Why Small-Ticket Corruption Is Grease In A Country Of Over-Regulation

About four weeks ago, a coffee shop opened near where this writer lives in Bengaluru. The establishment makes good idlis, benne (butter) dosas and akki (rice) rottis, but serves terrible coffee. Despite that, the owner of the coffee shop became a good acquaintance. Last week, he detailed (after much coaxing) the unofficial fees he had to pay government officials (city and state level) to get the requisite licences for setting up his establishment.

Every Indian state has a ‘Shops and Establishments Act’. These acts are an important part of the government’s (state and centre) attempt to solve every problem under the sun. Take the case of ‘The Delhi Shop and Establishments Act of 1954’. The regular bureaucratic red tape aside, it even specifies what parts of the city of Delhi will have its shops shut down on particular dates. Karnataka’s version of this act was passed in 1962 and has been regularly updated to higher levels of bureaucratic nightmare. The Act specifies everything from overtime wages as a percentage of normal wages, number of working hours per week, compulsory periods of rest (an hour of rest after every five hours of work keeps the labour inspector away), quantum of paid leave and also, predictably, the exemptions given to IT companies.

The coffee shop owner’s horror story doesn’t stop with the Shop and Establishments Act. He is supposed to get a Food Safety Licence from FSSAI, a Health/Trade Licence from BBMP (the city corporation), an Eating House Licence from the city police, an NOC from the Fire Department, a signage licence from BBMP, and also register with ESI (Employees’ State Insurance) for the crime of employing more than 10 people. He didn’t bother to do most of the above. He called off his attempt at being a law-abiding entrepreneur after his registration under the Shops and Establishment Act. Whenever the police arrive at his shop, he forks out a little cash and gives them free food. When the other ‘inspectors’ start arriving, he most probably will do the same. There are ‘Licence Consultants’ who can help him get all the above licences and registration for a few lakhs. They are unaffordable to him.

To top it, his shop is in a rented portion of a ‘residential building’. The owner of the building isn’t supposed to rent out any portion to commercial establishments. There are three 16-year-olds employed in the coffee shop. All from Udupi. One lives in a room in the shop owner’s building with four others (illegal again) and he had come to Bengaluru as his father couldn’t work for some reason and the responsibility of supporting the family fell on him.

One can’t help but think what would happen to these fellows if local and state government officials were not corrupt. These 15 employees would have either been without a job or would have been in a lower paying job. If somehow, the owner manages to run the establishment despite the higher costs of complying with the entire gamut of regulations, customers would probably have to pay Rs 100-120 for those wonderful benne dosas instead of Rs 30. If the zoning laws were properly enforced, customers would have to travel to the place by a scooter or auto. If not for the grease of corruption, entrepreneurs would have faced tougher odds to succeed.

The larger point is this: one cannot support corruption, but any reduction in corruption has to be accompanied by a reduction in government over-regulation. Currently, governments- state and centre- suffer from the twin diseases called ‘legislative and regulatory obesity’. Unless and until these twin diseases are cured, by simplifying the laws and reducing red tape, an honest bureaucracy could well be a problem rather than a solution. It is corruption which improves the ease of doing business in the short-term.

“Corruption helps grease the wheels (of development)” was a proposition put forward by N.H. Leff in a 1964 paper titled ‘Economic development through bureaucratic corruption’. Colin Leys questioned as to why people even believed corruption to be a problem in developing nations. This was in stark contrast to the hypothesis that ‘Corruption sands the wheels of growth’, supported by researchers like Paulo Mauro. Over the years, the ‘Corruption sands the wheels of growth’ hypothesis has become conventional wisdom with important institutions like the World Bank and the International Monetary Fund (IMF) supporting the view.

However, there is a remarkable amount of evidence as well as theoretical arguments against the conventional wisdom. Here is what Chris Blattman, Professor at the Harris School of Public Policy in the University of Chicago, wrote in 2012 when the British Prime Minister made plans to tie aid from the United Kingdom, with decreases in corruption:

Most of us fail to imagine that corruption can also grease the wheels of prosperity. Yet in places where bureaucracies and organisations are inefficient (meaning entrepreneurs and big firms struggle to transport or export or comply with regulation), corruption could improve efficiency and growth.

Doug Casey, multimillionaire speculator, author of ‘Crisis Investing’ and founder of Casey Research describes it more eloquently:

The worst of all situations is to have a mass of strict, stultifying, economically suicidal laws…and also have strict, effective enforcement of those laws. If a culture doesn’t allow people to work around stupid laws, that culture’s doom is further sealed with every stupid law passed, which is pretty much all of them.

Pierre-Guillaume Méon and Laurent Weill, in a cross-country study involving 54 developed and developing nations on the impact of corruption on efficiency for the Bank of Finland, found that corruption is efficiency enhancing in nations with ineffective institutions, and detrimental in nations with strong institutions. Although cross-country studies usually suffer from bad data, it is important to point out that this study uses two composite indices and one survey index to measure corruption and finds similar, or near similar, results through all three indices.

The story does not end there. Remember those zoning regulations mentioned earlier? This, in combination with land use regulations, has an enormous impact on the way we live and where we live. If you notice any city in India, citizens routinely flout these regulations (but not on a scale where others quickly take notice and wage bureaucratic campaigns against you). When you flout these regulations by changing the use of your building from residential to commercial, or build a few more floors than allowed, it increases the density of the areas you live in. High density living is good for everyone. It massively increases productivity (and decreases housing prices- but that’s a different story). It is a response to flawed floor-space index laws that create an artificial scarcity of land in sought-after urban centres.

Ryan Avent summarises the literature on the impact of density on productivity in his extremely impressive book, ‘The Gated City’:

Density boosts productivity, economists find, though estimates of the effect differ. Antonio Ciccone and Robert Hall find that doubling county-level employment density raises productivity 6 percent. They note that over half of the variation in output per worker across US states can be explained by density. That’s remarkable. Employment density – not skill level, not the composition of industry, not tax policy – explains most of the difference in productivity across states. Timothy Harris and Yannis Ioannides also find that doubling density raises productivity by 6 percent.

Economist Masayuki Morikawa finds that productivity rises between 10 percent and 20 percent when density doubles. Morris Davis, Jonas Fisher, and Toni Whited estimate that a doubling of density may increase productivity by between 17 percent and 28 percent. Their work suggests that more than 30 percent of real wage growth over the past 35 years is attributable to changes in density alone- a huge source of improvement in real earnings.

All the above studies were conducted in the West, which had already experienced long periods of growth in times where zoning and land use regulations weren’t as strict (pre-World War periods in the U.S., for example). India has had these regulations since we attained political independence and started growing as an economy. It is rational to expect productivity increases to be way higher than what was observed in the West.

Economist Pranab Bardhan, writing in the Journal of Economic Literature in a paper titled ‘Corruption and Development: A Review of Issues’, starts by mentioning how Kautilya in the Arthashastra had commented on how the existence of the bureaucracy and corruption were synonymous. Kautilya had also listed 40 ways of embezzlement. If one goes through the 40 ways, one finds that all of them concern government expenditure.

Not a single one of the 40 ways is about getting licences and corruption during ‘registration’. Kautilya would most probably have laughed at us if he saw the mind- numbing number of regulations entrepreneurs need to follow, to do something as simple as setting up a coffee shop.

Corruption has to go, and steadily so. But it exists because of bureaucracy. If bureaucrats become a large enough vote bank, they will lobby for keeping the regulations complex and plentiful. They would also get large budgetary allocations to do their lucrative policing. Bureaucrats in the U.S. constitute a significant vote bank for the Democratic Party, as they reliably vote Democrat in all kinds of elections- Federal, State and Local. In the long term, we may end up in a similar situation.

We may also end up like Italy, a nation with a highly corrupt bureaucracy as well as high per capita incomes and relatively low-levels of state dependency. Theodore Dalrymple has examined the case of Italy in a beautiful article in City Journal Magazine titled ‘The Uses Of Corruption’. However, the only point worth emphasising is that in the short term, small-ticket corruption acts as grease rather than sand for growth. As long as we have bad laws, corruption will not go away and may even be helpful, to a limited degree.

Coming back to Karnataka, B.S. Yeddyurappa was (during his term as Chief Minister) a reformer of such laws. He was at the forefront of implementing the Jawaharlal Nehru National Urban Renewal Mission (JnNURM) reforms- despite it being a UPA scheme- so as to receive significant funding for upgrading infrastructure in Karnataka’s cities. The present Chief Minister, Siddaramaiah, has largely ignored the Atal Mission for Rejuvenation and Urban Transformation (AMRUT) reforms. Sadly, Yeddyurappa has asked the Bengaluru unit of the BJP to protest against tariff rationalisation in the city’s water supply, one of the very few AMRUT reforms Siddaramaiah has paid attention to. One can only hope he changes tracks if he comes back to power in 2018.

Update: The Modi government, on 29 June 2016, came out with a Model Shops and Establishment Act for states to consider. The model act, if adopted by states, will ease many of the restrictive regulations in the current versions of the act.