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Impact of Corruption on Economic Growth Performance in Developing Countries
Quamrul Mahmud

2008

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Introduction
Economic development is a multidimensional process which requires many factors working efficiently in an interrelated system. From the inception of country concept, all countries in the world have been trying to increase economic growth. But economic history tells that only few countries have been successful to achieve desired economic growth while many other countries are lagging behind their economic goals.
Post war period, East Asian countries have shown tremendous success in developing their economic conditions from a lower-income country to a higherincome country

During the post war period, when trade liberalisation and economic integration were emerging issues, there was a major positive change in economic growth performance in different parts of the world. In this period many developing countries, especially in East Asia, have shown tremendous success in developing their economic conditions from a lower-income country to a higher-income country. But at the same time many developing countries, mostly in Sub-Saharan Africa, Central and South Asia and Latin America, have not yet been successful to break the vicious circle of poverty.

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Cross-country difference in economic growth performance in developing countries is caused by many factors such as institutional inefficiency, environment degradation, negative impact of globalisation and trade liberalisation, misuse of foreign aid, technological market backwardness, structure and

inefficient

resource allocation, non-competitive financial sector, inefficient utilisation of natural resources and, above all, government failure and corruption. This essay explains how corruption can be attributed as an important factor for cross-country differences in economic growth performance in developing countries. It will be argued that corruption is a major reason for decrease in investment, misallocation of resources, inefficiency of public and social services, international terrorism and income inequality.

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Impact of corruption on investment
Corruption hits economic growth through its negative relation with investment. Vaclav Havel, former Czech President (October 2001), argues, ‘corruption may either deter investment or render it less productive through its adverse impact on the risk and cost of doing business’ (Mauro 1995). Economic growth is lowered by corruption because investment is negatively correlated with corruption, especially when dishonest bureaucracies delay the distribution of permits and licenses for investment (Mauro 1995). Mauro (1995) also considers that negative association between corruption and investment is

significant, both in a statistical and in an economic sense. For example, if Bangladesh were to improve the integrity and efficiency of its bureaucracy to the level of that of Uruguay, its investment rate would rise by almost five percentage points and its yearly GDP growth rate would rise by over half a percentage point. Furthermore, corruption hinders investment by increasing cost of production and transactions because corrupt practices are conducted in secrecy and contracts are not legally enforceable (Brempong and Camacho 2006). Likewise, institutional inefficiency, as an ultimate consequence of corruption, also discourages both local and foreign investment.

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The magnitude of this effect is noteworthy: a one-standarddeviation increase (an improvement) in the corruption associated increase index with in is an the

investment rate by 2.9 percent (Mauro Moreover, direct (FDI), a of GDP 1995). foreign investment positive for

instrument

economic growth, is deteriorated by

corruption which has resulted in capital

flight in many parts of the world (Wei 2000). So, corruption reduces economic growth because it decreases the marginal rate (MR) of return on investment (ROI).

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Corruption and misallocation of resources

Corruption is a vital reason for misallocation of both physical and human resources. Open economic concept of perfect competition is severely hindered by corruption. Brempong and Camacho (2006) demonstrate in their study that corruption prevents economic growth because it distorts incentives and Market signals leading to misallocation of resources.

Moreover, corruption in developing world, where it has degenerative impact, destroys the productive capacity of local talent and entrepreneurs. The opportunities for corrupt practices lead to resources, especially human resources, being channelled into rent seeking rather than productive activities (Shleifer & Vishny 1993; Berthelemy et al. 2000 and Gupta et al. 2000). Entrepreneurial and academic skills may be attracted to public sectors to earn extra benefit through corruption.

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Furthermore, when corruption is widespread and institutionalized, some firms may devote resources to obtaining valuable licenses and preferential market access (Murphy, Shleifer and Vishny 1991) which leads to imperfect competition and monopoly in the market and inefficient allocation of valuable resources. In the extreme, it may be financially more rewarding for an entrepreneur to leave the private sector altogether and instead become a corrupt public official (Svensson 2005). Consequently, growth of private sector is reduced.

Corruption and public services

Corruption efficiency of

reduces both

bureaucrats and national institutions. public increases It paralyses and of

services suffering

common people. It distorts the proper functioning of state institutions allowing a few interest groups to seize these institutions for their private interest (Hellman et al.2000).Corruption increases uncertainty, especially in the case of decentralized corruption. This results in decreasing investment in both physical and human capital (Wei 2000; Alesina and Weder 2000).

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Furthermore, bureaucrats in developing and poor countries, where public expenditure is a major source of corruption, frequently invest in non-productive sectors, including national defence or infrastructure where misappropriation is relatively easier than other sectors. Abbey (2005) demonstrates in his research: ‘experience with public sector projects is replete with stories about roads that are pocked with potholes soon after completion, power plants that experience regular blackouts and sewerage systems that simply do not work’. Empirical study conducted by Abbey (2005) also shows that corruption and fraud in public procurement of Ghana, accounting for 50 to 70 percent of government expenditure, impact on governance, economic growth and development.

Furthermore, Easterly (2003) demonstrates that bureaucratic inefficiency caused by corruption affects growth indirectly by lowering investment rate and directly by leading to misallocation of investment among sectors. For example, a one standard deviation improvement in the bureaucratic efficiency index is associated with a 1.3 percentage point (absolute) increase in the annual growth rate of GDP per capita (Easterly 2003).

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Moreover, impact of corruption of public servants on micro level or firm level is noteworthy. Fisman and Svensson (2001) use firm-survey data of estimated bribe payments of Ugandan firms to study the relationship between bribe payments to government officials, taxes and firm growth which reveal that both the rate of taxation and bribery are negatively correlated with firm growth. For the full data set, a 1 percentage point increase in the bribery rate is associated with a reduction in firm growth of 3 percentage points, an effect that is about three times greater than that of taxation (Fisman and Svensson 2001).In addition, political corruption associated with civil and military bureaucrats, is assumed to have tremendous influence on other sectors of economy. Political corruption is defined by Transparency
‘The abuse of entrusted power by political leaders for private gain, with the objective of increasing power or wealth’ -Political corruption is defined by Transparency International (TI Report 2007)

International (TI Report 2007), the world wide anticorruption advocacy organization, as: ‘the abuse of entrusted power by political leaders for private gain, with the objective of increasing power or wealth.’ Abbey (2005) states that political corruption may not involve money changing hands; it may take the form of ‘trading influence’ or granting favours that poison politics and threaten democracy.

Abbey (2005) also demonstrates that corrupt politicians, with the help of corrupt bureaucrats, over the world tend to choose investment projects not on the basis of their intrinsic economic worth but on the opportunity for bribes and kickbacks these projects present and the ultimate sufferers are common people. So, political corruption has long-term impact on economic growth because politicians are supposed to lead the country for economic prosperity.

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Impact on poverty and terrorism
It is argued that corruption distorts income distribution and increases inequality among nations (Abbey 2005). A study by Brempong and Camacho (2006) reveals that there are statistically significant regional differences in income and growth performance due to corruption. For example, 1 percentage increase in corruption decreases growth rate of per capita income by about 1.7 percentages in OECD and Asian countries, by about 2.6 percentages in Latin American countries, and by 2.8 percentages in African countries. A 1 standard deviation increase in corruption increases the gini coefficient of income inequality between 0.05 and 0.33 points (Brempong and Camacho 2006). So, corruption increases the difference between rich and poor which is a major cause of social unrest in developing countries.

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Furthermore, it is evident that there is a strong relationship between corruption and economic under development which ultimately results in social unrest (Abbey 2005). It is also established that poverty, which creates hopelessness among poor, is one of the causes of international terrorism. Abbey (2005) says that corruption in poor countries is perceived as a direct threat to the security of richer countries which therefore have a stake in the fight to stamp out corruption and alleviate poverty and terrorism. Fighting corruption is also fighting terrorism as without corruption the attacks of September 11 could not have taken place, as argued by Peter Eigan (2005), Chairman of Transparency International (TI).

Corruption of social services and cross-country impact

A major source of corruption in developing countries is social services and non- government organizations. Many non-government organizations, which are supposed to provide social services on a not-for-profit basis, are actually engaged in business for their own benefit at the expense of the poor. This is why Brempong and Camacho (2006) argue that corruption decreases the quantity as well as the effectiveness of resources spent on social programs that benefit the poor. Even when resources spent on social programs are not reduced, corruption changes the distribution of this spending to benefit the rich at the expense of the poor (Gupta et al. 2000; Tanzi and Davoodi 1997). For example, health care expenditure may be tilted toward building modern hospitals that cater only to the rich at the expense of preventive health care that benefits the poor. In the same way, education spending could be skewed towards subsidizing higher education for the rich rather than towards primary and secondary education that benefit the poor. This is why corruption of social service organizations needs to be reduced to ensure economic growth of developing countries.

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Notably, there are differences in the magnitude of the impact of corruption among different countries and regions. Brempong and Camacho (2006) find significant regional differences in the effects of corruption on economic growth and income distribution. The largest negative effect of corruption on growth rate of income is found in Africa while the largest negative impact of corruption on income distribution occurs in Latin America (Brempong and Camacho 2006). Their study (2006) also reveals that impact of corruption on economic growth is minimal in OECD and Far East Asia, and most interestingly in China where corruption and economic growth both are increasing. Brempong and Camacho (2006) term this kind of corruption as developmental corruption which is also called centralised or coordinated corruption where corruption has positive correlation with development. Another form of corruption they term as degenerative or uncoordinated corruption, which is prevalent in Africa and Latin America, has negative relation with economic growth. So decentralised corruption -pervasive corruption- is more detrimental than centralised corruption -one-point corruption- for economic growth of a country.

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Conclusion

The analysis of different indicators of economic growth offered in this report indicates that corruption is a vital factor which negatively affects all aspects of economic growth. There may be different reasons for cross-country differences in economic growth performance but the impact of corruption is most pervasive for both short-term and long-term economic goals. Though the impact of corruption is not homogeneous across different regions of the world, corruption can be reduced, if not possible to eliminate at all, to sustain growth in the long run. Indeed, economic growth is a complex issue involving many interlinked factors which deserves analysis and reducing corruption is indispensable to minimize the gap between rich and poor nations.

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References

• • • • • • • • •

Abbey, J., 2005. The Growth and Corruption: It’s Impact on the Achievement of Middle Income Status, Centre for Policy Analysis, Accra, Ghana Brempong, K. G. and Camacho, S. M., 2006. Corruption, Growth, and Income Distribution, Springer-Verlag, Paris. Easterly, W., 2003. Elusive Quest for Growth: Economic Adventures and Misadventures in the Tropics, MIT Press, Cambridge, Massachusetts: 241-253 Mauro, P., 1995. ‘Corruption and Growth’, The Quarterly Journal of Economics, 110(3): 681-712 Mauro, P., 1996. ‘The Effects of Corruption on Growth, Investment and Government Expenditure’ IMF Working Paper No. 96/98 Olken, B., 2003. Corruption and the Costs of Redistribution: Micro Evidence from Indonesia, Manuscript, Harvard University Press Svensson, J., 2005. ‘Eight Questions about Corruption’, Journal of Economic Perspectives, 19(3):19–42 Shleifer, A. and Vishny, R.W., 1993. ‘Corruption’, Quarterly Journal of Economics, 108: 599-618 Transparency International, 2007. ‘Corruption Perceptions Index’, http://www.transparency.org.html (Access: 15/05/08)

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Contents

• • • • • • • • • •

INTRODUCTION IMPACT OF CORRUPTION ON INVESTMENT CORRUPTION AND MISALLOCATION OF RESOURCES CORRUPTION AND PUBLIC SERVICES IMPACT ON POVERTY AND TERRORISM CORRUPTION OF SOCIAL SERVICES AND CROSS-COUNTRY IMPACT CONCLUSION REFERENCES ABOUT ANALYSEES CONTACTS

PAGE 2 PAGE 4 PAGE 6 PAGE 7 PAGE 10 PAGE 11 PAGE 13 PAGE 14 PAGE 17 PAGE 18

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© Copyright 2008. Analysees Ltd, www.analysees.co.uk. All rights reserved. When quoting please cite “analySEEs.co.uk”. The above information does not constitute the provision of investment, legal or tax advice. Any views expressed reflect the current views of the author, which do not necessarily correspond to the opinions of Analysees Ltd or its affiliates. Opinions expressed may change without notice. Opinions expressed may differ from views set out in other documents, including research, published by Analysees Ltd. The above information is provided for informational purposes only and without any obligation, whether contractual or otherwise. No warranty or representation is made as to the correctness, completeness and accuracy of the information given or the assessments made.

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Mamun Ahmed

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