. To simplify matters, it is assumed in the paper that no such assets are
required to enter the intermediaries market, and the latter is thus fully competitive, with
all intermediaries earning zero profit. In this case all the net gains produced by
intermediaries are passed onto their clients and the bureaucrats involved.

Such gains are in part due to the aforementioned ability of intermediaries to cut the costs
of compliance with government rules through specialization and economy of scale. This
is the compliance cost reduction effect that consultancies yield irrespective of whether
they deal with honest or corrupt bureaucracy. While without corruption the compliance
cost reduction effect is the sole reason for intermediaries’ existence, with corruption there
are additional rationales to call on middlemen.

Namely, if getting a permit, obtaining a government service, etc. is conditional upon


paying a bribe, middlemen save bureaucrats and their private sector counterparts the time,
trouble, risks and embarrassment of negotiating an illicit deal. Illegality of the subject of
a bargain steeply increases the transaction costs of bargaining over a bribe. These costs

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could be high4, at times prohibitive, especially when the parties cannot trust each other
and seek risk premiums, and when the going ‘market rate’ of the bribe is not common
knowledge. Such costs, however, could be radically reduced by a competent and trusted
intermediary, who internalizes negotiations with bureaucrats, agrees with them in
advance on a pay scale for particular services requested by private sector agents, and
afterwards charges their clients an official consulting fee that covers the bribe and other
costs incurred by the consultancy. Once paid by the client, a middleman passes the bribe
to the recipient in exchange for the requested service. An agreement between an
intermediary and his/her client could be properly documented, which gives the client
access to standard contract enforcement mechanisms and remedies, unlike the case of
direct dealing with corrupt officials. As for the latter, they enter into symbiotic relations
with intermediaries, and trust and goodwill typical for such relations allow the sides to
easily arrive to a mutually acceptable deal. Overall, intermediaries “grease” corruption by
reducing the transaction costs that it involves, thus producing the transaction costs
reduction effect.

The compliance and transaction cost reduction effects benefit both private sector agents
and bureaucrats, although the allocation of cost savings produced by middlemen could
vary. When corruption is a given, the second effect makes the case for intermediaries
even stronger, because they alleviate the difficulties that are encountered in conducting
corrupt transactions.

However, the overall impact in terms of economic efficiency of intermediaries dealing in


bribes is not altogether clear. This is due to the third effect, which, unlike the first two, is
asymmetric – it does not benefit all the parties involved, but could create additional gains
for a corrupt bureaucracy at the expense of private sector.

Namely, when corrupt officials extort bribes directly from private individuals and firms,
they face the risk that the latter could lodge complaints and press charges leading, if
found proven, to stiff penalties. Victims of corruption have the incentive to complain5, on
the hope to avoid or recover the bribe. In addition to this incentive, they also could collect
and present evidences of bribery to substantiate their charges. Bureaucrats are aware of
the risk of exposure, which goes up as the size of the bribe increases (see e.g. Rose-
Ackerman, 1999, and Klitgaard, 1988), and this restrains the greed of corrupt officials.
Concerns about possible complaints could make a bureaucrat setting the bribe at a

4
According to a survey of Russia’s biggest firms (Kommersant, December 2, 2003), the respondents had to
maintain special departments in charge of relations with government, and the costs of such departments to
firms was the highest of all the transaction costs involving the authorities. The newspaper concludes that “it
is not sufficient any longer to bribe officials – one has to spend much more on keeping the staff that will be
delivering the bribes.”
5
This incentive arises in “corruption without theft” (Shleifer, Vishny, 1993; see also Rose-Ackerman,
1999), when a bribe is extorted on top of officially payable fees and duties, if any, and the applicant
otherwise qualifies for the requested service. This means that the bureaucrat and the applicant do not
collude to defraud the government by sidestepping the officially set rules and avoiding levies due, when
bribe is used to split the illicit gains (‘corruption with theft’), and when neither side has an incentive to
‘blow the whistle’.

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‘suboptimal’ level, below the one that maximizes the income from corruption if the threat
of exposure were absent.

Put differently, the size of a bribe is limited by two constraints. The first is market-
imposed: setting a bribe above this constraint is counterproductive, as the number of
those who can afford the bribe drops too steeply, and the increase in bribe does not offset
the reduction of the ‘bribe base’. The market constraint reflects the elasticity of demand
for the service that is provided by the bureaucrat in exchange for a bribe. The second
constraint is driven by fear: above this constraint an increase in bribe doesn’t provide a
sufficient premium for the greater risk of exposure. The lower of these two constraints is
binding and determines the choice of bribe.

Intermediaries set free corrupt officials of the fear constraint, because the victims of
bribery do not confront bureaucrats directly, can only guess what the size of the bribe is,
(as it is hidden in the middlemen’s fee), cannot collect and present any direct evidences
of bureaucrat’s wrongdoing, and are not even sure if a bribe is paid at all. Proofs of
bribery can be obtained by middlemen, but the latter have no incentive to upset the
symbiotic relationships they have with corrupt bureaucrats.

Removal of the fear constraint constitutes the indemnity effect which allows bureaucrats
to disregard the fear constraint and set the bribe at the “market” optimum. If the fear
constraint is binding, the indemnity effect has no impact on the actual level of bribe.
However, if the fear constraint is binding, this effect leads to an increase of the bribe to
its “market” optimum. In this case, corrupt bureaucrats clearly gain at the expense of the
private sector.

All three of the above effects make a corrupt bureaucracy better-off, and corrupt officials
are thus clear beneficiaries of intermediaries. As for the private sector, the gains of the
first two effects could be offset by the losses due to the third effect. A model presented in
the next section shows under what conditions such losses indeed occur, and provides an
assessment of the overall impact of intermediaries on the private sector.

3. Model

Consider a corrupt bureaucrat who controls entry to the official sector of the economy. It
is assumed that a continuum of entrepreneurs want to undertake business projects, but to
do so need permits from the bureaucrat. A project, once commenced, generates a steady
stream of profit with the discounted present value, estimated at the time the project is
started, of v . The value of a project is distributed across the continuum of entrepreneurs
with cumulative distribution function F (v) and density f (v) . The hazard rate of this
distribution
f (v )
H (v) ≡
1 − F (v )
is assumed monotonically increasing. This assumption is standard and made for
convenience; it does not affect the main conclusions of the paper.

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All entrepreneurs qualify for permits they need to start a business6. Permits are dispensed
by a bureaucrat who can extort a bribe from applicants on the top of the official
processing fee. The bureaucrat does not observe the value of an applicant’s project and
thus charges all applicants the same bribe.

Let the total cost of securing a permit borne by the applicant be c + µ , where µ is the
bribe pocketed by the bureaucrat, and c is the sum of the applicant’s other costs. Let b
be the cost of processing an application borne by the bureaucrat.

If there are no intermediaries, c is the total of the official application fee (which goes to
Treasury) plus the compliance and transaction costs incurred by the applicant, and b is
the total of compliance and transaction costs borne by the bureaucrat. When an
intermediary mediates the transaction, c is the total of reduced compliance costs and a
fee payable to the intermediary net of the portion of the fee which is passed by the
intermediary to the bureaucrat as a bribe (it is assumed for simplicity that an intermediary
eliminates transaction costs altogether). Similarly b is the bureaucrat’s reduced
compliance (processing) cost.

It is assumed that an intermediary earns zero profit, so that the part of the his/her fee net
of the flow-through bribe just covers the intermediary’s own costs. The total social cost
per application is thus c + b (this is obviously also true if an intermediary is not involved
in the transaction). It is further assumed that intermediaries are efficient in that the costs
of their services net of the bribe is less than the savings of the compliance costs of a
private sector agent (this means that without corruption entrepreneurs would be willing to
get consultants’ help with obtaining permits).

Suppose first that the bureaucrat who has a monopoly over issuing permits is not
concerned about the threat of exposure, and sets the bribe to maximize the gross income
from corruption. For bribe µ only the applicants who have projects with values exceeding
the entry cost of µ + c will apply, furnishing the bureaucrat with the net income of
( µ − b)(1 − F ( µ + c)) . The optimal bribe µ * solves the following problem:

max Ψ ( µ ) ≡ ( µ − b)(1 − F ( µ + c)) (1)


µ

and can be found from the first-order condition

1 − F ( µ + c)
µ =b+ (2)
f ( µ + c)

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In other words, the bureaucrat that controls the entry does not have to screen applicants; his role is to
collect and process applications and make necessary entry into official registries. For corruption models
where applicant screening is required see e.g. Guriev, 2004; see also Pendergast, 2003.

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Note that due to the monotonicity of the hazard rate, the bureaucrat’s net income is a
single-peaked function of the bribe, and equation (2) has the unique solution µ * .

4. When to blow a whistle?

The optimal solution µ * sets the market constraint on bribe. To obtain the fear constraint,
assume that private sector agents approach the bureaucrat directly, can collect evidences
of a bribe and lodge a complaint, which, if successful, results in a recovery of the bribe,
while keeping the permit.

Whether a victim of bribery attempts to lodge a complaint, depends on how costly it is


and what is the likelihood of proving the bureaucrat’s wrongdoing with the available
evidences. These depend on the degree of transparency and accountability of the public
service. High accountability and transparency imply clear and straightforward procedures
for processing applications and applicants’ complaints, if any, making it easier to prove
violations of rules by the bureaucrat, and to obtain appropriate remedies. Poor
accountability and a lack of transparency make complaints lengthy and burdensome and
chances of restitution slim.

Suppose that integrity and accountability of public service are such that the victim of
bribe has to spent T days to press charges, and that the probability of success of the
complaint is π . It is assumed that during the time it takes for a victim of bribery to
pursue a complaint against the bureaucrat, he/she cannot attend the business project for
which a permit was sought, and which could have been launched immediately, were the
complaint not lodged. The project has to be put on hold until the matter is resolved. This
means that lodging a complaint costs the victim the lost profit of α v , where v , as above,
is the discounted present value of the project if it is launched immediately, and
α = 1 − e − rT ( r is the discount rate). Parameters α , π ∈ (0,1) are, respectively, the input
and output characteristics of the available “complaint technology.”

Since a successful complaint recovers the same bribe µ , no matter what is the project
value v , it is clear that complaints will not be launched in case of highly profitable
projects, and that, ceteris paribus, complaints are more likely when government is more
accountable (i.e. with higher π and smaller α ). Furthermore, the complaint has a greater
appeal with higher bribes (and hence the fear constraint upon the bureaucrat). This
intuition is corroborated by the following analysis.

An entrepreneur has the choice of not starting the project at all, starting the project,
paying the bribe, writing it off as a part of start-up costs and moving on, and starting the
project, paying the bribe and attempting to recover it. Assuming risk-neutrality, the
payoffs of these options are as follows:

Do not start 0
Start, pay and move on v−c−µ

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Start, pay and attempt recovery (1 − α )v − c − (1 − π ) µ

Low-yield projects with small v will not be undertaken, since the start-up costs for such
projects are prohibitively high, no matter whether the entrepreneur attempts to recover a
bribe or not. Projects of high yield, as an inspection of the above table shows, will be
implemented with no attempts to recover a bribe. This means that the threat of complaint
comes from entrepreneurs with projects of medium profitability, high enough to apply for
a permit, but not too high to write off a bribe without attempting to get it back. Whether
such a middle range of profitability (“complaint interval”) exists, depends on the size of
the bribe and the parameters of the “complaint technology”.

Namely, a comparison of the payoffs available under various courses of actions leads to
the conclusion that a complaint interval is non-empty iff the following inequality holds:

α µ
< . (3)
π c+µ

The following diagrams illustrate the situations when (3) is violated, and no one files
complaints (Fig. 1a) and when (3) holds and some entrepreneurs with projects from the
non-empty complaint interval will indeed take actions against the bureaucrat (Fig. 1b).

Figure 1 here

α
The ratio ε ≡ is an unaccountability index; according to (3), if ε ≥ 1 (in this case
π
public service is egregiously unaccountable), complaints will never be filed, no matter
what is the bribe level. However, if ε < 1 , i.e. unaccountability is less than egregious, then
sufficiently high bribes µ > µ 0 , where
εc
µ0 = , (4)
1− ε

would trigger complaints. The threat of complaints does not in itself make the range
µ > µ 0 off-limits for the bureaucrat, but in this range economic gains, if any, from higher
bribes are reduced by the risk of exposure and punishment. Therefore for µ > µ 0 the fear
constraint is factored in by the bureaucrat in his/her decisions about the bribe level.

5. Is the fear constraint binding?

If ε ≥ 1 , i.e. government accountability is egregiously poor, then the fear constraint does
not restrict the choice of the bureaucrat at all. If ε < 1 , then for bribes above the threshold
(4) this constraint cannot be ignored any more. However, it is still possible that bribes of
that magnitude will not be of interest for the bureaucrat for purely economic reasons, if
very few people would be able to afford them. Indeed, if the “market optimum” level of

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bribe µ * is less than µ 0 , then the fear constraint does not bind the bureaucrat and his/her
greed is satisfied with impunity, because the bribe that maximizes the net gains from
corruption is not high enough to make victims to complain. This situation is illustrated by
Fig. 2a. On the other hand, if µ * > µ 0 , the fear constraint becomes binding in that it
affects the bureaucrat’s choice and clearly reduces his/her illicit profit (Fig. 2b). The
following proposition specifies conditions when this is the case.

Proposition 1. The threat of exposure reduces the bureaucrat’s profit and makes him/her
to set a bribe below the “market optimum” if and only if ε < 1 and

ε c
( c − b) H ( ) < 1. (5)
1− ε 1− ε

The proofs of this and the next propositions are omitted.

Figure 2 here

The left-hand side of inequality (5) monotonically increases in ε and c (recall the
assumption of monotonicity of the hazard rate). This means that the fear constraint is
binding if the civil service is sufficiently accountable, and/or if the non-bribe portion of
the costs borne by the applicant (the total of compliance and transaction costs) is modest.
The first of these conditions is intuitively clear, whereas the second one is less obvious
and requires an explanation. The argument is as follows: when compliance with
government rules and requirements, and reaching an agreement with bureaucracy are
themselves costly and burdensome before any bribe is paid, then a bribe added on the top
of these costs is not necessarily the main part of the total costs of obtaining an approval
from the bureaucrat. With high non-bribe start-up cost c , only sufficiently profitable
projects could recoup the costs necessary to overcome the steep entry barriers. Of these
entry costs, the non-bribe part c is sunk and cannot be recovered. If a high yield project
is finally given a go-ahead, the entrepreneur will be unwilling to lose valuable time in
attempting to recover the bribe, which is only a portion, perhaps not even the main one,
of the start-up costs, and will rather write it off and move on with his/her business.7

If intermediaries enter a bureaucratic services market where prior to their arrival


condition (5) was met and the fear constraint was binding, they produce, alongside the
compliance and transaction costs reduction effects, the indemnity effect. If condition (5)
does not hold, the indemnity effect does not arise.

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This argument shows that corrupt bureaucracy values complicated and cumbersome rules and regulations
not only because they make businesses vulnerable to extortion, but also because they afford impunity to
corrupt officials. There is a tradeoff involved, however, because excessive red tape of which a bribe does
not exempt reduces the ‘market base’ for corrupt bureaucracy. Investigating this tradeoff is beyond the
scope of the present paper.

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6. Implications for bureaucrats and private sector

It was mentioned earlier in the paper that all three effects of the intermediaries’ presence
– compliance and transaction costs reductions and indemnity – benefit (possibly non-
strictly) corrupt bureaucracy. Indeed, bureaucrats welcome cutting their own costs and
the non-bribe costs of their private sector counterparts. Reduction of the former benefits
bureaucrats directly, and the latter – indirectly, since it increases the demand for permits
for every given level of bribes and thus expands the bureaucrat’s private “tax base”8. The
removal of the fear constraint, if it was initially binding, gives bureaucrats an extra reason
to appreciate middlemen’s involvement.

The above model confirms that the first two effects, in the absence of the third one,
benefit private sector agents as well. Indeed, the total cost of securing a permit is c + µ * ,
and a standard analysis of problem (1) shows that when c + b declines, so does c + µ * ,
where, as before, µ * is the “market” optimal bribe.9 As a result, entry barriers get lower,
and the private sector is better-off because more entrepreneurs start their projects and
each of them pays lower start-up costs. Aggregate gains of the private sector due to the
compliance and transaction costs reduction effects can be calculated as follows. Assume
that intermediaries reduce the costs borne by private sector agents and bureaucrats,
respectively, from their initial values c and b to c < c and b < b , and that condition (5)
does not hold, so that the fear constraint is not binding. The new bribe µ * reflects lower
costs c and b , and c + µ * < c + µ * . In this case the net gains of the private sector

without intermediaries were ∫c+µ *
(v − c − µ *) f (v)dv , and with intermediaries they go up

to ∫
c+µ*
(v − c − µ *) f (v)dv . With intermediaries all parties involved are better-off, so
middlemen produce a Pareto improvement.

In the presence of the indemnity effect this is not necessarily the case any more. Indeed,
let condition (5) hold, and therefore without intermediaries the entry cost equals c + µ ,
where the bribe µ that the bureaucrat charges is less than the “market optimum” µ *
because the fear constraint is binding. While it is still true that the new entry cost with
intermediaries c + µ * is less than c + µ * , i.e. what it would have been without
intermediaries, were it not for the fear constraint, one cannot conclude that c + µ * is also
less than the actual entry cost without intermediaries c + µ . The indemnity effect now
works, from the private sector’s perspective, against the compliance and transaction costs

8
Note that the compliance and transaction costs reduction increases the risk of complaints (see the previous
section), but because intermediaries eliminate the fear constraint, this is of no concern for the bureaucrat.
9
This conclusion holds even without the assumption that the hazard rate H (v ) is monotonically
increasing. With this assumption, one can show that the optimal bribe µ * itself also declines with c, but
increases when b declines. Therefore when compliance and transaction cost savings accrue primarily to the
private sector, its agents gain due to lower non-bribe costs and reduced bribe.

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reduction effects, and a hike in bribe due to the removal of the fear constraint could
outweigh the reduction of the private sector’s non-bribe costs c, leaving the private sector
worse-off.

Recall that without corruption the presence of intermediaries cannot make private sector
agents worse-off, because they always retain the earlier available option of approaching
the bureaucrats directly. While this option is still nominally available when
intermediaries help transact with corrupt officials, the latter could deliberately raise the
costs of securing a permit without intermediaries’ help by putting up additional red tape,
dragging the case etc., and thereby making intermediaries the preferred private sector’s
option, even on the terms that are worse than those in effect when intermediaries were
absent.10

Under what circumstances is the indemnity effect stronger than the compliance and
transaction costs reduction effects? This is likely the case when the non-bribe costs borne
by private sector agents without intermediaries were already modest. If so, there is little
room for the first two effects. At the same time, according to Proposition 1, for small c
the fear constraint is binding, and its removal by intermediaries leads to a bribe hike,
possibly steep. The overall impact of intermediaries for the private sector in such a case is
clearly negative.

7. Intermediaries and government reform

Government reforms in transition and developing countries often provide for cutting red
tape and increasing accountability of civil servants. According to the foregoing analysis,
such reforms create conditions where the fear constraint is binding and restricts the level
of bribes, which makes intermediaries particularly desirable for a corrupt bureaucracy.
This conclusion is consistent with the proliferation of intermediary services observed
recently in Russia, where the government has passed a package of “de-bureaucratization”
laws reducing red tape for the private sector, and is attempting to modernize the
notoriously inefficient and corruption-prone civil service. Resorting to intermediaries
allows a corrupt bureaucracy to build protection against such reforms and keep collecting
bribes behind the middlemen’s shield.

Furthermore, intermediaries deny the private sector the benefits that the government
reform is expected to produce, allowing the bureaucracy to keep or even expand its illicit
gains at the society’s expense. Indeed, reining in the red tape reduces the private sector’s
compliance costs, and in combination with efforts to increase accountability of

10
Of course in practice some private sector agents still settle their cases without soliciting intermediaries’
help. The simple model used in the paper does not reflect this option, but the main conclusion still holds in
a more general situation when bureaucracy keeps open two channels of dealing with its counterparts –
directly and through middlemen. In this case corrupt officials effectively practice price discrimination,
offering a “menu” of two options, one of which involves intermediaries and the other does not. By
choosing one of the options, agents reveal information about their type, which allows bureaucrats to
increase their illicit income. It is well-known that price discrimination often leaves customers worse-off.
Notice that without intermediaries such discrimination is impossible.

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government officials make the fear constraint binding. Intermediaries lift this constraint
and allow bureaucrats to keep bribes at a level that would have been too risky if bribes
were collected directly from applicants. Middlemen thus suppress the restraint on
corruption that the government reform was supposed to tighten. At the same time after
such reform intermediaries’ help in cutting the legitimate compliance costs is limited, as
these costs have already been reduced by the implemented anti-red tape measures. The
overall balance for the private sector is thus clearly in the negative.

One can conclude that government reform implemented to increase the efficiency of the
civil service strengthens the bureaucracy’s demand for mediation. This general
conclusion can be illustrated by the following example.

8. One-stop shops

“One-stop” shop (also known as a “single window”) is a commonly used approach to


reduce the burden of compliance with multiple regulatory and reporting requirements. A
one-stop shop allows getting approvals, registrations, etc. from several government
offices that are involved in the process, by filing the required paperwork through a
“single window”, so that the submitted file is moved to the necessary desks and
processed without further involvement of the applicant. The aforementioned “de-
bureaucratization” laws recently enacted in Russia employ the one-stop shop idea in
business registration.

The standard argument for one-stop shops is that they cut the compliance and reporting
costs for businesses and individuals. However, this idea takes on additional merits if
bureaucracy is corrupt. When an applicant who wants to, e.g., start a business, has to
obtain multiple permits from several government offices, each of the involved
bureaucrats could demand a bribe. This leads to a multiple sources polycentric corruption
when corrupt officials prey on the same “tax base” without coordinating their actions
with each other. A lack of coordination makes the burden of corruption heavier for its
victims, and also reduces the corruption income of participating bureaucrats – a “cartel
agreement” inside the bureaucracy would have made all the parties, including the private
sector, better-off (Shleifer, Vishny, 1993). Such an agreement, however, is hard to
achieve (unless corruption is hierarchical and lower-level bureaucrats are strictly
controlled by their superiors – see e.g Waller, Verdier, Gardner, 2002) – the well-known
problems of enforcing a cartel are aggravated by the illicit and clandestine nature of the
activities that require coordination.

A one-stop shop offers a solution to this problem. Indeed, it forces the bureaucrats whose
approval is required, to reach an agreement, because a bribe can be collected only once
and has to be divided between those holding a veto power over an application. A one-stop
shop is thus a Pareto improvement even before the gains of reduced paperwork and hassle
are factored in. With these gains, which are the original rationale for introducing a one-
stop shop, the appeal of the idea is even stronger.

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One-stop shops have a major impact on intermediaries and the role they play. Namely,
although a one-stop shop reduces the aggregate burden of corruption borne by the private
sector, one can show that a one-time bribe collected at the ‘single window’ by the
“cartel” of bureaucrats is greater than any of the multiple bribes that were previously
payable to individual bureaucrats. Assuming that the cost of an attempt to recover a bribe
by lodging a complaint is the same, no matter what is the size of the bribe, this cost might
not be worth incurring for a relatively small bribe paid to an individual bureaucrat for
securing one of the many approvals, but could be worthwhile if the recovery of a much
bigger single bribe is at stake. It is thus possible that the fear constraint was not binding
for smaller partial bribes payable before a one-stop shop was introduced. However, when
such a shop is in place, this constraint could become binding, preventing bureaucrats
from reaping in full the benefits of their cooperation. In this case bureaucrats will be
particularly keen to deal with their clients through intermediaries who help get rid of the
hobble.

More formally, assume that without a one-stop shop, approvals of n bureaucrats are
required to start a business, and that securing each such approval entails the same
transaction and compliance costs c borne by an applicant and costs b borne by the
involved bureaucrat. If bureaucrat i charges bribe µ i and decides its size independently
from others, then in polycentric corruption equilibrium bribes µ i *, i = 1,..., n , solve the
following problems:

max Ψi ( µ i , µ −i ) ≡ ( µ i − b)(1 − F ( µ i + ∑ µ j + nc)) (6)


µi
j ≠i

This equilibrium is symmetric, and all bribes satisfy the equation

1 − F (nµ i + nc)
µi = b + (7)
f (nµ i + nc)

Comparison of equations (2) and (7) confirms that indeed the single bribe charged by the
“cartel” behind a “single window” is greater than each of the individual bribes11. Is this
increase sufficient to trigger complaints unheard of under the old system? Calculations
analogous to those presented in Section 4 lead to the conclusion that in the case of
polycentric corruption complaints can occur only if
µi
nε < (8)
n( c + µ i )

i.e. when bribes exceed the threshold of

εnc
µ i0 = . (9)
1− ε n

11
Monotonicity of the hazard rate is required to verify this fact.

13
Inequality (8) shows that if bureaucrats are sufficiently numerous, so that n > ε −1 , they
can act with complete impunity – no matter how high is a bribe that each of them
charges, applicants will never file complaints. If n < ε −1 , complaints are possible in
principle, but as before, this threat is of any significance only if bribes above µ i0 are of
economic interest for bureaucrats.

Proposition 2. In the case of polycentric corruption the threat of exposure reduces


bureaucrats’ profits and makes them to set bribes below the market equilibrium level
µ i * if and only if ε n < 1 and

εn c
( c − b) H ( ) < 1. (10)
1− ε n 1− ε n

Proposition 2 shows that the greater is the number of bureaucrats n in a polycentric


corruption equilibrium, the less likely the fear constraint will be binding for any of them.
On the other hand, in case of one-stop shop the fear constraint is binding when inequality
(5) holds. Comparing (5) and (9), one concludes that for sufficiently large n condition (9)
is violated even if condition (5) holds. It means that indeed the fear constraint that was
not a concern for bureaucrats in the case of polycentric corruption could well reduce their
profits in a one-stop shop, which strengthens bureaucracy’s appreciation of middlemen.
This is consistent with the earlier made general observation that corrupt officials could
respond to efficiency-enhancing public sector reforms by hiding their illicit actions with
the help of colluding intermediaries.

9. Conclusion

In a corrupt environment, intermediary firms and consultants become parties to corrupt


transactions. In addition to their conventional role of helping to cut the costs of
compliance with government rules and regulations, they considerably reduce the
transaction costs that corruption entails, as well as the threat of disclosure of bribery.
Reduction of the compliance and transaction costs benefits both corrupt bureaucracy and
private sector agents, whereas the protection against disclosure constitutes an additional
transfer of wealth from the private sector to corrupt officials. It is shown in the paper that
under certain circumstances the protection effect could prevail over the savings of
transaction and compliance costs, in which case the overall impact of intermediaries on
private sector is detrimental. Such an outcome is particularly likely in the wake of a
public sector reform aiming at greater transparency and reduced red tape.

Distortion of the role of intermediaries, when bona fide consulting co-exists with abetting
corruption, is an example of an institutional mimicry, whereby an institution is used not
only for its intended purposes, but as a cover for illicit activities. Other illustrations of
such abuse, observed in transition and developing economies, include setting up fake

14
NGOs or using insurance policies for tax evasion, fictitious trade with ‘fly-by-night’
firms to conceal money laundering, etc.

Efforts to reduce corruption are effective insofar as they are supported by citizens and
businesses – the main victims of bribery and sole witnesses of illegal actions of corrupt
officials. Intermediary firms hamper the mobilization of grassroots opposition to
corruption, because such firms hide the bribes in the consulting fees. This makes the
perception of corruption in the society less acute and leads to greater tolerance of the
status quo, while the scale of corruption remains unchanged or even increases.

However, while it is true that intermediaries help conceal corruption, at the same time
this sector provides market data that could be used to estimate the scale of bribery.
Attempts to measure corruption encounter well-known difficulties, which can be only
partially overcome by various palliative measurement tools. Market indicators play a
modest role in such approaches, but the presence of intermediaries makes an important
difference. Intermediary firms openly advertise their prices, and often compete with each
other. This allows one to estimate, using the going market rates, the legitimate costs
incurred by such firms (labor, office space, advertisement, taxes etc.), as well as their
profits which should be consistent with the market structure, and ascribe the differences
between sales, as per published prices, and ordinary costs and profits, to bribes paid to
officials. This method is particularly informative when the market for intermediary
services is highly competitive, so that intermediaries’ economic profits should be close to
zero, and the part of their sales which cannot be attributed to legitimate costs is a good
proxy for bribes.

15
References

Bardham, Pranab. “Corruption and Development: A Review of Issues,” Journal of


Economic Literature, 35 (1977), 1320-46.
Guriev, Sergei, “Red tape and corruption,” Journal of Development Economics”, 73
(2004), 489-504.
Klitgaard, Robert E. Controlling Corruption (Berkeley: University of California
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Oldenburg, Philip. “Middlemen in Third-World Corruption,” World Politics, 39
(1987), 508-35.
Olimpieva, Irina, Oleg Panchenkov, and Elena Nikiforova, “Middle Layer,” Expert
North-West (2004), No. 4 (in Russian).
Prendergast, Canice. "The Limits of Bureaucratic Efficiency," Journal of Political
Economy, 111( 2003), 929-58.
Rose-Ackerman, Susan. Corruption and Government. Causes, Consequences, and
Reform (Cambridge: Cambridge University Press, 1999).
Survey of Administrative Costs in Russian Regions, Information and Consulting
Center “Business-Thesaurus”, 2002 (in Russian);
Shleifer, Andrei, and Robert W. Vishny, “Corruption,” Quarterly Journal of
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Waller, Christopher J., Thierry Verdier, and Roy Gardner, “Corruption: Top Down or
Bottom Up,” Economic Inquiry, 40 (2002), 688-703.

16
Fig. 1a

17
Complaint
Interval

Fig. 1b

18
µ* µ0

Fig. 2a

µ0 µ*

19
Fig. 2b

20

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