CORRUPTION and ECONOMIC GROWTH by Ditya Astrini

This week in Economics Society, Ditya discussed the topic “Is corruption beneficial or detrimental to a developing economy?”. Here is what she had to say.

Despite the fact that corruption is a problem faced in all countries in varying degrees, it is often regarded as a sign of underdevelopment. Recently, the pervasive nature of corruption has attracted more interest due to the media’s increased exposure to cases of high level corruption as well as the rise in awareness of this problem as to its impacts both socially and economically. Instinctively, through the negative scandals and what our ethical principles tell us, corruption would hinder prosperous economic growth. However, we see cases of Asian countries with corruption at the heart of the political system experiencing dynamic growth. There is no absolute relationship found between the two factors, making this topic widely disputed and discussed amongst scholars. The normative economic nature of corruption makes it difficult to establish a principle which can be broadly applied and this problem of establishing a relationship is exacerbated by corruption’s very definition. Corruption’s illegal nature implies that it a concealed activity where all parties withhold their involvement in it, making corruption difficult to measure empirically. Thus, we struggle to provide evidence to reveal the effect corruption has on an economy.

Corruption by its definition is condemned as illegal actions carried out by those misusing power. This can take form where power is concentrated in societies where the government and its decentralised units abuse their entrusted power for private gain. There is evidence of public sector corruption existing in all societies regardless of levels of economic development. This malpractice appears to be an inevitable waste product of the relationship between the state and society where state intervention occurs. This involvement often implies some responsibilities of the government handed over to a public official where the opportunity for corruption to occur arises for the transfer of responsibility entails devolution of power to the bureaucracy. This provides the public official with “administrative discretion” which could be abused in order to gain economic rents through bribes or side payments. Corruption is the result of a fatal combination of monopoly power (M), wide latitude of discretion (D) and the absence of accountability (A). This brings forward the popular formula, explaining corruption:

C = M + D + A

Economists use the word ‘rent’ to describe excess incomes in terms of what the recipient would have accepted given their next- best alternative. Bureaucrats and authoritative figures worldwide position themselves in a monopoly where they can benefit from firms willing to spend money to convince legislators to restrict their competition, allowing shipment across borders, approve expenditures or issue licenses in order for the private firms to receive a rent. Therefore, in this case rent- seeking activities can be categorised as illegal and considered a corrupt practice.

In contrast, Adam Smith argued that the selfish motives of men work together to yield the most unexpected of results: social harmony. Applying his theory, it can be argued that leaving men to pursue actions driven by self- interest may promote economic efficiency. In this case, corruption is driven by the incentive for both parties (the public official and the economic agent offering the bribe) greater gains and benefits. This hypothesis challenges our initial assumptions on corruption’s negative impact on economic growth.
Beneficial effects on a developing economy
Political corruption is suggested to be able to have a positive impact upon an economy’s growth. The main explanation behind this theory is that corruption acts as “speed money” which ‘greases the wheels’ of the economy especially in countries with poor institutions as it allows individuals to avoid bureaucratic delay and to overcome burdening red tape. In other words, corruption acts as the “grease” which lubricates the “squeaky wheels” of a bureaucratic and rigid administration.

As Huntington suggested, “in terms of economic growth, the only thing worse than a society with a rigid, over-centralized dishonest bureaucracy is one with a rigid, over centralized honest bureaucracy.” The availability of licenses and favours to bureaucrats are scarce and the allocation of these is dependent on who can pay the highest. Thus, this competitive bidding between entrepreneurs determines the best ability to gain revenue from current operations or reserves. In either case, these two sources of revenue rely on efficiency of production. Thus, this creates an incentive for rent seekers to act efficiently in order to muster the revenue required in order to successfully collect rent through bribery. And so, those willing and able to pay the highest bribes are likely to be those able to use it most productively.

It can also be argued that corruption may raise economic growth by incentivising government employees who charge rent- seekers bribes to work harder especially if the bribe comes in the form of a rate of payment. In this way, it can be argued that corruption introduces competition into an otherwise uncompetitive economy which can be beneficial to development. This is especially the case for countries with high levels of red tape which creates inefficiency, inaptness and mismanagement in bureaucracies in developing countries where the pressure for efficiency associated with corruption is seen as beneficial.

Moreover, economic growth may feed corruption through its provision of demand for bureaucratic services which contributes to more economic growth (thus, a producing a cycle of increased corruption and economic growth).

Thus, as a tool of speeding up the decision making process as well as carrying out these decisions, corruption could support Adam Smith’s theory of a “free market”. This is through allowing the “invisible hand” to lead economic agents, along with their “private interests and passions” towards a position which is “most agreeable to the interests of the whole society”.

Conversely, corruption must be separated as a characteristic of a free market. Although similarities can be drawn between a “shadow” market for corruption and its official counterpart of a legitimate market exchange, this analogy can be criticised in three ways:
Firstly, our initial instincts regarding the resemblances between the two concepts are more superficial than they are substantial. By examining the features of the free market, the fallacy of such analogy becomes apparent. The “shadow” market for arrangements lacks the presence of the unrestricted competition innate within an official transaction. In a free market, decisions are based upon full information- though it must be acknowledged that perfect information is often not attained leading to market failure. Nevertheless, this imperfect information is still relatively complete when compared with that provided in the market of corruption which is based on secrecy. It must be recognized that corruption is not an example of market failure. In a market for corruption, information is divided within only the parties involved within the corrupt arrangement and as established, all parties benefit from concealing their activities.

Secondly, there is a distinct difference between the degrees of uncertainty involved in the two different markets. In both markets, a degree of risk is always involved. However, in a free market there is less uncertainty to the consequence of the decisions made due to the information provided. In contrast, due to corruption’s illegal nature the level of risk and uncertainty involved are considerably higher. This includes the risk of detection and punishment as well as the uncertainty of whether the intended result is achieved due to the number of uncontrollable factors in hand.

Although previously the term “bidding” has been used to describe the way in which corrupt firms compete through bribes, the “shadow” market for corruption does not follow the same rivalrous behaviour present in an official market transaction. The shadow market for corruption indeed lacks a similar “bidding” process since if all competitors adopt a corrupt approach to a problem, then no one will benefit more than they would in a corrupt free market.

This can be demonstrated through a hypothetical analysis in illustrating corruption. In this model, there are R firms/individuals competing against each other in order to gain a project or action which is worth C through a public official. Some, or one, of these firms may choose to conduct in corrupt practices. Each briber can offer differing bribes which can be in different forms other than monetary. However, for the sake of the model, we assume that the distinctive gains each individual kickback holds over the rest cancel each other out. Therefore, with all firms/individuals being honest and not participating in any corrupt practices, the probability of one firm in attaining the project is:

p= 1/R

If firm X decides to offer a bribe to a corruptible bribe, this aims to increase the probability of firm X’s success depends on the ability of the bribee to affect the outcome. We let capacity of the bribee to do so be represented by the parameter b. In this case, let 0<b<1 where b=0 reflects the official’s incompetence in increasing p and where the bribe is completely ineffective. Therefore, the probability of firm X achieving the project can now be represented by p_1=p+b(1-p). Therefore, if we consider the inverse where b=1, firm X is guaranteed the project since p_1=1. This works on the “ceteris paribus” assumption that firm X is the only corrupt firm and all other R-1 firms remain honest.

However, if we consider that more than one firm seeks to bribe the official, all firms’ probability of success is not reflected by p_1. This is because the sum of all probabilities can exceed 1 which is impossible. To overcome this, we assume that the parameter b must be divided amongst the bribers. Therefore, b can be described as the “maximum premium” that the briber can offer.

The difference between p and p_1 depends on the proportion of other arrangement- seeking firms involved in bribery. If all R firms decide to bribe the official, the probability of any non-corrupt firm (in this case, none exist) is 0. Thus, the probability of any one of the corrupt firms getting the project is the same for all corrupt firms (in essencep=p_1) since the attempts to achieve the contract essentially cancels each other out. This shows how the “shadow” market for corruption lacks a bidding process where all competing agents can each offer a “bid” (a bribe in this case) to be supplied a certain product (a project in this case).
Detrimental effects on a developing economy
Corruption leads to inefficiencies and inequality in the distribution of benefits and costs. Since corruption is often associated with a small group of people manipulating the political system in order to obtain personal rewards, it is usually thought to hinder an economy.
Arrangements deplete nations’ funds and cause an increase of costs of goods and services. The funnelling of scarce public resources for personal use of the corrupt agent leads to an opportunity cost at the expense of the wider public. This distorts the composition of public investment in favour of specific sectors which are subject to corruption (and where rent is generated more easily and better concealed). More specifically, political corruption favours investment in construction and physical capital at the expense of health and education which enhances economic inequality as well as having a negative effect on future incomes. And since education and quality of health are determinants of the quality of human capital, which in itself is vital for economic growth, the bias associated against this type of investment is a hindrance to growth. Grand corruption is strongly tied to capital projects, increasing the number of these undertaken. The overall results include (a) an increase in the share of public investment in GDP; (b) a fall in the average productivity of that investment; and, because of budgetary constraints and other considerations, (c) a possible reduction in some other categories of public spending, such as “operation and maintenance,” education, and health.

This is illustrated by information released by Transparency International (TI) reports that, within the space of two or three years, in the city of Milan, the city where a massive corruption scandal broke out in the first place, the cost of city rail links fell by 52%, the cost of one kilometer of subway fell by 57%, and the budget for the new airport terminal was reduced by 59% to reflect the lower construction costs. This corruption scandal, often referred to as “tangentopoli” (bribe city) took down a political system which governed Italy for decades. Following this revelation, the country experienced on of the largest capital spending in GDP among the OECD countries. Keynes argued that the solution to economic depression is the induce investment made by firms through combining a decrease in interest rates with government capital investment. By expanding the productive capacity of the economy, capital spending promotes economic growth and is essential for countries to develop.

The main way in which corruption hampers growth is through its deterring effect on private investment. Foreign and domestic levels of investment rely on the business environment of a country. The quality of this is influenced by the regulations and legislation of that particular nation. Corruption increases the uncertainty of doing business since it goes against the rule of law and is associated with high levels of bureaucratic inertia. Red tape delays business transactions but also bears uncertainty since often, the price of the advancing their interest and – depending on the culture of bribing in that specific country – bribing is not necessarily a guarantee for delivery. Some describe corruption as a tax which adds to the cost of doing business. Corruption crowds out productive foreign and domestic investment: an increase in rental costs and the creation of decision uncertainty. It can reduce the incentive for both investors, both foreign and domestic investors.

Moreover, political corruption involved in the development stages of public projects means that capital spending becomes much less productive and much less of a contributor to growth than expected. This is through the amount that bribes build up on the total cost for the project; rent- seekers would involve themselves in areas of the decision making process regarding the public project which they can benefit from controlling. Therefore, political corruption increases the cost for public projects compared to the cost without corruption and thus, making the government’s spending capital much less productive.

Therefore, the effects of corruption extend into different aspects of the economy and in theory; political corruption should lead to a negative effect on growth due to the distortion of the proportions of how public funds are allocated. However, despite having its place in all societies, we see a variation in how corruption affects countries with different degrees. The impacts of corruption are mediated through political economy factors of each specific country, the level of its developments and the ways in which corruption is transmitted in individual countries.

Empirical Analysis and the Different Types of Corruption
The relationship between corruption and GDP per head can be tested through plotting the GDP values against the CPI. The Corruption Perceptions Index (CPI), a composite index based on independent surveys of business people and assessments of corruption in different countries provided by different countries provided by more than ten independent institutions around the world. Using the CPI as a proxy for growth and an indication of perceived corruption, we can determine the relationship between corruption and the average income. The data-set was 134 countries, with GDP per head for 2002, using constant US dollars.

FIGURE 1

ditya 1

This graph suggests the higher the levels of corruption within a country, the lower its GDP per head is likely to be. However, there are limitations to this analysis. The average income per capita is not fully representative of economic growth. The value of this factor can be skewed by outliers. Moreover, it does not take into account growth from the year before to illustrate development of the country. A more reliable proxy in this case would be the per capita income growth. This is shown on the figure below.

FIGURE 2

ditya 2

Figure 2 supports the first graph where the advanced industrialised economies usually have lower rates of corruption. This can suggest that the level of corruption can determine whether a country is developed or otherwise since the higher the corruption index, the lesser the corruption. We can also observe the median of the converging economies with high growth does not have a corruption level that is significantly lower than the median of the other developing countries falling behind. It was concluded that this comes down to the fact that corruption has different impacts in varying contexts because of four different types of corruption:

TABLE 1

ditya 3

Neoclassical corruption
This is the form of corruption adopted in forming models of corruption based on neoclassical economics. The assumption inferred is that corruption is driven from the abilities and legal powers of the state and its officials to exercise discretion to intervene and disrupt otherwise an efficient free market. This takes the form in creating kickbacks or rents for citizens or firms, which also act as obstacles for those who do not engage in corruption, by acting within the law to erode red tape and delays. The acceptances of such bribes are indeed illegal but it is the act of being able to create rents and restrictions is itself within their powers. This form of corruption is driven by interventionist state policies, giving public officials the capacity to create damaging rents and restrictions in the market. The other contributing driving factor is the incentive for the public officials to engage in these illegal practices. This is due to the low opportunity cost of corruption where the expected benefits of the act outweighing the expected cost of punishment. The effect of neoclassical corruption is overall substantially negative with the disruption of the free market mechanism leading to an inefficient allocation of resources which are lost in bribes and cannot be invested effectively.

Statist Corruption
This form of corruption is associated with state interventions which are legal and can potentially be beneficial. Such interventions include managing taxes and tariffs to speed up the progress of technological development, acceleration of domestic industry, regulation of financial markets and the allocation of credit or the prioritisation of infrastructure construction. These forms of intervention can reap benefits where corruption involving such interventions can contribute to the rapid transition for developing countries to catch up with advanced countries. However, corruption reduces the benefit to society. The different between statist and neoclassical corruption could be difficult due to both most likely having negative effects on a practical level.

Variants of Political Corruption and Primitive Accumulation
This form of corruption is driven by the lack of fiscal resources and the pressure from political factions seeking redistributive rents to increase off- budget resources. This could potentially be beneficial due to the political stabilisation and allocate resources to economic agents who are more efficient, leading to political stability with continuation of capitalist accumulation. On the other hand, accumulation could collapse causing political instability.

Variants of Political Corruption and Predation/Theft
Driven by an economy with a low productivity, unable to pay for enforcement of the law, public officials and firms exploit opportunities to engage in non- market asset transfers. This can include illegal or corrupt transfers such as land grabs. The effects of this are guaranteed to be negative with resources possibly being captured by unproductive agents causing the economy to fail or could be captured by emerging capitalists.

All developing countries have relatively high levels of corruption in aggregate. However, the net effects of corruption vary from country to country due to the composition of corruption.
Nigeria and the Paradox of Plenty
Assuming that corruption in fact does remove bureaucratic red tape and delays, it could be inferred that countries with sectors which are more susceptible to regulations creates a bigger incentive to remove delays through corruption. For instance, this could take the form of nations with significant natural resources such as oil. Iraq’s economy is made up largely of oil revenues, constituting to as much as 74% of GDP. This is mainly controlled by the government and so, the state effectively runs the economy where power is concentrated. Thus, the government is also targeted for opportunities to engage in corruption with rent seeking officials.

On the contrary, the paradox of the oil curse refutes this theory. Africa’s abundance of diamonds, gold and oil points towards to a nation of wealth and development. However, as we know, this is not the case as demonstrated by the average Nigerian income. This is referred to as the “curse of oil”. Poor countries, rich in natural resources are faced with problems of wasted wealth among many other factors. In fact, it was found that resource- rich countries grow more slowly than other countries. This is often referred to as the “Dutch Disease” caused by the boom in the natural resources sector. This refers to the situation in the Netherlands where large natural gas discoveries followed by a recession. This has been blamed on the surge in the natural resource sector by drawing capital and labour away from the manufacturing sector which increases manufacturing costs whilst simultaneously reducing the amount of manufactured goods produced to hinder export led growth in the long run. It has been concluded that this Dutch disease can be avoided through the diversification domestic production and service industries. However, this itself is a difficult task to achieve and requires careful management of the revenues gained through natural resources both economically and politically.

Nigeria is a large country with a population of over 160 million people. As a country divided by ethnicity, tribes and religion, Nigerian government struggles to maintain a stable majority coalition. The instability creates uncertainty for those in high positions over their hold of power whether if elected through democratic elections or imposed by military force. Nigeria has adopted a society, along with most post- colonial countries, a system of state which lacks sufficient legitimacy to ensure the cooperation of the citizens and the civil service. This implies a culture accepting of corruption at all levels including that of the top of government where corrupt agents in both public and private sectors interact to undermine democracy and public bodies. Therefore, Nigeria has the conditions where a stable democracy has been sought out but has lacked success. The uncertainty of tenure of those in high positions creates an incentive for them to seek rents at a faster rate, feeding into such behaviour in the first place. This creates a cycle through which corrupt actors feed into a more corrupt nation.

Several scandals in Nigeria contribute to the hindrance of economic growth. A major source of corruption is the oil industry; petroleum deposits in Nigeria count towards 90% of Nigeria’s exports and a majority of the revenue of the Nigerian government. Since the oil reserves are controlled by the state, it can create huge windfall gains to those who control them and their political allies. This discourages participation in productive entrepreneurship where people are encouraged to struggle for a share of the rents and engage in corruption.

This is demonstrated in the petroleum crisis where Nigeria profited greatly. However, from the data we see that only few in Nigeria profited greatly from this; after ten years after the oil boom, the Nigerian income per capita of $390 compared to ten years ago pre- oil boom in 1974 where the average Nigerian income came in close to that at $330. Moreover, during the 1980s the country’s economy declined at a rate of 0.4% per year and in 1990 Nigeria was the 17th poorest country in the world with a per capita income lower than that of Kenya or India. This illustrates how the wealth of the nation is not distributed equally and instead, concentrated in the hands of those controlling the oil reserves.
The Exception of Asia
The theory that corruption “oils the mechanism” can be used to explain the high rates of growth in some countries of South East Asia which was characterised by much corruption. Until the currency crisis in 1997, countries in South East Asia such as Thailand and Indonesia were provided of examples to support the view that corruption can be beneficial for growth.
Between 1986 and 1997, the average economic growth rate per year in Indonesia, Thailand, Malaysia, South Korea, Hong Kong, the Philippines and South Korea came at nearly 7% compared that of the rest of the world’s average annual economic growth rate of about 2.5%. The coexistence of this superior economic growth and the high levels of corruption associated in these countries pre- 1997 seem to provide evidence against studies suggesting an inverse correlation between corruption and economic growth.

A theory offered to explain this theorises that institutionalised corruption meant that it created a less harmful effect than that of random corruption that rent seekers knew who to go to and how much to pay in the form of bribes. The CPI results of 1996 show that Indonesia’s mean score of 2.7 is very close to that of India. This suggests that in the perception of foreign businessmen the two countries are about as equally corrupt. However, if we consider the economic performance between the two countries we see a variance; Indonesia’s GDP per capita (nominal) of $1, 154 far exceeds that of India’s $396. The difference seen can be argued to be as a result of the way corruption operates in the two different countries. In Indonesia, corruption is largely controlled by the first family. This is combined with the close relationships between the top military leadership and the ethnic divisions, creating a more predictable environment for corruption to promote economic growth. This contrasts with the anarchy- like and fragmented system of bribery in India demonstrates how the way in which corruption is carried out within the country can have varying effects of corruption’s impacts.

Despite there being found a negative relationship between corruption and growth in a cross- country comparison, Ali, Cullen and Gasbarro claimed that a study found that the correlation for Asian countries was positive. However, upon examination the study concluded that on net, corruption has a far less detrimental effect on growth in Asia then elsewhere despite still having a negative effect on growth. It found that an increase in 1 standard- deviation of corruption had a direct effect of reducing economic growth rates by 1.18% compared that that of Asia which was only reduced by 0.14%. This study then suggested that “during 1980-94 Asia did not pay the price paid elsewhere for corruption; in other words, corruption may indeed have acted as grease money in Asia during this period”. However, corruption eventually took its toll on Asia where it could have contributed to the 1997 financial crisis through the aggregated effects of investment in the wrong type of capital.

The explanation for East Asia being an anomaly is referred to as crony capitalism. This refers to an economy whose success relies on close relationships between business people and the state. Instead of success being attributed to a free market and the rule of law, crony capitalism implies a dependence on favouritism shown to some businessmen by the government of the day. This can be in form of dirigisme (an economy where the government exerts strong directive influence in capitalist economies) such as government grants, tax breaks amongst other incentives.
Although cronyism and its link with corruption are seen as inhibitors of economic growth, there may be certain conditions where corruption can be beneficial. Developing countries usually have weak institutional structures, and so “if there is a balance of power among a small and stable set of government and business elites, money politics can actually reduce transaction costs and make long- term agreements and investments more efficient”. Thus, a balance between elites allows less abuse and less discretion where corruption can be more predictable and controlled in successful economies with crony capitalism. In this case, it can be argued that corruption may provide an environment in which it promotes economic growth.

Despite this, there continues to be a lack of empirical evidence supporting the idea of benign corruption to growth where high levels of corruption is linked with rapid economic growth and stronger evidence indicates the alternative hypothesis. Moreover, delays are no more the cause of corruption than they are the consequence of it. Arrangements aim to overcome bureaucratic delays and contracting an agreement presumably brings inertia to an end. However, if more than one individual or firm engages in corruption, these presumably efficient agreements become redundant for if everyone resorts to bribery, no one but the public official benefits more than they would without the bribes. The underlying problems which prompted corruption all still remain; impatience with red tape, greed for monopoly profits and the queues exist once more.
Conclusion
On a theoretical level, the reasons given as to how corruption can in fact benefit economic growth can be largely undermined. Bureaucratic actions may not only be the cause of corruption but can also ironically, be a result of arrangements through the possible changes in the order in the queue where it may cause public servants to be less efficient in executing the arrangement. However, this theory works on a more practical level as it is the explanation offered to the anomaly of Indonesia along with other South Asian countries. It should be stressed however, that these countries act as exceptions to the broader and more general rule that corruption is often linked to underdevelopment. This is as a result of the competition for resources and resource allocation where corruption leads to a reduction of public resources. Therefore, it effectively deprives people of basic goods and services which should have otherwise been provided, especially to the lower income groups of society.

The question title proposed assumes that corruption is a factor which influences economic growth either positively or negatively. However, correlation does not imply causation. In general, empirical analysis shows that there is a negative relationship between corruption and growth. However, that is not to say that corruption indeed causes underdevelopment. We can consider an alternative causation theory; that rapid economic growth causes more opportunities for corruption, hindering growth. This could be due to the fact that corruption itself is a characteristic of underdevelopment and is an indicator of other obstacles for developing countries to grow successfully.

Upon analysis of the four different types of corruption, an underpinning factor which determines the composition of aggregate corruption lies in the political situation and system of a country. Thus, corruption may in fact be an indicator of the state of the country’s political stability and in turn and indicator of the country’s potential growth abilities and prospects. Long- term, sustainable and stable economic growth can be achieved through proper business transactions, a stable financial sector and political stability. A stable government is vital to achieve sustained economic growth for developing countries by allowing business to freely interact with each other, allowing the efficient allocation of resources. The act of corruption represents damaging intervention and should therefore be discouraged in order to promote economic growth. In this way, corruption can show a cost of providing the state to intervene and supports the idea of minimal interference of the free market mechanism.

Different forms of anti- corruption policies and actions are touched upon in the table of the different forms of corruption (Table 2). However, the cures for corruption itself are another widely discussed and debated issue; with the recent attention put upon corruption, many countries tackle the problem differently. Nevertheless, broadly speaking it is important for developing countries to attempt to solve corruption and to remove their potentially harmful effects in order to achieve economic growth. By following the assumption that corruption itself is not a cause of underdevelopment but an indicator of it, anti- corruption policies should not only tackle the superficial symptoms of corruption but acknowledge the political system behind it. This could take form of tackling the culture of corruption ingrained in many developing nations as exemplified with the example of Nigeria before being able to cure corruption effectively.

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