GROWTH AND DEVELOPMENT Topic 6: Governance, Corruption and Development

Dr. Gonzalo Forgues-Puccio E-mail: gff2@st-andrews.ac.uk (MSc Autumn Term 2011-12)

Lecture Outline

The Importance of Good Governance Controlling Corruption to Improve Governance Definition and Types of Corruption Measuring Corruption The Economics of Corruption

A simple agency model of corruption A monopoly model of corruption How corruption may corrupt

Fighting Corruption Corruption and Development

2

The Importance of Good Governance

The World Bank defines governance as the traditions and institutions by which authority in a country is exercised for the common good. This includes:

the process by which those in authority are selected, monitored and replaced, the capacity of the government to effectively manage its resources and implement sound policies, and the respect of citizens and the state for the institutions that govern economic and social interactions among them.

Source: World Bank, http://go.worldbank.org/MKOGR258V0 (permanent link) 4

To many economists the gap between rich and poor nations can be explained by the economic environment in which their citizens operate. For example, Hall and Jones (1999) find that differences in what they define as social infrastructure (institutions and government policies that determine the environment within which economic agents operate proxy for governance) are essential in explaining differences in income per capita.

Source: Global Monitoring Report 2006

Governance can be measured using six dimensions (World Bank Governance Indicators):

Voice and accountability:

extent to which a countrys citizens are able to participate in selecting their government, as well as freedom of expression, freedom of association, and free media.

Political stability and absence of violence:

perceptions of the likelihood that the government will be destabilized or overthrown by unconstitutional or violent means, including political violence and terrorism.

Government effectiveness:
quality of public services, quality of civil service and degree of its independence from political pressures, quality of policy formulation and implementation, and credibility of the governments commitment to such policies.
7

Regulatory quality:
ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development.

Rule of law:
extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, the police, and the courts, as well as the likelihood of crime and violence.

Control of corruption:
extent to which public power is exercised for private gain, including both petty and grand forms of corruption, as well as capture of the state by elites and private interests.

Controlling Corruption to Improve Governance

Source: World Bank, 2011 Worldwide Governance Indicators

10

11 Source: World Bank, 2011 Worldwide Governance Indicators

According to the World Bank public sector corruption is one of the greatest obstacles to economic and social development. This view is supported by a large number of empirical analyses that find a significant negative relationship between corruption and development. There are many channels through which corruption affect the progress of nations.

12

Some of the most important findings to date demonstrate that corruption:

reduces investment (e.g., Mauro, 1995), causes higher inequality (e.g.,Gupta et al., 2002), disincentives innovation (e.g., Mahagaonkar, 2008) distorts public expenditure decisions (e.g., Tanzi and Davoodi 1997), and reduces foreign investment (e.g., Wei, 2000)

13

Definition and Types of Corruption

14

Large debate between economists, sociologists and political scientists about definition of corruption. Most definitions based on public sector corruption. Not because corruption is absent in the private sector. Rather because the public sector has the ability to distribute benefits and impose costs on members of a society.

15

A very popular definition is due to Bardhan (1997) who defines corruption as the use of public office for private gain. Generally speaking, public sector corruption refers to illegal, or unauthorised, acts on the part of public officials who abuse their positions of authority to make personal gains.

Examples of corruption are:

Bribery Embezzlement Fraud Nepotism

16

Broadly speaking there are two types of corruption:

Bureaucratic or Petty Corruption: Subordinate public officials use authority transferred to them by the government to either extract bribes from the private sector or to embezzle public funds (or even commit fraud). Political or Grand Corruption: The political elite can design or change public policies for their own benefit at the expense of the populace.

Political corruption sometimes is hard to detect given that normally there is no explicit bribe involved. Bribes take the form of very well paid executive positions in the private sector, expensive holidays, properties abroad, etc.

17

Can we measure corruption?

18

Corruption is very difficult to quantify due to the intrinsic secrecy of illegal acts. Only objective and measurable information available: cases of unlucky bureaucrats discovered and convicted for engaging in corrupt deals. There have been some unsuccessful efforts to use this objective measure of corruption in empirical analyses. They have failed because there are some obvious problems with this approach:
19

First, we end up measuring other factors like the quality of policing or the judiciary instead of the level of corruption. Second, and most fundamentally, we only have information about the fraction of corruption that is exposed and not about the aggregate level of corruption. Given these problems, there is an increasing consensus that perceptions are perhaps the best way to measure corruption.
20

Recently many Corruption Indices have been developed due to globalisation and an increase in the demand for anti-corruption policies. These indices are based on surveys about corruption perceptions of entrepreneurs, citizens and experts in industrial and developing countries. The various Corruption Indices differ from each other in three fundamental ways - public availability, methodology and country coverage. In spite of their differences they are highly correlated with each other.
21

The most widely used Corruption Indices are:

The Transparency International Corruption Perception Index The Control of Corruption Index (part of the World Banks Governance Indicators) The Corruption Index of the International Country Risk Guide (ICRG), published by Political Risk Services Inc.

22

The Economics of Corruption

23

Corruption arises naturally in the public sector due to transfer of responsibility and imperfect monitoring. This generates a principal-agent relationship between the government and its bureaucracy, and between the populace and the political elite. An agent responsible for certain tasks (e.g., tax collection or policy design) may profit from his position in the knowledge that he cannot be perfectly monitored by the principal.

24

A simple agency model of corruption

25

 Lets consider the classical example of corruption in tax collection. Firms in some countries can bribe a corrupt tax official to declare a lower profit in order to avoid or reduce taxation. Assume that tax collection is delegated to a tax official (agent) responsible to investigate if a firm has tax liabilities. Firms are only liable to pay taxes if > 0.
26

 Firms tax liability is

where

We assume that, p, is the probability of succeeding in corruption. Hence, the government (the principal) discovers corrupt acts with probability (1-p). Corruption exposure results in the dismissal of the tax collector involved. In addition, he has to pay the penalty

In the same manner the firm that is discovered engaging in tax evasion pays the penalty .
27

 The tax collector earns the wage, w, and can get the wage, in the private sector. Some tax collectors are more honest than others, possible because of internalised moral costs. We assume that a fraction are corruptible and are honest. All parties are risk neutral.

28

 What happens if an honest tax collector finds out that a firm is liable for taxation? Answer: The firm pays taxes in full.

What happens if the tax collector is corruptible? Answer: two possibilities

29

Decision Tree for the Firm

Succeeds with prob. p

bribe Caught with prob (1-p) not to bribe

 The firm has the incentive to offer a bribe provided that the expected profit of engaging in corruption is greater than the expected profit of being honest:

Simplifying:

Intuitively, a firm is willing to engage in corruption if the bribe plus the expected penalty from corruption, is less than the expected savings in taxes.

31

Decision Tree for a Potentially Corrupt Agent

Succeeds with prob. p to be corrupt

w + b - (b)*

w0 Caught with prob (1-p)

not to be corrupt

-f

* The need for secrecy imply high transaction costs. We model this in terms of the cost function:

 A corruptible tax collector has the incentive to engage in corruption if the expected income of engaging in corruption is greater than the expected income of being honest:

Simplifying:

Intuitively, a corruptible bureaucrat is willing to accept a bribe, if the expected benefit from corruption is higher than the expected cost.
33

 The incidence of corruption in this model is a function of government policies in terms of: Public sector wages, w Monitoring, p And legal punishments, f and g.

34

A monopoly model of corruption (Shleifer and Vishny, 1993)

35

The Basic Ingredients of Corruption

Illicit behaviour flourishes when agents have monopoly power over clients, when agents have great discretion, and when accountability of agents to the principal is weak. A stylised equation holds:
CORRUPTION = MONOPOLY + DISCRETION - ACCOUNTABILITY

Source: Klitgaard (1991, p. 75) 36

Assumptions:

There is only one governmental good (e.g. a passport or a license). We assume that this good is homogeneous and that there is a demand curve for this good D(P). This good is sold by a public official who can restrict the quantity of the good (official has monopoly power). No risk of detection. The official price of this good is P.
37

The cost of producing the good is immaterial to the public servant. But, what is the marginal cost to the official of providing this good? Two cases:

Corruption without theft - the official actually turns over the official price of the good, P , to the government. However, asks for a bribe on top of the price. The marginal cost to the bureaucrat in this case is P. Corruption with theft the official does not turn over anything to the government. Sells the good in exchange for a bribe that is below P. Hence, marginal cost in this case is zero.

38

Corruption without theft

P
P + Bribe

D(P)

MR
Qc
Source: Shleifer and Vishny (1993) 39

Q*

Corruption with theft

P D(P)
P Bribe

MR
Q*
Source: Shleifer and Vishny (1993)

Qc

Q
40

Sometimes, an agent needs several complementary governmental goods supplied by various officials with monopoly power on the goods that they provide. In this case, the way in which these agencies organize for the provision of goods is a key determinant of the impact of corruption on the economy.

41

If bureaucrats act as independent monopolists, then each of them will set their own bribes by maximising their individual bribe revenue ignoring the effects on the provision of other governmental goods and the bribe taking capacity of other bureaucrats. In contrast, if bureaucrats act as a joint monopoly, then they will set the value of bribes in such a way as to maximise their aggregate bribe revenue, internalising negative externalities.

42

The assumption that each of these complementary governmental goods is provided only by a single public official is ruling out the possibility of competition among bureaucrats. If instead, each governmental good was provided by several public officials, competition would eventually bring bribes to zero. In this case, decentralised (or competitive) corruption may be less harmful than centralised (or monopolistic) corruption.
43

How Corruption may Corrupt

44

Many authors have pointed out that significantly different levels of corruption can be observed in countries that have public sectors with similar characteristics. In most developed countries in spite of the low probability of being caught and sporadic monitoring the great majority of officials are honest. A plausible explanation attributed to Andvig (1991) is that corruption may corrupt. In other words, the expected benefit of engaging in a corrupt deal depends on the incidence of corruption.
45

How corruption may corrupt

The horizontal axis measures the number of corrupt officials. The vertical axis measures the officials payoffs.

Source: Andvig et al (2000 )

The decreasing curve depicts all the possible combinations of payoffs and incidence of corruption than an honest official can have. It is intentionally drawn to show a negative relationship. In relatively transparent societies corruption is highly condemned and the legal sanctions are severe. Conversely, if corruption is widespread, social sanctions are low and an official that is caught can always pay a bribe to avoid legal sanctions.
47

The inverted-U shape curve depicts all the possible combinations of payoffs and incidence of corruption for a corrupt official. This curve initially increases until the turning point D, where it becomes decreasing. As the incidence of corruption increases the cost of incurring in corrupt practices decreases in term of legal and social sanctions. However, beyond a certain point corrupt officials start to proliferate and then we observe an excess supply of corrupt favours and lower payoffs.
48

If we define equilibrium as a situation in which individual actors have no incentives to change their behaviour, we can identify three equilibria in the previous figure: points A, B and C. At point A, the payoffs for being honest are higher than for being corrupt. Consequently there are no incentives to move from this point. At point C, the payoffs for being honest have turned negative so all the officials choose to be corrupt.

49

Notice that A and C are stable in the sense that the marginal decisions of an additional official will not affect the outcome. But what about point B? At point B, officials are indifferent between being honest or corrupt. However, if just one additional official chooses to be honest or corrupt, the rest of the agents will choose to move from this point. Therefore, B is an unstable equilibrium.

50

The attractiveness of this simple model is its ability to explain that the level of corruption depends on initial conditions. For instance, if an economy is at a point between A and B, where the payoffs for being honest are higher than the payoffs for being corrupt, it will converge to A. On the contrary, if the economy is located at a point between B and C, where honesty does not pay, it will converge to C.

51

Fighting Corruption

52

Like illness, corruption will always be with us. But as this sad fact does not keep us from attempting to reduce disease, neither should it paralyse efforts to reduce corruption. Corruption involves questions of degree
Klitgaard (1991, p. 7)

53

Let us try to think about a function that relates the marginal social cost of corruption with the total amount of corruption.

The very fist unit of corruption may produce modest additional social cost. But as corruption increases each extra unit may bring greater costs to society. Hence, the marginal social cost of corruption may be increasing in the quantity of corruption.

Also, let us think about a function that relates the marginal social cost of removing corruption with the total amount of corruption.

If corrupt activity is low, then it may be very costly to detect. But, if corruption is widespread, then detection becomes increasingly easier (and cheaper). Hence, we can imagine that the marginal social cost of removing corruption is a decreasing function of the quantity of corruption.
54

The Optimal Amount of Corruption

Marginal Social Cost cost of corruption

MSC*

cost of removing corruption

Q*
Source: Klitgaard (1991, p. 26)

quantity of corruption
55

Heterogeneity of Corruption
Marginal Social Cost cost of corruption country A cost of corruption country B

MSCA MSCB cost of removing corruption country A and B

quantity of corruption
56

International Efforts to Fight Corruption

Transparency International

Transparency International was founded in 1993 and it is a global network including more than 90 locally established national offices. TI bring together relevant players from government, civil society, business and the media to promote transparency in elections, public administration, procurement and business.

The World Banks anticorruption strategy

The World Bank in 1997 began its anticorruption efforts in Eastern Europe and Central Asia with the design of diagnostic tools. It has since developed a full program of analytic work, technical assistance, training programs and lending instruments targeted towards reducing corruption. The WB has taken the lead in the fight against corruption globally.
57

International Efforts to Fight Corruption (cont.)

OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions

The OECD convention entered into force on 15 February 1999 and requires that bribery of foreign public officials be punishable by criminal penalties comparable to those applicable to their own public officials.

United Nations Convention against Corruption

UNCACs main objective is to facilitate international cooperation and technical assistance in the prevention and fight against corruption focusing on assets recovery for the affected countries. It came into force in 14 December 2005. So far 140 countries have signed it and 154 countries have ratified it (States Parties).

58

59

Corruption and Development

60

The graph illustrates two points: Richer countries have lower corruption. Corruption varies greatly across countries.

Source: Svensson (2005)

The Solow Model with Government

We assume a Cobb Douglas production function augmented by government expenditure:

In per capita terms:

Expenditure in public goods is financed by a lump-sum tax:

62

The capital accumulation path is given by:

Disposable Income

In per capita terms:

For simplicity we normalise population equal to 1. Hence (4) becomes:

63

In equation (5) we have two new terms:

First, we have government expenditure increasing the productivity of the factors of production. Second, we have taxation reducing disposable income and hence savings and investment.

Depending on the magnitudes of these two effects the introduction of government into the model increases or decreases the steady state level of capital. Generally speaking, the benefits of having a government are greater than the costs in terms of taxation.
64

The Solow Model with Government

65

Corruption in the Solow Model

Now assume a fraction of taxes is embezzled and taken offshore (or lost to tax evasion).

The capital accumulation path in per capita terms is now:

Households are still paying the full amount of their taxes but they only get a fraction of their money in terms of public goods and services. The rest has been lost to corruption.
66

Corruption in the Solow Model

67

The Vicious Circle of Corruption and Development

Capital Accumulation

DEVELOPMENT

CORRUPTION

Wages (legal income)

68

References
Aidt, T.S., 2003. Economic analysis of corruption: a survey, Economic Journal, 113 (491), F632-F652. Jain, A.K., 2001. Corruption: a review, Journal of Economic Surveys, 15, 71-121. Klitgaard, R., 1991. Controlling Corruption, University of California Press, London (paperback). Lambsdorff, J.G., 2006. Causes and consequences of corruption: What do we know from a cross-section of countries? In: Rose-Ackerman, S. (Ed.), International Handbook on the Economics of Corruption, Edward Elgar Publishing Limited, Cheltenham, 3-51. Shleifer, A. and R. Vishny, 1993. Corruption. Quarterly Journal of Economics, 108, 599-617. Svensson, J., 2005. Eight questions about corruption. Journal of Economic Perspectives, 19(3), 19-42.
69