Economic and Fiscal Costs of Corruption in a

Country

Public sector corruption isnt simply about taxpayer money going missing. Broken
institutions and corrupt officials fuel inequality and exploitation keeping wealth in the
hands of an elite few and trapping many more in poverty.

Student number: 397022

Name: Katitja Molele

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1. Introduction

South Africa suffered an illegal outflow of R185 billion due to corruption in the public sector
between 1994 and 2008, it is estimated that in 2009 government corruption totalled R70
billion.

Global Financial integrity, 2012.

Spanning from biblical times to modern days, governing individuals and public officers had to
deal with a fair share of corruption, although recently this has become sophisticated. An
example of this is provided in the bible New International Version, 1987 in John 12: 5 where
Judas as a high ranking disciple used to help himself with the money that was to be used for
the poor and wellness programmes.

Transparency internationals Global perception Index, 2015 reports that majority of Africans
(58%) say that corruption has increased over the past year. This is particularly the case in
South Africa where more than four-in-five citizens (83%) say they have seen corruption rise
recently. Figure 1 below provide a picture of how for example, sub-Saharan Africa think
corruption has changed over period leading to year 2015.

Figure 1. Transparency international: Global perception Index, 2015

Over the past years numerous studies have been carried out to look at the effects of
corruption on growth and well-being of emerging and established economies around the
world. Mankiw N.G, and Taylor M.P (2014) found a fundamental relationship between
productivity, growth and living standard of citizens of a country. The authors argue that
nations with high productivity generally enjoy high living standards. To improve productivity
and boost living standards for less productive counterparts, policy makers need to ensure a
productive levels of government expenditure while creating favourable enabling environment
for private investment.

Corruption is seen as a major hindrance when it comes to the development and economic
growth of a country as it reduces the overall societal trust on state and the accountability of
public institutions. Mo, P in his Journal of comparative economics.2001 found that a 1%
increase in the corruption level reduces the growth rate by about 0.72 %.

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This essay provide a perspective regarding economic and fiscal costs of corruption in a country
by looking at key drivers of growth of an economy and how these are affected by corruption.
Therefore it remains the duty of the state and public institutions to deploy policies that
protect and enhance private sector investment for growth. Political stability and zero
tolerance to corruption are some of the stands that the government should continue
embracing.

2. Gross Domestic Product (GDP) as a measure of growth

According to Mankiw N.G, and Taylor M.P (2014), GDP measures the market value of all final
goods and services produced within a country in a given period of time. This production
depends on demand which depends on income which is itself equal to production.
Productivity is proven to be a good measure of output. The authors argue that nations with
high productivity generally have better economies and citizens enjoy high living standards.

To provide a clear context, the discussions and arguments in this essay will look at the factors
affecting GDP and growth and second, how GDP movements affects employment as a
measure of the well-being and prosperity of the nations. As indicated, to measure the effects
of corruption on economy and fiscal costs we look at how the various components of the GDP
model are affected by corruption.

The formulae below highlights the composition of the GDP,

= Consumption + Investment + Government spending + Exports Import

In 2012, Blanchard O & Johnson D, 2014 alluded that in the South African context for example
Consumer spending contributed (66%) to the GDP while Government Spending, Gross
Investment, and Net exports contributed 30%, 12%, and -7.2 to the GDP respectively. For this
essay we will assume that exports equals imports and focus on consumer spending (66%),
Government Spending (30%) and Gross Investment (12%) as these have great impact on
movements of the GDP and growth.

This essay is simplified for purposes of the assignment and is limited to the scope and word
count as per requirements. It must be noted that ideally a comprehensive study will consider
a wide variety of factors in addition to the ones outlined, analysed and argued in the essay.
The assumptions are that the factors considered in this essay are certis paribus and sufficient
for the study at hand. Only the factors that affect the GDP equation (how these are affected
by corruption) of the demand and expenditure equation are analysed and discussed in detail.
The essay does not provide mechanisms for eliminating corruption but merely highlight the
benefits of corruption free societies.

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2.1 The effects of Corruption and Consumer spending (66%),

Economists monitor inflation, a steady increase in the prices of goods and services in an
economy because inflation is seen to affect the consumer spending. Marhubi A, 2000: 1999
studied the relationship between corruption and inflation. The author concluded that both
makes public income decrease and public expenditure increases (in the economies in which
corruption is widespread, the governments carry out more public expenditure as they cannot
be used effectively and pursuant) and finally the governments appeal more monetizing and
all of this can result in inflation.

Inflation is seen to reduce the level of real wages and minimizing the purchasing power of
money. Inflation leads to income loss due reduction in disposable income. As illustrated in
figure 1 a and b, this effect reduces consumer spending which lowers the demand shifting the
demand curve down leading to a reduction of output.

2.2 The effects of Corruption on Investment and Economic growth

Voyer, Peter A 2004 in his journal on the effects of corruption on the Japanese Foreign Direct
Investment suggested that in emerging nations, where comprehensive legal and regulatory
frameworks do not exists to effectively curtail fraudulent activity, corruption serves to reduce
FDI. This suggestion was reiterated by Mauro, P 1995 where his study indicated that a one
standard deviation increase in the corruption index is associated with a 4% point decrease in
annual growth rate per capita GDP.

The effect of corruption on investment is clearly articulated by the rating agencies which are
firms that rate debtors ability to make interest payments. As an example in recent times in
South Africa, we have seen Standard & Poor (S&P) and Fitch downgrading South Africas
investment grade to Junk status. S&P pointed to the political divisions and corruption as the
reason for the downgrades fearing that this could weigh in on investor confidence and
exchange rates and potentially drive increases in real interest rates.

We know from basic macroeconomics that a decrease in the supply of money will increase
interest rates and make the cost of borrowing very high. From government perspective, cost
of borrowing raises because investors seek high protection due perceived risk of investment
and decrease in purchasing power of money to be repaid in the future. As can be seen, the
junk status has adverse effects on fundability of a countrys economy as certain large investors
are prohibited in most cases by policy to invest in economies labelled as Junk. Figure 1 and b,
provide an illustration of how low FDI reduces the demand and shift the demand curve down
leading to a reduction of output.

On the other hand it can be argued that the inability to borrow foreign printed money can
boost local production and create real jobs. Most African countries are rich in minerals, raw
materials and high unemployed labour that can force self-sufficiency.

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2.3 The effects of Corruption on Government spending

In most developing countries, taxes, donations and FDI are the most common channels of
income for the government. Using data from the World Values Survey and TI, Eric Uslaner
showed that high levels of perceived corruption are associated with high levels of tax evasion.
Thus, one indirect impact of corruption is to persuade people that it is acceptable not to pay
taxes because government has been captured by corrupt ofcials and those who support
them. Thus, in corrupt governments, individual projects are excessively expensive and
unproductive.

As described above, low taxes imply low government income which negatively affect
government expenditure on essential government programs in a long run. We have also seen
in section 2.2 that high interest rates lead to escalation in the cost of borrowing. This in turn
will reduce government income as govern is indebted to pay high interest rate payment. The
ripple effect is that government spending will reduce in a long run. As can be seen in figure 1
a and b, and similarly to section 2.2, a decrease in government spending shifts the demand
curve down leading to a reduction in output.

In providing public good, bureaucrat set optimal bribe prices at which to approve applications
from service providers. The bribe can be taken as tax and increases the price of goods and
services which know affect demand and supply economics. Although govern spending would
have been carried out, the efficiency of the spending important services would not have been
achieved.

Figure 1. Equilibrium in goods market and moments of GDP from short run to long run.
Demand, Z & Production Y

Production
Production

Demand
Demand

Ye Y1 Y2

a. Equilibrium in goods market b. Effects of decrease in GDP components

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3. Effects of low output, high prices (on GDP) that leads Unemployment

We have seen in the essay that corruption can cause inflation which a consistent raise of the
prices of goods and services. Considering figure 2 below, it can been seen that this increase
in prices of goods and services reduces real wages thus leading to the price setting line shifting
down. As can be seen below, this downward shift lead to the natural unemployment rate
moving to the right from U1 to U2 .

Figure 2. Effect of prices and real wages and employment.

Real Wages, W/P

Price setting 1

Price setting 2

Wage setting

U1 U2 Natural unemployment rate

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4. Conclusions

Ghalwash, T. (2014) established that corruption increases inefficiencies in government

expenditure and reduces investment and human capital, leading to a negative impact on
output and employment. In Nigeria, for example, Shehu Usman Rano Aliyu., & Akanni Oludele
Elijah. (2008) discovered that about 20% of the increase in government capital expenditure
ends up in private pockets which renders government expenditure ineffective and
unproductive. Figure 2a and 2b below provide a view of how the economic growth is affected
by ineffective government expenditure.

Mo, P in his Journal of comparative economics.2001 found out that a 1% increase in the
corruption level reduces the growth rate by about 0.72 %. The author deduce that the most
important channel through which corruption affects economic growth is political instability.
This further reduce the level of human capital which is key to productivity. Low levels of
productivity negatively affect employment and there it is the duty of each country to improve
productivity by rooting out corruption which will ensure that more resources are available for
important priorities such as tax relief and spending on public programmes like health care,
education, and social services.

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5. References
1. Mauro, P. (1995). Corruption and Growth. Quarterly Journal of Economics, 110, 681-712.
2. Shehu Usman Rano Aliyu., & Akanni Oludele Elijah. (2008). Corruption and Economic
Growth in Nigeria:
3. Ghalwash, T. (2014). Corruption and Economic Growth: Evidence from Egypt. Modern
Economy, 5, 1001-1009.
4. Mankiw N.G, and Taylor M.P (2014). Macroeconomics : South African Edition
5. Voyer, Peter A 2004. Journal of Business Ethics. Effects of Corruption on Japanese Foreign
Direct Investment, Volume 50, Issue 3, pp 211 224.
6. Mo, P. 2001. Journal of comparative economics. Corruption and Economic Growth,
Volume 29, issue 1, pp 66 79.
7. AL-Marhubi, F.A 2000. Corruption and Inflation, Economic letters, 66. Pp 199 -202.

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