A Positive Theory of Red Tape

Countries vary greatly in the amount of time and number of procedures it takes to open a business (`red tape'). In this paper we first document a negative relationship between measures of red tape and quality of a country's... [ view full abstract ]

Countries vary greatly in the amount of time and number of procedures it takes to open a business (`red tape'). In this paper we first document a negative relationship between measures of red tape and quality of a country's legal system. We show that this relationship survives even after one controls for other variables that are usually associated with the presence of red tape. We then develop a model in which red tape can be welfare improving in the presence of an imperfect legal system. We show that when the legal system is ineffective in preventing opportunistic behavior from taking place in business relationships, increasing the cost of setting up relationships can be welfare improving. By making business relationships costlier to form, red tape drives out less productive individuals who are only willing to form relationships because they can engage in opportunistic behavior. Thus, red tape can arise as an endogenous response to institutional failure.