Honesty in a Regulatory Context Good Thing or Bad?

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 'reversals' with command-and-control methods being preferred for intermediate values of population honesty, a tax system being preferred at the extremes. This means that if - because of the spread of "ethical shareholding" or for whatever reason - the honesty 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 it is supposed to police (Yaeger [1991]). Though environmental regulation is used as an example for the purposes of exposition, the results are of more general interest.