Honesty in a Regulatory Context: Good Thing or Bad?

Abstract

It is often taken for granted that if more firms were innately honest or ethical in the way they behaved, this would be a good thing. In this paper we use the example of environmental regulation to show that such a claim cannot, in general, be sustained. If regulation is by pollution tax we show that - once optimal agency response is taken into account - social welfare is non-monotonic in the proportion of firms that report emissions honestly. The choice of policy instrument may itself be characterised by 'reversais' with command and control methods being preferred at the extremes. This means that if - because of the spread of "ethical shareholding" or for whatever reason - the honestly of the corporate population increases through time, we should not be surprised to see at first a switch away from market-based instruments, and then a switch back. The model is argued to be consistent with a number of the stylised features of American regulatory history. It may also provide a defence of the USEPA's willingness to tolerate a 'distasteful culture of dishonesty' amongst those if is supposed to police (Yaegar (1991)). Though environmental regulation is used as an example for the purposes of exposition, the results are of more general interest.