Legalize, Tax, and Deter: Optimal Enforcement Policies for Corruptible Officials∗

There is a heated debate on the merits of legalizing certain illegal, harmful and corrupting activities (such as trade in illicit drugs), but little theoretical insights on the consequences for optimal enforcement policies and corruption. We propose a model where the government hires law enforcers to report those who engage in a harmful activity. Offenders are allowed to respond by offering bribes to the law enforcers in exchange for their silence. When standard anti-corruption policies are costly to implement, we show that an alternative tax-and-legalize policy can yield significant benefits, especially in countries with weak institutions and for activities that are not too harmful. However, a tax-and-legalize scheme eliminates the distortions stemming from the threat of corruption by increasing the equilibrium number of harmful activities, which might explain why it is not as widespread a policy as the theory suggests. JEL Classification: D73, K42, O10, H21