Corruption

How so? Corruption sabotages economies and undermines political institutions. Its most devastating impact is on investment. By discouraging investment, corruption crushes economic growth and slashes per capita incomes. According to Mauro (1995), for example, if Bangladesh had cut corruption over the period 1960–1985 to the level of one of the world’s cleanest countries (Singapore), it would have increased its growth rate by 1.8 percentage points per year. By 1985, its per capita income would have been more than 50 percent higher. Low-per-capita-income countries suffer higher infant mortality—54 deaths per 1,000 live births in Bangladesh versus 3 per 1,000 in Singapore—and lower average life expectancies—fifty-nine years versus eighty years (U.S. Census Bureau 2000.) Another insidious way in which corruption kills is that it skews public spending away from operating budgets such as health care and toward capital budgets—military spending, for example, where bribes are easier to extract (Klitgaard 1988; Mauro 1996; Tanzi and Davoodi 1997).

Corruption hurts investment in at least three ways. First, it increases the cost of doing business, which then raises the threshold revenues required for businesses to break even. Second, it causes producers, on the margin, to bribe officials rather than invest in cost-saving technology or new products. Third, if public funds end up in the pockets of government officials, taxes will be higher and public investment lower, hurting economic growth.

There is an important distinction between business-to-business corruption and government corruption (Melese 2002). The former is almost always either beneficial or self-correcting, while the latter is neither.

In its mildest and most benign form, business-to-business bribery facilitates communication and helps cement relationships between principals (customers) and agents (suppliers). “Facilitation payments” (anything from generous commissions to free meals and entertainment) can replace costly contingent contracts with implicit contracts that ensure quality, quantity, and meeting of schedule requirements. In such a case, business-to-business bribery has an offsetting benefit: it reduces transaction costs and greases the wheels of commerce.

Bad cases of business-to-business bribery typically involve private gains with no offsetting benefits. This more sinister form is like a worm that eats into corporate profits. For instance, by concealing debt and overstating revenues, corporate managers might boost a firm’s stock price, increasing the value of their stock options. In the case of fraudulent financing and accounting, shareholders are the victims. Such corruption, if revealed early, is self-limiting because shareholders want to avoid its costs. If revealed too late, the outcome is bankruptcy. Honest and transparent market institutions are all that are required, although to say this is not to say that achieving honesty and transparency is always easy.

Government corruption, in contrast, does not involve a self-correcting market mechanism. It occurs because government officials, whether politicians or bureaucrats, have the power and discretion to grant favors in the form of subsidies, contracts, tax breaks, regulations, and permits.

Whereas government corruption is most acute in the poorest and least free countries, it is by no means limited to those countries. Take the case of a young congressman named Lyndon B. Johnson, who had built his family fortune from approximately zero in 1943 to at least fourteen million dollars by the time he was first elected U.S. president in 1964. About half his family’s wealth derived from a single permit his wife held that allowed her to operate KTBC, a radio station in Austin, Texas. Johnson’s wife bought the license for a very low price and then applied for permission to operate the radio station twenty-four hours a day and on a much better part of the AM band. The Federal Communications Commission granted her permission within one month. In return, Johnson helped save the FCC from budget cuts (Caro 1990, pp. 82–111). Here is a case of corruption that was probably completely legal. The key to corruption is the combination of power and discretion in the hands of government officials.

Most government corruption is “negative sum”: losers lose more than winners gain. This explains the economics literature’s almost exclusive focus on government corruption. Yale Law School economist Susan Rose-Ackerman, for example, author of one of the few book-length studies of the economics of corruption, devoted ten of eleven chapters to government corruption.

Government corruption allows long-established, politically connected firms to monopolize markets. Typically it is the long-established firms that figure out which government official has the power, or can obtain the power, to keep new firms from competing; then they bribe him, either with outright payments or with promises of future employment and shares. These bribes eat up some of the monopoly profits. Competition shifts from the marketplace to the political arena. Instead of investing in better products or processes, firms invest in government-sanctioned barriers (exclusive licenses, contracts, permits, etc.) or political favors (regulations, tariffs, quotas, etc.) to gain and preserve market power. Krueger (1974) and Tullock (1980) referred to this as “rent seeking,” and Bhagwati (1982) introduced the term “directly unproductive profit seeking (DUP)” for it. Perhaps a better term is “privilege seeking.” Nobel laureate George Stigler also pointed out that government regulation creates opportunities for corruption, which, he wrote, “turns regulations into gold” (cited in “Corporate Bribery,” Cato Policy Report, February 1980). The LBJ example mentioned earlier illustrates the point.

Consider the poorest region on earth, sub-Saharan Africa. In many African countries, political coalitions and special interest groups enrich themselves and preserve their political power at the expense of their populations. Throughout the region, governments control many of the most valuable resources. African governments are often the primary investors, importers, and bankers in their countries and employ a large fraction of the educated labor force. This leaves few options for new businesses. Meanwhile, to preserve their grip on government, dominant political coalitions forcibly transfer income and wealth to their supporters. The results are grim. According to Transparency International’s (2004) “Corruption Perceptions Index,” of the sixty countries in the world that scored less than 3 (10 is highly clean and 0 highly corrupt), more than a third were from sub-Saharan Africa. Not surprisingly, therefore, the International Monetary Fund (IMF 2000) reported that the ratio of investment to GDP in sub-Saharan Africa hovered around 17 percent throughout the 1990s, well below the rate experienced by developing countries in Latin America (20–22 percent) and Asia (27–29 percent) (Hernández-Catá 2000, p. 6).

Some economists argue that paying bribes to the right officials can mitigate the harmful effects of excessive government regulation. If firms had a choice to wade through red tape or pay to circumvent it, paying bribes might actually improve efficiency and spur investment. Although this view is plausible, a pioneering study by Mauro found that corruption “is strongly negatively associated with the investment rate, regardless of the amount of red tape” (Mauro 1995, p. 695). In fact, allowing firms to pay bribes to circumvent regulations encourages public officials to create new opportunities for bribery.

Governments take various steps to make corruption unprofitable. These mostly boil down to increasing penalties or increasing the probability of detection. In the United States, both briber and recipient are subject to penalties under U.S. Code title 18, section 201 (“Bribery of public officials . . .”). The statute states that perpetrators can be “fined . . . not more than three times the monetary equivalent of the thing of value . . . or imprisoned for not more than fifteen years, or both.” Surprisingly, although the 1977 Foreign Corrupt Practices Act forbids U.S. companies to make payments to foreign officials, it does not rule out “grease payments,” that is, payments to speed up or otherwise facilitate international transactions (Bardhan 1997, p. 1337). The 1998 OECD anticorruption treaty follows in its footsteps. Although the treaty threatens multinationals that bribe foreign governments, the hidden danger is that it invites more creative ways to cheat. Unfortunately, government institutions such as the IMF and World Bank inadvertently contribute to corruption by lending to corrupt governments (Easterly 2002; McNab and Melese 2004).

There are three main strategies for reducing corruption. The first—and in this author’s view, better—strategy is to reduce the power and discretion of public officials. The fewer rules, regulations, and contracts public officials have the discretion to write, modify, or enforce, the less opportunity there will be for corruption. The more transparent their actions and the more they have to lose, the better. In some cases, eliminating corruption is as simple as removing government, such as through deregulation or privatization. Clarke and Xu (2002) found that increasing competition reduces corruption. Mohtadi, Polasky, and Roe (2004) found that as trade barriers fall, so does corruption. Also, devolving more tax and decision-making authority to state and local governments reduces the central government’s monopoly power and reduces the gains from corruption (Martinez-Vazquez and McNab 1998, 2002a, 2002b).

The second strategy, somewhat paradoxically, is to pay more to government officials who have discretion so that they will have more to lose by exercising their discretion corruptly. Under the Ch’ing dynasty, for example, district magistrates received an extra allowance called yang-lien yin, or “money to nourish honesty” (Bardhan 1997). Today, one of the world’s cleanest countries, Singapore, pays its public officials so-called efficiency wages that always remain above prevailing wages; government officials who are tempted to be corrupt know that they will give up a lucrative job. Of course, for such incentives to work, officials must be convinced that if caught, they really will lose their jobs.

The third way to reduce bureaucratic corruption is to reduce the monopoly power of the bureaucrat. Shleifer and Vishny (1993) showed that if instead of a single corrupt official there are many competing corrupt officials, competition can cause bribes to drop to close to zero. Rose-Ackerman (1994) suggested that multiple officials with overlapping jurisdictions might help reduce corruption because the potential briber would face the costly prospect of persuading every official involved. She pointed to overlapping involvement of local, state, and federal drug enforcement agencies in helping reduce police corruption in the United States.

Competition works well if regulators monitor each other to prevent bribes or compete with each other to grant permits. Competition does not work well if permission is required of each one. If several public agents (agencies) have overlapping jurisdiction and each has veto power, this rapidly increases the cost of doing business and reduces the probability of success for legitimate projects (such as obtaining a permit to launch a new business). A simple example illustrates the point. Suppose there is a 50 percent chance that a single public agent will grant a permit. Now, if two agents must be consulted and each has the same veto power, then the probability of success drops to 25 percent; with four layers, the probability drops further to only 6.25 percent. Consider the World Bank’s observation that starting a business in Mozambique takes nineteen steps, five months, and a year’s worth of income (World Development Report 2002). Instead of protecting consumers and businesses, the danger is that competing and overlapping jurisdictions might crush market activity, investment, and economic growth.