Governing through non‐enforcement: Regulatory forbearance as industrial policy in advanced economies

Dewey, Matías; Di Carlo, Donato Article — Published Version Governing through non‐enforcement: Regulatory forbearance as industrial policy in advanced economies Regulation & Governance Provided in Cooperation with: John Wiley & Sons Suggested Citation: Dewey, Matías; Di Carlo, Donato (2021) : Governing through non‐enforcement: Regulatory forbearance as industrial policy in advanced economies, Regulation & Governance, ISSN 1748-5991, John Wiley & Sons Australia, Ltd, Melbourne, Vol. 16, Iss. 3, pp. 930-950, https://doi.org/10.1111/rego.12382 This Version is available at: https://hdl.handle.net/10419/233740 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/4.0/ Governing through non-enforcement: Regulatory forbearance as industrial policy in advanced economies Matías Dewey Institute of Sociology, University of St. Gallen, Switzerland Donato Di Carlo Max Planck Institute for the Study of Societies, Germany & European University Institute, Italy Abstract Political economy scholarship generally assumes that governments are interested in enforcing economic regulations. Cases of non-enforcement are predominantly studied in the context of developing countries and are chiefly associated with states’deficient institutional capacity. This article casts doubts on these assumptions by showing how governments in advanced democracies manipulate the regulatory regime and generate selective non-enforcement of economic regulations to shape markets at their discretion. We argue that regulatory forbearance becomes an attractive form of industrial policy when governments are prevented from intervening discretionally in markets due to legal obstacles, which they cannot overcome; or when the productive structure of the country makes alternative forms of intervention unviable. Drawing on the study of tax non-enforcement in two most-different cases of strong and weak state capacity such as Germany and Italy, the article theorizes three techniques through which governments manipulate regulatory regimes: legal and organizational sabotage and shirking. By shedding light on the economic logic of forbearance, the article points at non-enforcement as an overlooked mode of regulatory governance and suggests the need to inquire further into governments’strategic agency behind regulatory regimes. Keywords: regulatory regimes, non-enforcement, taxation, industrial policy, economic regulation. 1. Introduction The changing nature of states’economic governance is at the core of the political economy scholarship. Early works on states’economic governance focused on the developmental state’sinterventions to foster industrialization (Gerschenkron 1962). Subsequent studies investigated how the activist Keynesian state managed aggregated demand (Marglin & Schor 1992) and shaped the supply side of the economy through industrial policy (Shonfield 1965; Zysman 1984; Katzenstein 1985; Hall 1986; Federico & Foreman-Peck 1999). The deepening of European integration and the rise of neoliberalism in the 1980s have brought about the regulatory state where pro-competition rule-making has replaced discretionary fiscal spending (Majone 1994,1997). Thus, scholars have started to ponder on whether states have “retreated”from the rising global economy (Strange 1996) or whether they retain the capacity for economic governance. A growing body of industrial policy research has shown that governments continue to shape markets through “market-supporting”interventions (Levy 2006) and carry on aiding selected domestic producers or sectors by making strategic use of economic reregulation (Thatcher 2014; Bulfone 2020a). Overall, while the literature has acknowledged the resilience of states’ economic activism, governments’strategic actions to alter the composition and functioning of the economy through regulatory non-enforcement have gone unnoticed. In this article, we shed light on regulatory forbearance as a subtle mode of regulatory governance through which governments shape the supply side of the economy. By combining recent scholarship on law enforcement (Van Rooij et al.2013; Amengual 2016; Milmanda & Garay 2019; Holland 2016,2017; Gordon & Hafer 2013; Correspondence: Donato Di Carlo, Max Planck Institute for the Study of Societies, Germany & European University Institute, Italy. Email: [email protected] Declaration of conflict of interest: The authors declare no conflict of interest. Accepted for publication 18 December 2020. © 2021 The Authors. Regulation & Governance Published by John Wiley & Sons Australia, Ltd This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and reproduction in any medium, provided the original work is properly cited. Regulation & Governance (2022) 16, 930–950 doi:10.1111/rego.12382 17485991, 2022, 3, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/rego.12382 by ZBW Kiel - Hamburg (German National Library of Economics), Wiley Online Library on [01/12/2022]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License Ronconi 2012; Dewey et al.2021; Dewey 2018) with political economy literature on industrial policy and states’ economic activism, we highlight aspects of what can be thought of as a non-enforcing state. We contend that forbearance, put into practice through the strategic manipulation of the regulatory regime, can become a form of industrial policy. Although previous work on non-enforcement has predominantly focused on developing countries and chiefly associated non-enforcement with weak states’institutional capacity or corruption (Migdal 1988; Brinks et al.2019), we argue instead that governments exploit the selective non-enforcement of economic regulations as a strategic means to govern the economy. By tinkering with enforcement mechanisms—that is, applying “political leniency”(Holland 2016: p. 233) or pursuing the “reduction in the stringency”and effectiveness of enforcement mechanisms (Gordon & Hafer 2013: p. 209) —governments confer selected advantages to targeted socio-economic groups who benefit vis-à-vis other law-abiding market actors. Through fewer disbursements to the state, these groups of non-compliers enjoy a combination of higher profits and the capacity to pass on part of such savings onto their final prices, capturing market shares from compliant competitors. Regulatory forbearance, therefore, can be thought of as functionally equivalent to direct subsidies used as old instruments of industrial policy in an age where the EU competition policy and state aid regulations significantly constrain governments’ discretionary interventions in markets (Jabko 2006; Clift & Woll 2012; Bulfone 2020b). Drawing on two most different cases of advanced democracies such as Germany and Italy, we analyze forbearance in the realm of tax enforcement, with implications that have the potential to travel to all those domains where economic regulation imposes substantial costs to producers. In fact, the higher the costs of compliance, the higher the incentive to defect will be for the rule-taking producers. For governments, forbearance becomes an attractive policy choice when they want to aid sizeable producer groups or economic sectors but lack the legal competence to do so lawfully; or when the productive structure of the country is such that regulatory forbearance can be deployed more effectively than alternative lawful industrial policies. We theorize a set of three techniques through which governments pursue forbearance. In fact, while corruption and state capture are often taken for granted in developing countries, monitoring and enforcing regulations in advanced democracies is often the competence of independent state agencies shielded from political interference. Therefore, as we document in the case studies, governments resort to alternative means such as legal sabotage, organizational sabotage, and shirking to generate selective non-enforcement. The contribution to the existing literature is twofold. Firstly, this article expands our current understanding of forbearance (Gordon & Hafer 2013; Holland 2016,2017). To our knowledge, no attention has been paid to the economic or developmental dimension—as opposed to short-term electoral motivations—of regulatory forbearance. Moreover, forbearance has been so far analyzed only in developing countries where state capture seems to be the rule (Holland 2016,2017). We fill these gaps by dissecting the mechanisms through which rule makers generate non-enforcement in order to affect economic outcomes in advanced economies. Secondly, this article contributes to ongoing debates on the political economy of regulatory governance (Guidi et al.2020), highlighting the importance of the enforcement side of regulatory governance and rule makers’strategic agency behind regulatory regimes. The argument draws on different primary and secondary sources of information, including interviews with two high-ranked politicians who held key positions in office in the two countries. However, since the phenomenon in question consists of bypassing the legal setting, this article cannot but run against limitations when trying to collect empirical material on the subject. Given the vested interests of the actors involved, we acknowledge upfront the difficulty of pinning down situations of regulatory forbearance. Nevertheless, we regard this article’s insights as a starting point for future research on the study of regulatory non-enforcement. This article unfolds as follows. The first five sections present a review of the literature and unpack the economic logic of forbearance and governments’incentives to employ it as a form of industrial policy. Section six provides the logic of case selection and section seven a stylized account of the two cases. Finally, conclusions wrap up the findings and discuss implications for future research on regulatory governance. 2. Non-enforcement in the literature This article combines insights from the literature on non-enforcement with the literature on industrial policy and state-centered political economy. Work on non-enforcement has been usually associated with the expansion of © 2021 The Authors. Regulation & Governance Published by John Wiley & Sons Australia, Ltd 931 Governing through non-enforcement M. Dewey, and D. Di Carlo 17485991, 2022, 3, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/rego.12382 by ZBW Kiel - Hamburg (German National Library of Economics), Wiley Online Library on [01/12/2022]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License illegal economies and white-collar crime (Reuter 1984;Andreas1998;Paoliet al.2009; Snyder & Duran-Martinez 2009; Pontell et al.2014; Dewey 2017;Bergman2018). Non-enforcement has also been identified as a mechanism for dealing with crime-related phenomena and the management of complex social constellations (Buxton 2006;Houborg et al.2014;delaFeria2020;Schmoll2020). Commonly focused on street-level bureaucrats, this body of research builds on the assumption—very much present in studies on law enforcement in general—that governments are willing to enforce the law, even if they fail to do so. Accordingly, failing to enforce the law is explained on the basis of deficient states’institutional structures. Here, explanations of non-enforcement generally allude to weak institutional capacity of tax bureaucracies (Sun 2015, p. 71), usually caused by the lack of resources or rampant corruption (Migdal 1988;Brinkset al.2019). We contend that the weak state explanation cannot be generalized. Firstly, cases exist in which states considered “strong”do not enforce the law in certain spheres as well as cases in which supposedly “weak”states are capable of effective law enforcement. Lack of state capacity refers to structural impediments, which are treated by the literature as more or less constant over time. Yet, swings in compliance suggest that the will to enforce the law may be responsive to changes in the government’s political attitude. In fact, the state capacity explanation tends to ignore the self-interested motivations of those political actors controlling the state (Acemoglu 2005). Secondly, and relatedly, explanations for non-enforcement based on state capacity tend to treat the latter as given “exogenously”and “frozen”over time. However, once we allow for the self-interested motivations of the rule makers, we must consider that state weakness may be endogenous to politics (Besley & Persson 2013), that is, to the willingness of rule makers not to enforce the law by proactively undermining state capacity. In other words, as political sovereigns, governments dispose of the legal capacity to both strengthen and reduce state capabilities. Indeed, state capacity is not frozen in time: a plethora of examples exist in which supposedly weak states—ranging from, for example, Bangladesh to Paraguay and Rwanda—successfully upgraded their state capacity to extract tax revenues, thanks to sustained political commitment and administrative reforms (OECD 2015). Taking heed of these criticisms, current studies analyze the lack of enforcement as a result of purposeful political agency. Thus, politicians’strategic law non-enforcement has been used as a response to increasing competitive pressures produced by trade opening (Ronconi 2012) or even as a tool to extract resources from specific economic activities (Ceccagno 2017; Dewey 2018; Dewey 2020). This perspective has gained momentum with Holland’s( 2016,2017) work on forbearance. In her view, politicians capture enforcement agencies and use regulatory non-enforcement to redistribute benefits with the expectation of being rewarded by voters during elections. 1 Although we find these arguments compelling, we extend Holland’s electoral explanation in two ways. First, we highlight the economic logic of forbearance put to use for industrial policy motives rather than purely electoral ones. Second, while Holland studies forbearance in developing countries—where non-enforcement occurs because of state capture—we cast light on the techniques through which forbearance can be pursued in mature democracies where semi-autonomous enforcement agencies are shielded from direct political interference. 3. The economic logic of forbearance Our analysis follows the Organisation for Economic Co-operation and Development (OECD)’s conceptualization of industrial policy as “any type of intervention or government policy that attempts to improve the business environment or to alter the structure of economic activity toward sectors, technologies or tasks that are expected to offer better prospects for economic growth or societal welfare than would occur in the absence of such intervention”(Warwick 2013, p. 16). Two types of industrial policies are generally distinguished (Foreman-Peck 2006). Vertical policies selectively alter the structure of the economy by redistributing resources among sectors, industries, or firms (e.g. through targeted tax incentives or exemptions, subsidized credit, direct subsidies). Vertical policies to “pick winners”are a form of state support for industries or businesses deemed to have great potential. Policies to “help losers”provide aid to industries and businesses in trouble, interfering with the process of creative destruction. Horizontal policies, instead, apply to the economy as a whole and secure the framework conditions necessary to foster business activity or improve the ecology of the economy. The distinction between industrial policy and other types of public policy interventions is not always clearcut. 2 From an industrial policy standpoint what matters is that, through these policies, the state seeks to influence the supply side of the economy (Thatcher 2014, p. 10) by lowering producers’input costs in the process of output © 2021 The Authors. Regulation & Governance Published by John Wiley & Sons Australia, Ltd932 M. Dewey, and D. Di Carlo Governing through non-enforcement 17485991, 2022, 3, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/rego.12382 by ZBW Kiel - Hamburg (German National Library of Economics), Wiley Online Library on [01/12/2022]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License production (Foreman-Peck 2006, p. 39). Regulatory forbearance can be understood as a market-distorting instrument of industrial policy, which applies horizontally—that is, by undermining the erga omnes applicability of the regulatory regime—but whose economic effects are produced in a way similar to vertical industrial policies 3 —i.e. by favoring specific producer groups or sectors and creating winners and losers. Forbearance falls within this category because non-enforcement fosters selective non-compliance with costly regulations which, under normal conditions of full enforcement, would instead be borne equally by the same producers in the economy. Compliance with economic regulations imposes costs by requiring specific expenditures by company owners to make their businesses conform to the provisions mandated by legislation. Besides tax regulations, other examples of costly economic regulations are labor, health, and safety standards as well as environmental regulations (Rothstein & Demeritt 2019; Rothstein et al.2019). 4 The higher the costs imposed by economic regulation, the higher the incentive for producers to defect will be. Defection occurs through partial compliance or, at worst, fraudulent behavior. Non-compliance then yields an unfair competitive advantage vis-à-vis other rule-abiding producers which, through forbearance, political rule makers tolerate or may even incentivize. This article focuses on tax regulations because it represents one of the major costs which economic agents incur during production. Tax policy serves multiple purposes in society (e.g. redistribution and stabilization). But governments have made extensive use of tax policy’s allocative function (Musgrave 1959) as an instrument of industrial policy—for example, to attract capitals in a global economy (Reurink & Bernardo 2020) or to grant fiscal subsidies (Thatcher 2014)—and foster distinctive models of capitalism (Shonfield 1965; Haffert 2019). If, with governments’connivance, tax regulations are enforced only for some producer groups, regions or sectors but not for others, the latter de facto enjoy a tolerated exemption vis-à-vis other actors subjected to effective enforcement. Non-enforcement becomes selective because the possibility to avoid regulation—tax evasion in our case—is not an equally viable option for all economic actors or sectors in the economic system. It is well known for instance that tax evasion is hardly an option for audited larger corporations while smaller firms or the self-employed, often subjected to simplified accounting, enjoy a greater capacity to evade taxes, especially within some identifiable segments of the service sector (e.g. retail, construction, hospitality). 5 Selective tax non-enforcement jeopardizes compliance and reduces the effective tax rates by facilitating tax evasion (Genschel & Schwarz 2011, p. 352). Tax evasion by some distorts market competition and undermines the principle of “horizontal tax equity”according to which taxpayers in similar circumstances should bear similar tax burdens (de la Feria 2020, p. 11). Less tax disbursements to the state lower the relative input costs, which the non-compliant producers face vis-à-vis the compliant ones. Thanks to relative lower production costs, the non-compliant economic actors can make higher profits—which can be reinvested to further increase one’s own competitiveness—or can pass part of the savings onto lower prices capturing market shares from those law-abiding competitors (Santiago 2010). Therefore, forbearance works as a functional equivalent to a fiscal subsidy, which can be targeted at both “helping the losers”and “picking winners.”In the former sense, as we show in the Italian case, forbearance slows the process of creative destruction by granting less productive and less innovative undertakings a greater chance to survive than the one they would have in a regime of effective regulatory enforcement (Bobbio 2016). In the latter sense, as we show in the German case, forbearance can be used as a tool for attracting profitable and innovative businesses within one’s jurisdiction by promising a lax approach to the enforcement of costly regulations (Genschel & Schwarz 2011, p. 352). In both cases, forbearance tampers with the self-regulating mechanism of markets and alters the structure of the economy. 4. Governments’incentives to pursue economic forbearance We expect governments to have incentives to deploy forbearance especially under two circumstances: 1When they want to aid sizeable producer groups or sectors in the economy but lack the legal competence to do so lawfully. 2When the productive structure of the country is such that regulatory forbearance can be deployed more effectively than alternative lawful industrial policies. Institutionalist scholarship in political science argues convincingly that governments’policy choices are significantly shaped by the incentives and constraints posed by the institutional setting (Steinmo et al.1992; Hall 2010). © 2021 The Authors. Regulation & Governance Published by John Wiley & Sons Australia, Ltd 933 Governing through non-enforcement M. Dewey, and D. Di Carlo 17485991, 2022, 3, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/rego.12382 by ZBW Kiel - Hamburg (German National Library of Economics), Wiley Online Library on [01/12/2022]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License An established body of literature also indicates that the state’s institutional and legal characteristics go a long way in explaining public policymaking (Katzenstein 1978; Evans et al.1985; Hall 1986). Behind our first expectation lies the insight that every policy presupposes the government’s legal capacity to enact it within a given policy system (Scharpf 1997). However, when governments are confronted with significant legal obstacles to policy action, regulatory forbearance provides them with a convenient path to circumvent these constraints without the need for legal and institutional change. Leaving the policy system unaltered de jure, forbearance makes it more flexible de facto, enabling policy choices hitherto unviable. For instance, Germany’s subnational governments are responsible for fiscal expenditures but lack the legal capacity to alter tax policy, which is a federal competence. Thus, Länder governments seeking to alter tax policy (e.g. to make it more business-friendly) cannot do so selectively due to the high consensus needed in the upper chamber to alter the German fiscal constitution (Scharpf 1988; Di Carlo 2019). Alternatively, it could be the case that supranational regulatory regimes prohibit given policy choices altogether. Within today’s systems of multilevel governance, policy choices must conform with regulatory regimes in place at different levels of the polity (Scharpf 1997). This is particularly the case for industrial policymaking in Europe. Since the 1970s, the strengthening of EU competition policy and state aid regulations have increasingly curtailed governments’capacity to intervene discretionally in the economy (Jabko 2006; Clift & Woll 2012; Bulfone 2020b). Thus, national or subnational governments have incentives to deploy forbearance because they have only limited or no direct power over higher-level regulations, which they cannot readily change. But the government can also be expected to the select industrial policies most attuned to the productive structure to which these must apply. The literature in political economy has long suggested that policy choices can be driven by an economy’s structural characteristics and the mode of economic coordination among firms and suppliers (Hall & Soskice 2003). Thus, the productive structure of the country should equally provide incentives and constraints, which shape the selection of alternative types of industrial policy. We do not intend to imply that these structural features fully determine governments’choices but only suggest that governments cannot be indifferent to the initial characteristics of the economy when selecting the most effective industrial policies among a set of alternatives. 6 By the country’s productive structure, we mean the constellation of available input factors (e.g. capital, skills, raw materials), the dominant mode of production in the economy, the nature of the prevalent economic activities and the characteristics of the socio-economic groups which underpin them. Assuming a government interested in seeking re-election but also fostering economic and social development, regulatory forbearance will be more effective at aiding selected producer groups or sectors if, compared to alternatives, it can achieve greater economic and social gains at the minor political and economic costs within the shortest possible time horizon. 7 This clearly depends on the characteristics of the productive structure and on the regulatory domain to which forbearance is to be applied. For the case of tax non-enforcement, regulatory forbearance becomes an attractive policy in a productive system where (a) a large number of producers is in a position to benefit from tax non-enforcement; (b) non-enforcement produces tangible economic aid in the short term; 8 (c) given the characteristics of the productive system, alternative industrial policies are either unviable or will only yield uncertain future rewards. 5. Forbearance through the strategic manipulation of regulatory regimes Governments in advanced democracies are neither in charge of regulatory enforcement nor can easily capture enforcement agencies. Therefore, we need a better understanding of the techniques through which governments pursue forbearance. A regulatory regime is an infrastructure utilized by regulators to achieve regulatory goals (May 2007). We introduce an analytical distinction to differentiate, within the regime, between the roles of rule makers,rule enforcers, and rule takers. 9 Rule makers are those political actors which design regulatory regimes and derive their authority to pass legislation from their political—temporary—control of the polity. Rule enforcers are state agencies or ministerial departments to which the legal competence to carry out regulatory enforcement is assigned. Rule takers are all those individual or collective actors who are compelled to abide by the law by virtue of their participation in economic activities. © 2021 The Authors. Regulation & Governance Published by John Wiley & Sons Australia, Ltd934 M. Dewey, and D. Di Carlo Governing through non-enforcement 17485991, 2022, 3, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/rego.12382 by ZBW Kiel - Hamburg (German National Library of Economics), Wiley Online Library on [01/12/2022]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License Rule makers and rule enforcers may have conflicting interests. This is because rule makers are political actors in government who perform a plethora of wider socio-economic objectives while enforcement agencies have a narrow mandate to ensure law enforcement. Governments may conceivably have an interest in undermining the effectiveness of the tax regulatory regime if non-enforcement becomes a strategic means to shape economic outcomes. Non-enforcement produces economic advantage by bending the erga omnes applicability of regulation to provide targeted support to specific sectors, firms, regions, or clusters of producers. Holland (2016,2017) has shown that governments may neutralize enforcement to gain electoral advantages. But governments are not only responsive to electoral groups. They are also responsible for ensuring economic growth and citizens’protection from the vagaries of capitalism (Scharpf 1999;Mair2009). Through industrial policy, governments may legitimately aspire to promote the development of a particular sector, to create or preserve employment, to improve or alter the distribution of income, or even to address regional backwardness (Warwick 2013,p.17). To the contrary, enforcement agencies’legal mandate is precisely that of ensuring the erga omnes applicability of regulations. In many regulatory domains of advanced democracies, enforcement competencies are assigned to state institutions which are separated and semi-independent from parliaments and governments (e.g. environmental protection agencies or labor inspectorates in the respective regulatory domains). Among developed democracies, this is part of a more general trend of increasingly delegating powers to non-majoritarian institutions (Thatcher & Stone Sweet 2002). In the realm of taxation, “national revenue bodies”do enjoy substantial autonomy in the exercise of law enforcement which shields them from political interference (OECD 2009). Therefore, governments cannot just simply capture state agencies, if only because they would run the risk of being publicly named and shamed, with ensuing reputational losses. This article’s key insight is that they must resort to more subtle ways to manipulate the effectiveness of regulatory regimes and weaken enforcement. We distinguish among three complementary techniques which governments can employ conjointly or interchangeably. Manipulation through legal sabotage can take place at two distinguishable points in time. Ex ante, rule makers can purposefully design inconsistent, inappropriate, or unclear legislation, which creates opportunities for rule takers to exploit loopholes in order to escape enforcement. Alternatively, rule makers can purposefully design weak sanctions in order not to credibly discourage defective behavior by rule takers. By favoring non-compliance by rule takers, ex ante legal sabotage is meant to reduce the capacity of rule enforcers to comply with their legal mandate to enforce tax regulation even before enforcement takes place. Contrarily, ex post, rule makers can purposefully abrogate or reverse legislative measures which, after their introduction, have proven to be effective in increasing compliance, thus aiding rule enforcers to effectively enforce the law. This constitutes a legislative reversal to re-establish the status quo ante. Manipulation through organizational sabotage occurs when rule makers purposefully sabotage the capacity of independent enforcement agencies. This is the process through which governments can reduce state capacity from within. State weakness is thus engineered endogenously. There are different ways in which rule makers can engineer and maintain deficient bureaucratic capacity. Enforcement agencies can be kept purposefully understaffed by governments that either obstruct the competitive exams required to access the public administration or constrain their budgets. In more extreme cases, agencies’legal independence can be diminished or revoked to compel enforcement agencies to comply with the government’s political objectives. Manipulation through shirking is a form of state inertia producing effects similar to the logic of institutional change through drift (Streeck & Thelen 2005). But this is a strategic type of state inertia. It arises anytime rule makers purposefully avoid or delay the adoption of legislative measures needed to recalibrate the regulatory regime in the face of clearly understood deficiencies which incentivize or permit non-compliance by rule takers. This is a form of shirking because, by reproducing ineffective institutional regimes, governments evade their political mandate to ensure the rule of law and the representation of the public interest in the polity. 6. Logic of case selection Germany and Italy have been selected according to a “most different systems”design (Gerring 2006, pp. 139–142). Both cases exhibit very different state capacities where, however, notable instances of forbearance of tax regulations are observed. Controlling for the state’s institutional capacity is pertinent in light of the main alternative explanation for non-enforcement found in the literature. In this sense, if state capacity were the crucial © 2021 The Authors. Regulation & Governance Published by John Wiley & Sons Australia, Ltd 935 Governing through non-enforcement M. Dewey, and D. Di Carlo 17485991, 2022, 3, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/rego.12382 by ZBW Kiel - Hamburg (German National Library of Economics), Wiley Online Library on [01/12/2022]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License explanatory variable, we would not observe regulatory forbearance within states with strong enforcement capacity and adherence to the rule of law. Table 1provides a set of indicators that aptly capture these cases’differences and show that the quality of governance, adherence to the rule of law, and state capacity in Germany are much higher than Italy. Italy clearly epitomizes a state with weak bureaucratic capacity, pervasive corruption, and persistent clientelistic ties between politicians and socio-economic groups (Ranci 1987). Instead, Germany represents a polity with medium-high bureaucratic capacity, strict adherence to the rule of law, and low corruption (Thijs et al.2018, p. 55). 7. Forbearance in action 7.1. Germany: Forbearance as “Standortfaktor” In line with expectation 1 mentioned earlier, the German case shows that governments have incentives to tolerate and stimulate tax non-enforcement when they lack the legal capacity to intervene discretionally in the economy and cannot alter the policy system through institutional and legal reforms. The beneficiaries from a selective enforcement of tax regulations in Germany are the businesses located in a given Federal state which pursues regulatory non-enforcement. Most importantly, as shown by the data mentioned later, it is small and medium-sized enterprises (SMEs) who benefit from lax tax enforcement. The losers are the economic actors resident in the Federal states which do enforce the law. In this way, within the same national economic market, some actors in Federal states with weak enforcement enjoy a competitive advantage vis-à-vis those where enforcement is done effectively. This is how non-enforcement becomes a “Standortfaktor” Table 1 Indicators of state capacity and quality of democratic institutions in Germany and Italy Italy Germany Corruption (Corruption Perceptions Index, 2018) High Score: 52/Ranked: 53rd Low Score: 80/Ranked: 11th Adherence to rule of law (Rule of World Justice Project’s Rule of Law Index, 2019) Low Score: 0.65/Ranked: 28th High Score: 0.84/Ranked: 6th Regulatory enforcement (World Justice Project’s regulatory enforcement index, 2019) Low Score: 0.59/Ranked: 33rd High Score: 0.85/Ranked: 7th Quality of national institutions (WEF Global Competitiveness Index: Institutions pillar, 2018) Medium low Score: 56.4/Ranked: 56th Medium high Score: 73.5/Ranked: 16th Adherence to rule of law (SGI†, 2018) Medium low Score: 7.3/Ranked: 21st High Score: 9.0/Ranked: 5th Quality of democracy (SGI, 2018) Medium low Score: 7.3/Ranked: 20th High Score: 8.7/Ranked: 5th Government effectiveness (Scores from World Bank Governance Indicators, 2017) Low Score: 0.50 High Score: 1.72 State structure‡Unitary (regionalized) Federal Administrative tradition‡Rule-of-law legalism (Napoleonic) w/extensive clientelism and party patronage Rule-of-law legalism (Rechtsstaat) Tax administration Centralized Decentralized Economic forbearance Present Present †SGI indicates Sustainable Governance Indicators from Bertelsmann Stiftung/World Economic Forum. ‡Information compiled from PollittandBouckaert( 2017,p.63).Source:authors’elaboration based on data from the reports from the indicated institutions and years. [Correction added on 18 January 2021, after first online publication: The indicators of the rows ‘Administrative tradition’and ‘Tax administration’under columns ‘Italy’and ‘Germany’have been interchanged.] © 2021 The Authors. Regulation & Governance Published by John Wiley & Sons Australia, Ltd936 M. Dewey, and D. Di Carlo Governing through non-enforcement 17485991, 2022, 3, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/rego.12382 by ZBW Kiel - Hamburg (German National Library of Economics), Wiley Online Library on [01/12/2022]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License (a factor for relocation) within Germany. Forbearance becomes a way for local governments to selectively confer a competitive advantage and attract businesses in the competition for business relocation across states. To understand how the manipulation of the tax regulatory regime interacts with the structural constraints of the German state, one needs to appreciate the peculiarities of the German polity. Germany’sfiscal federalism consists of joint tax revenues that are distributed across national and subnational levels. Although tax legislation in Germany is centralized, subnational governments have only little or no capacity to set taxes. However, Federal states are independently responsible for tax collection and enforcement. Additionally, the constitution regulates the transfer of revenues from various taxes within state levels. The latter is known as a fiscal equalization system, an institutional mechanism through which financially strong states transfer revenues to financially weaker states. Although such redistributive mechanism plays a crucial role in financing subnational governments, the combination of centralized tax policy and decentralized enforcement has been historically problematic. The incentives to defect that it provides have in fact been a recurring critique (Troost 2016). According to a recent example, once fiscal equalization has taken place among states, the Länder can retain only a fraction of the taxes collected. In this regard, the German Economic Institute (Hentze 2015) asserts: “If, for example, Schleswig-Holstein collects an additional 100 euros in wage tax, 57,50 euros will go to the state and its municipalities. However, due to additional receipts (generated in the context of the equalization system), Schleswig-Holstein loses transfers worth 48 euros. What remains for the state are just 9 euros.”Thus, states have little incentives to step up their enforcement efforts while the joint decision-making system and the architecture of Germany’s federalism make a change of the rules of the game extremely difficult. The manipulation of the regulatory regime occurs within this entrenched institutional framework. Generally, governments compete in fiscal matters in four different ways (Genschel & Schwarz 2011, p. 351): by reducing the statutory tax rate, narrowing the tax base, improving national secrecy legislation, or relaxing tax enforcement. The first three choices are not an option to governments of the German states. Although in some cases, Germany’s subnational governments have become famous for not collecting taxes altogether—for example, the German rural village Norderfriedrichskoog did not levy business taxes to attract DAX companies (Zeit Online 2008)—extant literature consistently points to the non-enforcement of tax regulations as the preferred mechanism used by the German states to chase national investments and improve local attractiveness (Lenk & Schneider 1998; Cremer & Gahvari 2000; Stöwhase & Traxler 2005; Genschel & Schwarz 2011; Troost 2016). As we make clear below, the attribution of the intention to not enforce the law to political actors, a difficult task when it comes to unearth the causes of non-enforcement, is based on several factors. First, the German state exhibits overall bureaucratic capacity, which could be put to use to enhance the effectiveness of the tax administration. Second, there is clear knowledge about the fiscal losses generated by understaffed tax administrations and also about the financial gains that more auditors and tax investigators would bring (Troost 2016). Third, state oversight agencies as well as unions and other civil society organizations have been calling for greater attention to this phenomenon at least since 1998 (Lenk & Schneider 1998). Fourth, state oversight agencies at the federal and state levels have denounced repeatedly the lack of auditors and tax investigators especially in richer states as well as pointing at regional governments’behavior as driven by tax competition motives (Engels 2006; Blasberg et al.2014; Schäfers 2018). 7.1.1. Manipulation through organizational sabotage The German case presents a rather insulated bureaucracy that does not directly execute politicians’desires. This means that, to understand how governments manipulate the regulatory regime through organizational sabotage, we need to observe how governments tinker with institutions in charge of enforcing tax laws. German tax enforcement institutions are manipulated through the understaffing of specific segments of the subnational tax administration, specifically the staff of auditors and tax investigators. This manipulation has been acknowledged in a 2006 report entitled “Problems with the enforcement of tax laws.”Written by the president of the German Oversight Agency, the report stated that “some federal states give the impression that it is not worthwhile hiring more auditors because of the Federal states’fiscal equalization system”(Engels 2006, p. 78). Although this is a problem largely acknowledged at the federal level, understaffing has several consequences, the most relevant of which is the sabotage on the effectiveness of state enforcement efforts and, consequently, the spread of tax noncompliance. © 2021 The Authors. Regulation & Governance Published by John Wiley & Sons Australia, Ltd 937 Governing through non-enforcement M. Dewey, and D. Di Carlo 17485991, 2022, 3, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/rego.12382 by ZBW Kiel - Hamburg (German National Library of Economics), Wiley Online Library on [01/12/2022]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License 7.2.3. Manipulation through organizational sabotage Italy’s tax administration (Agenzia delle Entrate) has suffered severely from constant staff reductions over the last decade. Despite an anti-evasion rhetoric, the tax agency has, since its creation in the early 2000s, often reported severe shortages in personnel and reductions in funding. 14 Especially after the financial crisis, the number of employees in Italy’s tax administrations has decreased by more than 10% (Fig. 3), leading the trade unions confederations to file multiple formal complaints to the government, asking to invest in human resources to address the tax administrations’severe shortages (Parente 2019). In conjunction with a decreasing number of employees, the number of tax inspections among small undertakings and the self-employed professionals has halved during the last decade (Table 4). That is to say, tax inspections have declined steadily exactly for these groups of producers known to be at the greatest risk of evading. Additionally, after the creation of the new enforcement Agency, in 2002, the available funding has been reduced throughout the mid-2000s, leading the agency’s head to warn publicly against the diminished deterrence Figure 3 Number of employees in Italy’s tax administration (2007–2017) (in thousands). Source: Authors’elaboration based on data from Italy’s Ministry of Economy and Finance, Ragioneria Generale dello Stato. Table 4 Yearly number of tax inspections conducted by the Italian tax enforcement agency according to the size of the business undertakings (2009–2018) Type of taxpayers 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Large undertakings 1.667 2.609 2.763 3.011 2.981 3.112 2.734 2.367 2.264 2.224 Medium-sized undertakings 7.248 15.524 16.08 15.211 14.363 14.211 13.262 11.12 10.776 9.986 Small undertakings and self-employed professionals 244.470 219.878 178.263 173.387 167.392 160.007 140.972 104.162 144.877 140.238 Source: Authors’elaboration from Agenzia delle Entrate’s annual financial reports. © 2021 The Authors. Regulation & Governance Published by John Wiley & Sons Australia, Ltd944 M. Dewey, and D. Di Carlo Governing through non-enforcement 17485991, 2022, 3, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/rego.12382 by ZBW Kiel - Hamburg (German National Library of Economics), Wiley Online Library on [01/12/2022]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License capacity caused by meagre budgets (Agenzia delle Entrate 2005). In 2016, the Renzi-led government cut by 30% the Agency’s fund for anti-evasion interventions and again reduced its overall budget (Fiore 2015). In all, when scrutinizing the Italian tax administration, the OECD concludes that “several reforms and spending cuts have tarnished the agencies’autonomy in the key area of financial autonomy”(OECD 2016, p. 37). 8. Concluding discussion Despite the rise of the regulatory state which constraints governments’political discretion in economic policymaking, debates on states’economic activism have highlighted new forms of market-supporting interventions (Levy 2006) as well as of strategic economic re-regulation (Thatcher 2014;Bulfone2020a). Recent contributions have also made a plea for a more political economy-centered approach to the study of regulatory governance (Guidi et al.2020). However, unlike other research fields in which phenomena such as state inaction, non-enforcement, or state tolerance are gaining momentum (Gordon & Hafer 2013;Houborget al.2014;Huisman2019;Beqiraj et al.2020; Berger 2020; Beyers & Nicholls 2020;Sabrow2020), regulatory non-enforcement has received little attention in the study of public policymaking and political economy more generally. By bringing together the literature on state-centered political economy and industrial policy with sociological and political studies on law non-enforcement, our aim was to shed light on the non-enforcing state, that is, governments’strategic use of forbearance as a mode of regulatory governance. This article argued that forbearance, put into practice through three techniques that generate selective non-enforcement of economic regulations, can be used as a form of industrial policy to shape markets and aid selected groups of suppliers or sectors in the economy. We argue that forbearance becomes an attractive policy choice when governments want to aid sizeable producer groups or economic sectors but lack the legal competence to do so lawfully; or when the productive structure of the country is such that regulatory forbearance can be deployed more effectively than alternative lawful industrial policies. The study of non-enforcement as a form of industrial policy bears wider insights for ongoing debates on the political economy of regulatory governance and law enforcement. Indeed, regulation produces the intended outcomes only when complied with or effectively enforced. The general assumption in the literature is that governments share an interest with regulatory agencies to enforce the law. The regulatory state is thus responsible for ensuring a level playing field in which economic actors must compete. Cases of non-enforcement are then explained by weak state capacity. This article’sfindings challenge both claims and point, instead, to governments’ interest in the strategic non-enforcement of the law when they can confer competitive advantages and target specific socio-economic groups who benefit vis-à-vis other law-abiding market actors. Thus, our case studies indicate that regulatory non-enforcement cannot always be explained fully by weak state institutions. To the contrary, we posit that states’weakness may at times be endogenous to politicians’will to neutralize enforcement. The German and Italian cases suggest that rule makers can tinker with the functioning of regulatory regimes to sabotage enforcement with the aim of shaping markets in an attempt to circumvent the constraints imposed by the rise of the regulatory state. The article has focused on the case of tax regulations due to the substantial costs which taxation imposes on the production process. Yet, the general logic of the argument can be expected to travel to those other regulatory domains which substantially affect the process of economic production by increasing input costs. Among these, laws in the realm of labor, health, and safety standards as well as environmental regulations are other regulatory domains in which forbearance by governments yields substantial competitive advantages to the non-compliant producers. Governments can then resort to legal or organizational sabotage and shirking as techniques to manipulate the functioning of regulatory regimes. Yet, we concur that these are techniques more likely to be adopted within the context of developed democracies where independent regulatory agencies are hard to capture by politicians, contrary to developing countries where state capture of regulatory agencies is widespread. Given the increasing constraints on governments’discretionary capacity to intervene in markets in the age of regulation, this article suggests that non-enforcement is likely to increase in importance as a subtle mode of governance through which governments can circumvent structural impediments in public policymaking. Future studies could investigate in greater details governments’strategic agency behind non-enforcement. Given the difficulty of collecting evidence on illegal behavior, this could be attempted through ethnographic fieldwork or © 2021 The Authors. Regulation & Governance Published by John Wiley & Sons Australia, Ltd 945 Governing through non-enforcement M. Dewey, and D. Di Carlo 17485991, 2022, 3, Downloaded from https://onlinelibrary.wiley.com/doi/10.1111/rego.12382 by ZBW Kiel - Hamburg (German National Library of Economics), Wiley Online Library on [01/12/2022]. See the Terms and Conditions (https://onlinelibrary.wiley.com/terms-and-conditions) on Wiley Online Library for rules of use; OA articles are governed by the applicable Creative Commons License archival analyses of declassified documents uncovering governments’decision-making motives. Such detailed analyses, however, were beyond the purpose of this article. Acknowledgments For their comments and suggestions, we are indebted to Jens Beckert, Fabio Bulfone, Josef Hien, Alisha Holland, Martin Höpner, Arjan Reurink, Lucas Ronconi, Timo Seidl, Wolfgang Streeck, Cornelia Woll and three anonymous reviewers. An early draft of this article was presented in one of the meetings of the economic sociology research group at the Max Planck Institute for the Study of Societies (MPIfG) and at the workshop on the “Political Economy of Law Enforcement”held at the MPIfG in November 2019. We are grateful to all the participants in these meetings for their helpful insights. [Correction added on 13 January 2021, after first online publication: Acknowledgments section has been added.] Endnotes 1 Casaburi and Troiano (2016) document an alternative view whereby politicians make electoral gains when they commit to enforce the law effectively. 2 Governments’support for education and training could be classified as a form of social policy as well as an industrial policy designed to increase an economy’s skills supply while lowering producers’cost for skills-formation (Durazzi 2019). Similarly, a direct subsidy or targeted tax exemptions to groups of suppliers could legitimately be analyzed as redistributive fiscal policy as well as vertical forms of industrial policies. 3 Horizontal policies that produce vertical effects are well known in the industrial policy literature (e.g. the Irish fiscal strategies targeted to favor export-oriented FDI) (Cohen 2006, p. 88; Regan & Brazys 2018). 4 To mention but a recent example of costly health and safety regulations, the e-commerce giant Amazon reports that it will spend $4 billion in foregone profits to keep up with changes in the health and labor standards required to keep its operations ongoing during the recent COVID-19 global pandemic (Financial Times 2020). 5 To the contrary, larger corporations usually have a greater capacity to engage in more sophisticated practices of tax avoidance across international jurisdictions. 6 Our interest here is on the effectiveness of a given industrial policy in granting aid to selected producer groups, regions or sectors. Therefore, our aim differs from the study of economic efficiency as understood by welfare economics. 7 The literature in political science indicates that, under general circumstances, governments tend to prioritize policies which yield the greatest political and economic returns in the short term while avoiding policies with uncertain future rewards (Jacobs 2011). 8 Similarly: where non-enforcement is already widespread and revoking forbearance produces tangible short-term economic and social damage without an alternative, which will generate certain future benefits. 9 On the distinction between rule makers and rule takers in regulatory regimes, see also Streeck and Thelen (2005). 10 Authors’translation from Italian. For analyses on the many acknowledged deficiencies of the post-war tax regulatory regime see Andriani & Violante, 1979. 11 Hien (2018) argued that the roots of Italy’s problem with tax evasion are to be found in the deep-seated conflict between the Church and the State and how the former has proactively tried to undermine the latter’s capacity to tax. We acknowledge this original argument which, however, focuses on the legitimizing role of the Church on Italians’tax non-compliance behavior. Our article focuses on non-enforcement from the perspective of the government. 12 The Fund for the South (Cassa per il Mezzogiorno) was mandated to build public infrastructures (e.g. roads, aqueducts, and water reclamation) until the late 1950s. It was only then that it could intervene for the industrialization of the South. However, the capital-intensive plants that were built could not absorb the large numbers of unskilled laborers across the South (Carey & Carey 1955). 13 The myriads of self-employed professionals and general partnership companies across Italy are taxed via the IRPEF income tax levied on the individuals’profits. However, these “minor taxpayers”were allowed to use simplified bookkeeping procedures, which made the determination of their actual revenues and expenditures hard to establish (Pedone 1984, p. 391). Limited liability companies are instead taxed via the business tax (IRPEG then replaced with IRES in 2004). 14 See the yearly reports of the Italian tax agency Agenzia Delle Entrate, publicly available online. © 2021 The Authors. Regulation & Governance Published by John Wiley & Sons Australia, Ltd946 M. Dewey, and D. 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