Feb 19, 2018

How does Corruption affect Economic Growth?

Corruption is the abuse of public power for personal benefit or for the benefit of one’s family, friends, clan, tribe, party etc. (Tanzi 1998). Across the world, regardless of the size and type of economic system in place, accusations of corruption have caused governments to fall and prominent politicians including Presidents and Prime Ministers to lose their office.

Scholars and economists have long argued that corruption negatively affects economic growth (Mauro 1995). I argue that corruption can retard economic growth through several channels including

Misallocation of public expenditure
Corruption, especially political or grand corruption, is often tied to capital projects. Since commissions paid out by enterprises to public officials to win investment contracts are tied to project costs, an incentive is created for larger projects which carry higher commissions in absolute terms (Tanzi and Davoodi 1997). As such, corruption is likely to increase the number of capital projects undertaken in a country.

However, empirical investigations have shown that an increase in the share of current expenditure has positive and statistically significant growth effects. By contrast, the relationship between the capital component of public expenditure and per capita growth was established as negative; the standard type of capital expenditure commonly undertaken in developing countries, such as capital, transport, communication etc had either a negative or insignificant relationship with economic growth. Productive expenditures can become unproductive when used in excess. In contrast, higher current expenditure, components such as Operations & Maintenance (O&M) expenditure was associated with higher economic growth. (Devarajan et al 1996)

Nevertheless, corruption induces a misallocation or excessive allocation of resources to unproductive capital projects. This explains why in so many poor countries, governments would rather spend their limited resources on infrastructure projects and defense, where corruption opportunities are abundant, than on education and health where these opportunities are much more limited (Shleifer and Vishny 1993).

Reduction in Private Investment
Corruption affects private investment, by creating an unpredictable climate wherein investors are not guaranteed a return on their investment.

When corruption becomes endemic, it can threaten the basic rule of law, property rights and enforcement of contracts. An investor needs assurance that his money will be returned. Such assurance is dependent on the existence of a sound and well- functioning legal system and an independent judiciary to adjudicate disputes relating to investments (Azfar et al2001) .

Unraveling the East Asian Paradox
Paradoxically, the East Asian countries depicted a positive correlation between high rates of investment and growth with relatively high levels of corruption.

In unraveling this paradox, Campos et al (1999) argue that different corruption regimes have different effects on investment. They categorize countries into,

a. Those with high levels of corruption and low predictability;
b. Those with high levels of corruption and but greater predictability;
c. Those with low levels of corruption and high predictability

East Asia’s puzzling economies fell in the second category above, as corruption in many of such economies were seemingly well organized rendering a very high degree of predictability (Campos et al 1999).

When corruption is more centralized, that is, a system in which, there is a single public official, who can decide on awarding franchise, the degree of uncertainty about the possibility of actually obtaining the franchise, upon payment of bribes, is much lower. Conversely, in situations in which corruption is decentralized, that is, when several government officials have a veto power over a firms’ application, but none have absolute power to grant the franchise, the degree of uncertainty or unpredictability is higher. In the second situation, firms will invest lesser than in the first situation. (Shleifer and Vishny (1993)

The East Asian miracle economies, with high levels of corruption, attracted higher levels of investment compared to other developing countries, simply due to that reason (Campos et al 1999). As a result, compared to most developing countries, the East Asian countries have grown faster. Nevertheless, their economies would have grown even faster if they were in the third category, that is, low levels of corruption and high predictability, which invariably would have attracted more investment than the first and the second categories (Campos et al (1999))

Misallocation of Talent
Corruption can also hamper economic growth through a misallocation of talent.

In general, the attractiveness of an occupation to talent is determined by three factors, the size of the market, returns to scale and the compensation contract (how much rents on their talent can be captured). In many countries, rent seeking rewards talent more than entrepreneurship does.

The type of activities that most talented people choose can have a significant impact on the allocation of resources. Investment in unproductive human capital such as, building up connections and rent seeking, referred to as ‘political capital’, is socially unproductive (Lui 1996). Investment to acquire political capital competes for resources that could be used for investment in productive capital. Such diversion of resources to non-productive political capital lowers the economy’s long term growth rate (Lui 1996).

It has been found that a 1% improvement in the level of corruption is associated with a 0.27% point increase in the growth rate of GDP per capita through encouraging human capital accumulation. (Kim et al 2010).

Productive Inefficiencies
It is a well-established principle in economic theory that free market/competition as an organizing principle, economizes the allocation of resources. Efficiency criteria would guarantee that the most efficient project would be chosen because it maximizes profits.

However, when public officials exercise discretionary powers, often, the decisions with regard to selection of firms could be based on informal criteria such as friendship, kin relationships, common political backgrounds as well as the capacity of parties to pay bribes rather than on efficiency criteria. Such a system will not reward productive efficiency but will reward only moral unscrupulousness or the capacity to build relationships/friendships with public decision makers. Hence, firms can come out on top irrespective of their technical inefficiency. (Della Porta 1997),

Since the key to a country’s economic development lies in the destination of resources for productive investment, the exclusion of efficient firms from the public sector impose significant long term costs. (Della Porta 1997).

Convincing evidence is found to establish the pervasive impact of corruption on the long run economic growth of a country. Governments across the world fall short of achieving the desired levels of economic development as genuine efforts are not taken to deal with this systemic problem. If governments are serious about long run growth, tackling corruption needs to be prioritized at the top of any policy maker’s agenda.

Chamindry photo 2

- Chamindry Saparamadu

(The author Chamindry Saparamadu is a lawyer and an international development consultant.)

Azfar, Oma and Lee, Young and Anand Swamy. 2001. ‘The Causes and Consequences of Corruption’ Annals of the American Academy of Political and Social Science, Vol. 573, Culture and Development: International Perspectives (Jan, 2001) pp 42-56

Campos, Edgardo J and Lien, Donald and Pradhan, Sanjaya. 1999. ‘The Impact of Corruption on Investment: Predictability Matters’ World Development Vol. 27 No.06, pp 1059-1067, 1999.

Della Porta, Donatella and Vannucci, Alberto. 1997. ‘The Perverse effects of Political Corruption’, Political Studies, XLV, 516-538 (1997).

Devarajan, Shantayanan; Swaroop, Vinaya and Heng-fu, Zou. 1996. ‘The Composition of Public Expenditure and Economic growth’, Journal of Monetary Economics, 37 (1996) 313-344

Kim, Byung Yeon and Kim, Min-Jung, ‘Corruption and Economic Growth’, http://ec.ut.ee/eaces2010/artiklid/Kim%20Kim-Corruption%20and%20economic%20%20growth.pdf, access December 2010

Lui, Francis T. 1996. ‘Three Aspects of Corruption’, Contemporary Economic Policy, Vol. XIV, July 1996

Mauro, Paolo. 1995. Corruption and Growth, The Quarterly Journal of Economics, Vol. 110 No. 3 (Aug 1995) pp 681-712

Shleifer, Andrei and Vishny Robert, M. 1993. ‘Corruption’ The Quarterly Journal of Economics, Vo. 108, No. 3 (Aug 1993) pp 599-617

Tanzi, Vito. 1998. ‘Corruption around the World: Causes, Consequences, Scope and Cures’, IMF Staff Papers Vol. 45 No. 4 (December 1998)

Tanzi, Vito and Davoodi, Hamid. 1997. “Corruption, Public Investment and Growth’, IMF Working Paper WP/97/139. International Monetary Fund