Political Economy of Corruption

by Ananya Raihan

In many market oriented economies, government restrictions upon economic activities give rise to rents of a variety of forms. Sometimes, rent-seeking is perfectly legal. In other instances, rent-seeking takes form of bribery, corruption, smuggling, and black markets [Krueger, 1974]. Corruption is generally defined as an illegal or unauthorized transfer of money or an in-kind substitute. If we consider both the supply side and demand side of the phenomenon, from the supply side, the person bribed for any service must necessarily be acting as an agent for another individual or organization since the purpose of the bribe is to induce him to place his own interests ahead of the objectives of the organization for which he works [Rose-Ackerman, 1974]. Another possible definition of corruption is " the use of public office for private gains" [Bardhan, 1997], when public officials use their office not to maximize social welfare, but to serve their individual interests. Corruption is mostly a public-sector phenomenon, but it is also pervasive in the private sectors both in developed and developing countries..

There are two types of corruption, especially in public sectors : firstly, administrative and bureaucratic corruption which involves the use of public office for pecuniary gain, and secondly, political corruption involving the use of public office by politicians both for pecuniary gain and for purposes of remaining in office [Tanzi, 1994; Rose-Ackerman, 1978]. An alternative definition which does help to separate these two phenomena is that proposed by Shleifer and Vishny [1993], "the sale by government officials of government property for personal gain". This definition might be extended to include the purchase of government goods from the private sector. Shleifer and Vishny distinguish further between "corruption without theft" and "corruption with theft". The former occurs when an official demands a bribe but passes on the regular payment to the government. This could happen if an official charged a bribe in addition to an import license fee, but then passed the license fee on to the state treasury. Corruption with theft involves instances where the regular payment is not made to the government. An example here would be when customs officials let goods enter the country without paying a duty in exchange for a bribe.

Michael Beenstock [1979] draws a distinction between extortionary, subversive and benign corruption and explores their effects on allocative efficiency. Corruption tends to have at least two principal aspects: market imperfection, and illegality or secrecy, and corruption is the secret and usually illegal abuse of conferred monopoly status. However, certain types of corruption may not reflect market imperfections, e.g., where bureaucrats are paid low wage-rates and the commissions they hope to earn through corruption are effectively the competitively determined supply price for their services. Extortionary corruption takes place when the applicant in a government office is not engaged in any illegal activities. But due to monopoly power of the official he has to pay a bribe for service. If the applicant is engaged in any illegal act, and government officials facilitate him in exchange of bribe, the type of corruption is then subversive; for example, the import license of goods, where the applicant hopes to bribe the bureaucrat in return for an illegal reduction in the import duty. Political corruption, or the abuse of conferred political monopoly, operates on broadly the same principles that have already been identified. Likewise, with legal corruption where justice is sold.

It is not always obvious when a payment is bribe and when it is a gratuity, commission or tip. For example, the difference between paying a waiter a percentage and paying a bureaucrat a percentage. The difference is that in the former case there is nothing covert while in the second case the transaction is usually secretive, especially in the case of subversive corruption [Beenstock, 1979].

Monopoly power does not have a major bearing on the level of corruption in customs, to the extent that corruption in the customs is of the form of corruption with theft, that reduces cost for private-sector operators who pay bribes. The terms of level of discretion, when a customs agent is allowed to apply one of several rates to a product, or when a tax inspector is given substantial leeway to decide whether companies are given deductions or not, will be an incentive to demand a bribe in exchange for offering favorable treatment.

The quantitative restrictions upon international trade give rise to corruption in various forms. The determinants of corruption in foreign-aid projects can be examined from the same framework as with other areas of government activity.

Current research has turned up at least five sets of conditions, the interplay of which is conductive to bureaucratic corruption in developing countries:

• Broadly speaking, one set of conditions pertains to the functional role of government in the development process, which in some countries facilitates corrupt practices. More specifically, it involves the extent to which the government intervenes in the domestic economy and the concomitant opportunities this provides for corruption to occur.

• The nature of the political system and its leadership, including its stability and degree of responsiveness to competing public demands, also has some bearing on the incidences of corruption. Relative instability contributes to insecurity of tenure. Therefore, public servants are impelled to seek opportunities for self-enrichment rather than to make a long-term commitment to promote and safeguard public goods.

• Certain socio-economic factors, for example, conditions of poverty and inequity, operate in the external environment but impinge directly upon public bureaucracies and the behavior of their administrators.

• Society?s cultural norms and practices (such as kinship loyalty), which form an integral part of the informal organizations, shape the public?s perception of government and its bureaucratic apparatus, and influence to a greater or lesser degree the behavior of administrators.

• Organizational factors, such as structural arrangements and decision-making processes, personnel management practices, and administrative control and accountability systems, form still another set of conditions.

Krueger presents a model of competitive rent-seeking when it originates from quantitative restrictions upon international trade. In such a case competitive rent-seeking leads to the operation of the economy inside its transformation curve. The welfare loss associated with quantitative restrictions is unequivocally greater than the loss from the tariff equivalent of those quantitative restrictions. Competitive rent-seeking results in a divergence between the private and social costs of certain activities. [Krueger, 1974]

When quantitative restrictions are imposed upon and effectively constrain imports, an import license is a valuable commodity. There are some costs associated with licensing: paper work, the time spent by entrepreneurs in obtaining license, the cost of administrative apparatus necessary to issue licenses and so on. In many cases resources are devoted to competing for those licenses. If licenses are allocated in proportion to firms? capacities, a rational entrepreneur may still expand his plant capacity if the expected gains from additional import license he will receive, divided by the cost of the investment, equal the returns on investment in other activities. If licenses are allocated pro rata in proportion to the applications for those licenses from importer-wholesalers, usually because of larger-than-optimal number of firms, each importer-wholesaler receives fewer imports than he would buy at existing prices in the absence of licensing. But he realizes a sufficient return on these licenses he does receive to make it profitable to stay in the business. Thus, competition for rents occurs through entry into industry with smaller-than-optimally sized firms. Competition may also occur through allocating resources to influencing the probability, or expected size of license allocation. Some means of influencing the expected allocation -- trips to the capital city, locating the firm in the capital, bribery, hiring relatives of officials or employing the officials themselves upon retirement etc.

In developing countries there is a competition for government jobs and it is reasonable to believe that expected total remuneration is the relevant decision variable for person?s deciding upon careers. Generally, entry into government service requires above-average educational attainments. If there appear to be high official-plus-unofficial incomes accruing to government officials and high educational attainment is prerequisite for seeking a government job, more individuals will invest in higher education [Krueger, 1974].

Some of the empirical works on corruption use a single case as an illustration to propose a theory about corruption. Robert Wade [1985] presents such a framework in his study. After presenting a description of an agency plagued by problems of corruption where officials demand bribes from villages in exchange for irrigation services, Wade focuses on how corruption is organized hierarchically. Officials demand bribes from villages, but in order to be posted to a position where they can demand bribes they themselves need to make payoffs to a superior, and so on, in a chain of corruption that reaches to the level of local politicians who can influence bureaucratic postings and who need bribe money for campaign finance.

According to Wade, the basic causes of corruption in this system are: excess bureaucratic control and declining real salaries in the public sector. Wade also adds a third causal factor, in that even honest officials may need to become corrupt to get sufficient money for transfer to a higher post. In terms of effects on growth, there are substantial negative effects on the economy and environment, Wade argues, primarily because officials under pressure to raise money create new opportunities for bribe collection by managing the irrigation network so as to maximize opportunities for bribes. This includes using capital-intensive techniques that improve opportunities for graft, which supports the theoretical argument made above about corruption biasing the activity of bureaucrats. Wade also cities numerous examples of how the quality of service provided by the irrigation department was eroded by prevalent corruption.

The one important aspect of corruption where Wade does not come to a firm conclusion is with the issue of organization. At the outset of the paper he refers to corruption in this case as a smoothly functioning market kept in place by a strongly centralized hierarchy of authority. Later he acknowledges that there is actually a substantial amount of uncertainty in the system. What seems clear from his description is that this system is organized in the sense that bureaucrats have to pay to be transferred to a post where they can extract bribes from the populace, but once in their positions officials operate as independent monopolists, which should have negative effect on the economy. There is also no apparent form of association between officials and village representatives which might reduce uncertainty.

Ades and Di-Tella [1995] in an unpublished paper look at the relationship between certain structural variables in the economy and the extent of corruption. They find that the size of monopoly rents in an economy, attributable either to policy factors or distance from trading partners, is significantly correlated with the level of corruption as measured in indices provided by risk assessment agencies.

Some studies which perform cross-country regressions to examine the effect of institutional inefficiency and corruption on growth use two types of data: (i) indices of corruption from private firms that analyze country risk for investors, (ii) indices based on survey questionnaires which the authors prepared.

The principal agent theory

In this theory the principal is defined to be the top level of government and the agent is a government official designated to carry out a specific task. The work of Rose-Ackerman [1978, 1994] and of Klitgaard [1988, 1989, 1995a, 1995b], drawing on this framework, is especially pertinent here. Klitgaard stresses three dimensions of institutional structure that he considers most critical in bearing on the opportunities for corruption:

- the monopoly power of officials;

- the degree of discretion that officials are permitted to exercise;

- the extent to which there are systems of accountability and transparency in an institution.

Monopoly power could exist for the legal reason that a certain official is the only person charged with performing a certain task. The greater the amount of discretion which is given to an agent, the more opportunities there will be for agents to give ?favorable? interpretations of government rules and regulations to businesses in exchange for illegal payments.

Asymmetries of information present principals with a challenge in that they often find it difficult to monitor the actions of agents effectively and hold them accountable for their actions when they fall to carry out an assigned task [Rose-Ackerman, 1978; Laffont, 1997]. Ambiguous, rules and regulations of government offices with complicated language,and absence of easy access to them, i.e. asymmetric information flows, also render opportunities for corruption.

For a given set of opportunities and incentives, there should be only one equilibrium level of corruption. Once a high-level corruption equilibrium is reached as a result of a temporary change in the nature of opportunities and incentives, widespread corruption may be very hard to eradicate even if the situation with regard to opportunities and incentives returns to normal. Frequency-dependent equilibria models propose that as the percentage of officials engaging in corruption increases, the potential costs for any new officials to begin engaging in corruption (loss of reputation, chances of being cost) decrease [Andvig, 1991; Andvid & Moene, 1991]. Informal societal institutions or social norms can also promote or deter corruption. Tanzi [1994] suggests that, in many developing countries where family ties retain a greater importance than they do elsewhere, officials in public office will be less able to escape demands that they extend special favors to family and friends.

The additional factors of a broader economic perspective may be relevant to corrupt practices. First of the factors is, the prevailing nature and extent of poverty in the economy and the national distribution of income and wealth, in general, as well as the recent trends in these distributions. Recent aggregate performance of the economy and the trends in real incomes is also a significant factor.

In cases of licensing for business (import, investment, travel pass etc.) two aspects of market imperfection can be considered. First, the conferred monopoly that the delegation of authority engenders puts the bureaucrat in a position to extract a monopoly profit in the forms of bribes if he is prepared to ignore the law. Second, the applicatant will have to face appeal costs both physical and possibly pecuniary if he wishes to lodge a complaint about the behavior of the official. In practice appeal costs include the costs of waiting, the desire not be nuisance, legal fees, the fear of jeopardizing future applications etc.

Effects of corruption on economic development and growth

When rent-seeking originates from quantitative restrictions upon international trade, competitive rent-seeking leads to the operation of the economy inside its transformation curve. The welfare loss associated with quantitative restrictions is unequivocally greater than the loss from the tariff equivalent of those quantitative restrictions. Competitive rent-seeking results in a divergence between the private and social costs of certain activities

The effects of corruption on the economy can be thought of in terms of the distortionary effects on the allocation of resources - i.e., the extent to which ongoing economic activity is redirected and rendered less efficient - and the disincentive effects -- i.e., the degree to which risk and uncertainty are introduced into the economic environment and thereby deter prospective economic activities and, especially, investment.

The broader distortionary effects that arise from corruption may be summarized as follows [OECD, 1997]:

1. Multiplier effects: Any redirection of economic activity carries multiplier implications for the economy as a whole, and these will be directly related to the factors identified earlier. Their identification will be particularly problematic, but, in the case of major capital investment projects, for example, they may be substantial. The loss of a road linkage to one region of a country - attributable to an act of corruption - in favor of an irrigation project in a different region would entail measurable and substantial multiplier opportunity costs;
2. Competitiveness Effects: If the nature of the corruption constitutes a bias against one group of enterprises, then there will be competitive bias that distorts the structure of economic development. For instance, in the situation where international trade tax is evaded through corruption, domestic producers may well face a more costly overall tax regime vis-?-vis importers;
3. Fiscal Effects. Some forms of corruption will impact on fiscal objectives, in part through direct mechanisms whereby the government loses income directly from a corrupt act, but also indirectly through the tendency of corruption to drive economic activity into the black economy and out with the administration of the tax authorities. Adverse effects may be substantial, both in terms of a loss of aggregate fiscal discipline, and in a reduction of the effectiveness with which different public expenditures are prioritized;
4. Debt Effects. Some corrupt acts will add to national indebtedness as costs are unnecessarily incurred in international transactions. The servicing of this excess debt burden presents a long-term burden; and
5. Growth and investment. While the impact of the efficiency issues, raised above, may only be qualitatively rather than quantitatively definable, the ramifications for the volume and quality of investment and for growth may, nonetheless, be cumulatively highly significant.

Apart from the role of corruption in determining the pattern of economic development, in project design and implementation, it may be the case that prices are inflated by transfers which the corruption engenders. If the bureaucrats who handle projects pocket 10 percent of input costs, the financial cost of the project would tend to be 10 percent greater than its underlying economic cost [Beenstock, 1979]. As we deduct official taxes or monopoly rents for shadow-pricing purposes, we can also deduct the pecuniary amount as unofficial taxes that are generated by bureaucratic corruption.

To discuss the allocative effects of corruption it might be argued that if contractors are allocated on the basis of corruption, it is unlikely that the successful contractor would be the most efficient in terms of quality and cost and that corruption would tend to lead to allocative inefficiency. But it might be the case that the most efficient contractor can afford to pay the most attractive bribes. Then it would not be obvious that corruption necessarily generated allocative inefficiency.

Welfare cost of rent seeking activities

Competitive rent-seeking for import licenses entails a welfare cost that would be incurred if the same level of imports were achieved through tariffs. The effects of tariff upon production, trade, and welfare are well known. For focusing upon additional cost of competitive of rent-seeking Krueger proposes a model. In the model initially free trade is assumed, then a tariff or equivalent import restriction is introduced. Finally an equal import restriction with competitive rent-seeking is examined. Two commodities are consumed by the country under investigation: food and consumption goods. Food is produced domestically and exported. Consumption goods are imported. Distribution is production activity whereby food is purchased from the agricultural sector, exported, and the proceeds are used to import consumption goods which are sold in the domestics market. Labor is assumed to be the only domestic factor of production. It is considered that the country is small and can not affect its international terms of trade. The model shows that people will seek distributive rents until the average wage in distribution and rent-seeking equals the agricultural wage. Agricultural production and food consumption are reduced by the introduction of rent-seeking. Since the import level remains unchanged, rent-seeking entails a welfare loss beyond that for an import restriction without seeking. To the extent that rent-seeking is competitive, the welfare cost of import restrictions is equal to welfare cost of the tariff equivalent plus the additional cost of rent-seeking activities. The total value of rents reflects the agricultural wages times the number of rent-seekers. It also reflects the value (at current prices) of the domestic factors of production which could be extracted from the economy with no change in the final goods and services available for the society?s utilization.

Generally the more inelastic domestic demand the less is likely to be the welfare cost of a given tariff. For the quota-cum-rents case, the opposite is true: the more price-inelastic is demand, the greater will be the value of rents and the greater, therefore, the deadweight loss associated with the rent seeking. Usually it is believed that competition among importers will result in a better allocation of resources than will a monopoly. If a rent-seeking is a possibility, however, creating a monopoly position for the one importer will generally result in a higher real income if not in a preferable income distribution for society. Devaluation under quantitative restrictions may have important allocation effects because it diminishes the value of import license, and hence the amount of rent seeking activity, in addition to its effects upon exports.

Mauro [1995] focuses more directly on the effect of corruption on growth. From nine indicators Mauro constructs one index for bureaucratic efficiency (legal system, red tape, corruption) and a second index for political stability (using the remaining six indicators). In the regressions relevant to corruption, Mauro finds that both the individual corruption variable and the bureaucratic efficiency index are statistically significant determinants of the average level of investment over the period 1960?85, even when controlling for other determinants of investment. A one-standard derivation improvement in the bureaucratic efficiency index is associated with a 4.1 percent of GDP increase, or 3.3 percent GDP for the same change in the corruption index.

While the bureaucratic efficiency and corruption indices are both significantly correlated with economic growth, when further tests are conducted, the relationship with the bureaucratic efficiency index is shown to be robust while that with the corruption variable is not. As a final step, Mauro tests the influence of his variables on allocative efficiency by including the level of investment on the right-hand side of the growth regression. The result is that the bureaucratic efficiency index remains statistically significant but the value of its coefficient is reduced by a third. The corruption variable loses its statistical significance. It should also be noted that Brunetti (1995) uses Business International data to test the importance of the same political variables as Mauro (1993), using the same indices but different specifications for the regression and per-capita growth 1980-1990 (instead of 1960-85). In this specification, none of the variables are statistically significant.

Economic policy and the design of the state institutions that might reduce the scope of corruption

In Krueger?s model, an import prohibition might be preferable to a non-productive quota if there is competition for licenses under the quota. This follows immediately from the fact that a prohibition would release resources from rent-seeking and the excess cost of domestic production might be less than the value of the rents.

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For some types of corruption the presence of competition is from the supply side, i.e. from the side of public official. When more than one government agent can issue the same license, competition among different officials will drive the bribe price down to zero [Rose-Ackerman, 1978]. One remedy to the problem of monopoly power that is suggested by Rose-Ackerman is the creation of overlapping jurisdictions for official duties. This argument can be applicable in the case of corruption without theft, not applicable for the case of corruption with theft. In this case, corruption reduces overall costs for business in addition to lining the pockets of government officials, so businesses have an incentive to seek out corrupt state agents. Competition among businesses will lead to the spread of corruption with dead-weight loss to the economy [Krueger, 1974].

In case of corruption occurring due to asymmetric information flows, strict and transparent rules and regulations that spell out all the details of a particular question would seem an appropriate antidote to the problem of excess discretion. Rules and regulations should be simplified and easily accessible to the people.

Corruption due to asymmetric information in monitoring and controlling accountability of the officials may be reduced by reinforcing hierarchical control through state institutions. But those who are paid to monitor the actions of lower-level officials can themselves be bribed not to blow the whistle. Increasing hierarchical control can also exacerbate the problem of informational asymmetries if officials far removed from the actual activities taking place are called upon to take judgements which depend upon having accurate information [Gould & Amaro Reyes, 1983, Rose-Ackerman, 1978].

To reduce the corruption in customs the best strategy seems to be to move towards a simplified tax and tariff structure which will leave less room for discretion on the part of customs officials.

The policy-makers recognize that there can be hidden corruption costs involved in ordering goods, especially for state use; it may often appear that the purchase of standard items sold on private markets will be justified despite some quality loss. When goods must be ordered especially for government use, policies should be designed to reduce the vagueness in purchasing instructions given to officials, thereby reducing the costs of effective surveillance and increasing the probability of detection of serious speculation.

Conclusion

The paper attempts to accumulate the existing knowledge regarding corruption, its internal mechanism, interacting agents, effects of corruption on economic performance of economies and the policy implications of the issue.

If individuals choose their activities on the basis of expected returns, rates of return on alternative activities will be equated and, in that sense, markets will be competitive. In most cases, people do not perceive themselves to be rent-seekers and, generally speaking, individuals and firms do not specialize in rent-seeking. Rather, rent-seeking in any form is a part of economic activity, such as distribution of production, and part of the firm?s resources are devoted to the activity (including hiring of expeditors).