Slides3 - Corruption and Efficiency

PhD Course: Development Economics – Macro Aspects Chapter 3.
Corruption and Efficiency
Corruption and Efficiency

Toke Aidt, 2003, Economic analysis of corruption, Economic Journal 113, F632-F651.
Shleifer, A. and Vishny, R.W., 1993, Corruption, Quarterly Journal of Economics 108,
599–617.
Empirical material from: Daniel Kaufmann and Aart Kraay, 2002, Growth without Governance,
Economia 3, 169-215.
Economic analysis of state behavior (public governance) is multi-dimensional

I Policy design → Public Economics
I Politico-economic issue → IPE
I Political institution building, Political power struggle → Social Econ
I Protection of (property-) rights and civil liberties
I (Non-) Efficiency of the bureaucracy.
Here: on one aspect of the last item: corruption.

Def. corruption:
1 The use of public office for private gains.
2 An act in which the power of public office is used for personal gain in a manner
that contravenes the rules of the game.
Compare
gift-giving ,lobbying, campaign contributions, bribery
Professor Dr. Holger Strulik 1 / 28
PhD Course: Development Economics – Macro Aspects Chapter 3. Corruption and Efficiency
3 Conditions for corruption to arise and persist:

1 Public officials must possess the authority to administer (or design) regulations in
discretionary manner.
2 This allows the extraction of rents.
3 Institutions are weak: there is some (high) probability to get away with illegal
actions.
Some activities:
issue of licences, permits, import quotas, passports etc.
block of entry of new firms
granting of subsidies, credits, tax exemptions, tax evasion etc.
allocation of real estate, contracts etc.
discretionary application of socially desirable regulations (e.g. public health and the
environment.
Is corruption harmful for economic development? (The reporter and the Italian official)

Top countries
Professor Dr. Holger Strulik

Country 2005 CPI
10: not corrupt
Index from 0-10
Rank Country/territory Score*

0: absolute corrupt
1 Iceland 9.7
2 Finland 9.6
New Zealand 9.6
4 Denmark 9.5
5 Singapore 9.4
6 Sweden 9.2
7 Switzerland 9.1
8 Norway 8.9
PhD Course: Development Economics – Macro Aspects
9 Australia 8.8
10 Austria 8.7
11 Netherlands 8.6
United Kingdom 8.6
13 Luxembourg 8.5
14 Canada 8.4
15 Hong Kong 8.3
16 Germany 8.2
Transparency International: Corruption Perception Index 2005.
17 USA 7.6
Chapter 3. Corruption and Efficiency
18 France 7.5
19 Belgium 7.4
Ireland 7.4
3 / 28
137 Azerbaijan 2.2
Cameroon 2.2
Ethiopia 2.2
Professor Dr. Holger Strulik

Indonesia 2.2
Iraq 2.2
Liberia 2.2
Uzbekistan 2.2
144 Congo, Democratic
Republic 2.1
Kenya 2.1
Pakistan 2.1
PhD Course: Development Economics – Macro Aspects
And bottom countries (Average: 5.0: Italy)
Paraguay 2.1
Somalia 2.1
Sudan 2.1
Tajikistan 2.1
151 Angola 2.0
152 Cote dÍvoire 1.9
Equatorial Guinea 1.9
Nigeria 1.9
Chapter 3. Corruption and Efficiency
155 Haiti 1.8

Myanmar 1.8
Turkmenistan 1.8
158 Bangladesh 1.7
Chad 1.7
4 / 28
Governance indicator Rule of law
y = 0.6851x - 5.3668
2.0 R2 = 0.6889
1.5
CHL
1.0
BHS
BLZ
CRI URY
0.5 TTO
GUY ARG
0.0 DOM
5.5 6 6.5 7 7.5 8 PAN BRA
8.5 9 9.5
BOL JAM MEX
-0.5 PER
SUR
SLV
NIC PRY ECU COL VEN
-1.0 HND GTM
-1.5 HTI
-2.0
ln(Real per capita GDP at PPP, 1995)
Indicators for: violent and non-violent crime, effectiveness and incidence of the judiciary,
enforceability of contracts.
Governance indicator Control of corruption
y = 0.6482x - 5.106
2.0
R2 = 0.5963
1.5 CHL
1.0
CRI
URY BHS
0.5 BLZ TTO
SUR
0.0 PER
JAM BRA
5.5 6 6.5 7 7.5 DOM8 8.5 9 9.5
SLV MEX
ARG
GUY COL
PAN
-0.5 VEN
HND BOL GTM
HTI NIC
-1.0 PRY ECU
-1.5
Indicators for “the frequency of having to make additional payments to get things done”,
effects of corruption on the business environment, political corruption
Governance indicator Government effectiveness
2.0 y = 0.6815x - 5.3762

R2 = 0.6666
1.5
CHL BHS
1.0
CRI
0.5 BLZ URY TTO
MEX
ARG
GUY R
0.0
5.5 6 6.5 7 7.5 SLVDOM
JAM8 PAN BRA
8.5 9 9.5
PER COL
-0.5 HND BOL GTM
NIC VEN
-1.0 ECU
HTI PRY
-1.5
-2.0
-2.5
Indicators for quality of the bureaucracy, bureaucratic delays, competence of civil

servants, credibility of government’s commitments to policy.
T A B L E 3 . Regression Resultsa
Regressor OLS IV First-stage
Intercept 7.867 7.845 2.445
(0.051) (0.058) (0.284)
Governance (rule of law) 0.999 1.370
(0.055) (0.095)
Imputed settler mortality –0.547
(0.064)
Standard deviation (residual) 0.630 0.820 0.741
Summary statistic
No. observations 153 153 153
R2 0.69 0.69 0.37
a. This table summarizes the results of estimating equation 4 by OLS and IV (columns 1 and 2) and the corresponding first-stage
regression (column 3). The dependent variable in the OLS and IV estimations is ln(per capita GDP); in the first-stage regression it is gov-
ernance. Standard errors are in parentheses.
T A B L E 4 . Regression Results Using Other Dimensions of Governancea

Regressor OLS IV No. observations
Voice and accountability 0.806 1.495 158
(0.074) (0.151)
Political stability 0.951 1.546 146
(0.068) (0.156)
Government effectiveness 0.978 1.389 144
(0.058) (0.121)
Regulatory quality 0.966 2.242 152
(0.084) (0.301)
Control of corruption 0.920 1.412 145
(0.063) (0.139)
a. This table summarizes the results of estimating equation 4 by OLS and IV for five other dimensions of governance. For reasons of
space, only the estimated slope coefficients and the number of observations are reported. The dependent variable is ln(per capita GDP).
Standard errors are in parentheses.
Why is corruption harmful?
An alternative view: Efficient corruption (Greasing the wheels):

corruption facilitates economic exchange that would otherwise not be possible.
It corrects pre-existing government failure.
It increases economic efficiency.
“In terms of economic growth the only thing worse than a society with a rigid, over centralized,
dishonest bureaucracy is one with a rigid, over centralized, honest bureaucracy.” (Samuel
Huntington, 1968).
Speed money.
“Bidding” for government contract selects the most efficient (lowest cost) firm.
The queuing model (Lui, 1985).
What’s wrong with this view?

Collection of bribes is mainly hierarchical and decentralized.
An Indian official to his friend: “If you want me to move a file faster I am not sure if I can
help you; but if you want to stop a file I can do it immediately”.

Competition over government services wastes resources (rent-seeking literature).

Misallocation of talent. In Chile and Uruguay enterprise managers spend 10% of
their time with public officials. In Russia and Ukraine they spend 40%.
The most powerful bidder/briber is frequently not interested in efficient
solutions. → IPE.
Bribe vs. Tax. Bribes are not collected by the treasury but privately (and siphoned
out of the country).
Illegal contracts between briber and bribee are not enforceable. → back to the
Insecure-Property-Rights theme.
(Noriega: “You cannot buy me. You can only rent me.”)
And most importantly:

The government failure that is supposed to be corrected by corruption may in fact
be in place and maintained because of its corruption potential.
→ Abandon the Efficient Corruption view. Take the Principal-Agent View. This comes
in 2 variants:
good principal - bad agent
bad principal - bad agent
Corruption with a benevolent principal.

Idea:
The agent, i.e. the bureaucrat is corruptible.
Yet, the principal, i.e. the policymaker, the designer of institutions, is benevolent.
How can corruption under optimally designed institutions persist?
A simple model of tax collection. 3 actors:

a tax authority (principal)
a tax collector (agent)
a firm liable to pay taxes on profits (for simplicity 100 %).
The setup:
The firm can bribe the collector to report: no profits.
Corrupt acts are discovered with prob. p.
Discovery results in
I dismissal of collector & penalty f
I penalty g for firm.
Collector’s wage: w . Reservation wage: w0 .

A fraction γ of tax collectors is honest.
Transaction costs (required by secrecy): collector gets fraction k of the bribe.
Suppose profits before inspection π > 0. Expected profits:

π − p · g.
Suppose the collector has all bargaining power. Extracted bribe:
b = max (k(π − pg ), 0) . (1)
The collector will not accept the bribe if

(1 − p)(w + b) + p(w0 − f ) ≤ w
i.e. if
(1 − p)b + p(w0 − w − f ) ≤ 0. (2)
The policymaker controls:

the wage for civil servants w
the monitoring system p
legal remedies: f , g .
Efficiency wages: offer high enough w = w e so that corruption (just) does not pay:
(1 − p)b + p(w0 − f ) = pw e .
Thus:
1−p
we = b + w0 − f . (3)
p
Observe:
Small mark-up on private sector wage w0 if the monitoring system is good (i.e. p is
high)
Yet, expect high wage costs if p is low.
⇒ an alternative, cost-saving incentive scheme (for poor LDCs):

Offer wages so low that only corrupt individuals would like to be tax collector
(w = 0).
Collect revenue when corruption is detected.
Besley and McLaren (1993) show: this may generate higher net tax revenues then
the efficiency wage system.
Institutional controls:
Better monitoring / auditing / reporting system: p ↑ → we ↓
Problem: what if the monitoring agents are themselves corruptible? → later

Legal remedies:
f ↑ or g ↑ → gain from corruption ↓ .
In the example: for f = b no corruption for
(1 − 2p)b + p(w0 − w ) ≤ 0
i.e. with private-sector wages no corruption for p > 1/2.
Problem: actually, optimal penalties are hard to design (avoid that punishment is
concave in b).
Optimal policy choice.

Simplest case: p = f = g = w0 = 0.
Design w and tax t so that social welfare is maximized.
Social welfare function:
up = (t − w ) + α(uf + ut )
uf : welfare of firm (-owner), ut : welfare of tax collector
α < 1: weight.
(
π−t if π > 0
uf =
−at if π = 0
a > 1, i.e. taxation harms firms more when there are no retained profits.
A fraction h of firms earns positive profits.

Social welfare without tax collector (gov. does not observe the value of π):
t + α [h · (π − t) + (1 − h) · (−at)]
Suppose: the derivative with respect to t is negative (for all t),
1 − αh
1 − αh − αa(1 − h) < 0 ⇒ < a.
α(1 − h)
Thus, the harm of taxing profitless firms is sufficiently large. → A tax collector is
really needed to report π.
Suppose the collector observes a noisy signal:

if the firm makes positive profits, the collector observes this correctly with prob.
i.e. with 1 − he wrongly observes π = 0.
He always correctly observes if the firm makes no profits.
Social welfare if the gov. could observe the signal directly:
up = · h · π + α · uf · h = h [π + α { · 0 + (1 − ) · π}] = h [απ + (1 − α) · · π]

Yet, the gov. needs the collector to report the signal and the guy is corruptible with
prob. (1 − γ).
An incentive contract that eliminates all corruption:
w = 0 for a report that the firm earns no profits.
w = kπ = b for a report that it does.
Implied social welfare:
u NC = h · (t − w ) + α [ut + (1 − )π] = h(1 − k)π + α [kπ + (1 − )π] h

= h [π + α(1 − )π − kπ + αkπ] = up − (1 − α)kπh.
Thus,
corruption is eliminated
but the fact that it could happen is enough to reduce social welfare.
Now, compare with tolerated corruption:

w = w0 = 0 irrespective of report.
All corruptible collectors misreport. They get kπ from firms with π > 0.
Incorruptible collectors report correctly.

Social welfare:
u C = γ · t + α [(1 − γ)kπ + (1 − )π] h
= πh − (1 − γ)πh + α [(1 − γ)kπ + (1 − )π] h = up − (1 − γ)(1 − kα)πh.
Social loss because of

transaction costs
collectors smaller welfare weight
(no loss for k = α = 1).
Compare lower transaction costs k ↑ lead to
u C ↑ (less deadweight loss):
u NC ↓ (higher efficiency wages needed to prevent corruption).
And u NC = U C for:
(1 − α)kπh = (1 − γ)(1 − kα)πh
(1 − α)k = (1 − γ) − (1 − γ)αk
i.e.
1−γ
[1 − α + α − γα] k = 1 − γ ⇒ k = k∗ = .
1 − αγ
[Insert: Welfare with and without corruption]

Observe:
k ∗ is high n societies with a large share of corruptible people (low γ)
i.e. zero tolerance against corruption is optimal when people are (inherently)
corrupt.
Yet, if only a few are corrupt tolerating corruption is optimal.
This seems somewhat counter-intuitive. Something is missing.

γ is not a given constant.
social interaction
multi-level corruption.
Self-enforcing equilibria: reward of corruption depends on how many others are corrupt.
Possible channels:
1 Social osmosis (Sah, 1991): people continue to be corrupt if they have interacted
with a sufficient number of corrupt people in the past.
2 Collective reputation (Tirole, 1996): honesty can only be observed imperfectly. It

does not pay off to be honest if the group to which one belongs has the reputation
to be corrupt.
3 Allocation of talent (Acemoglu, 1995): rent-seekers ask for bribes not to block the
activities of entrepreneurs. Cost of entrepreneurs is the higher the more rent-
seekers are around. If many are engaged in rent-seeking the incentive to be honest
entrepreneur is low (the parasites mechanism again).
4 Multilevel corruption.
We consider only the last item. Suppose:

The collector is monitored.
He is fired if caught be a non-corrupt auditor.
If caught by a corrupt auditor he passes the bribe.
In both subpopulations the fraction (1 − γ) is corrupt.
Yet, (1 − γ) is now a variable.
For that purpose: individual heterogeneity.
( “In the end everybody is corruptible. It’s just a matter of price.”)

Suppose the (moral) costs c of withholding information are distributed according to a

distribution function F (c).
[Insert: Cost of being corrupt]

For bribable individuals: expected payoff of accepting a bribe > w i.e.
(1 − p)(w + b) + p [(1 − γ)w + γ · 0] − c > w (4)
i.e.
w [−p + p − γp] + (1 − p)b > c ⇒ (1 − p)b − γpw > c.
In social equilibrium:
1 − γ = F [(1 − p)b − γpw ] .
Observe the possibility of multiple equilibria:
For low γ: γ ↓ → more officials are corrupt → prob. to get caught by honest
auditor ↓ → incentive to accept to bribes ↑ → γ ↓
For high γ: γ ↑ → less officials are corrupt → prob. to get caught by honest
auditor ↑ → incentive to accept to bribes ↓ → γ ↑ .
To see this better write

F (c) = F [(1 − p)b − γpw ] = F [(1 − p)b + (1 − γ)pw − pw ] .
[Insert: Multiple equilibria of corruption]

Observe:
Self-enforcing equilibria
History-dependence
Small improvements of institutions (p ↑ , w ↑ ) reduce corruption a little.
A large-scale reform is needed to eliminate the bad equilibrium and converge to the
good one.
A big bush of improvement of institutions (e.g. Hongkong, Singapore).
Yet, there is one serious further problem:

Reforms have to initiated by politicians.
They may themselves be corrupt.
They may be economic / political losers of a fight against corruption.
Status quo bias.
Corruption with non-benevolent principals.

Idea:
Economic policies / institutions are implemented / maintained not to eliminated
market failures but to create corruption opportunities.
Model:
A government official controls entry into an economic activity by issuing licences.
no market distortions (i.e. there is no need for licences)
number of licences: λ
b(λ) economic value of a licence for an entrepreneur.
b 0 (λ) < 0, b(λH ) = 0.
λH : number of firms under free competition
Bribe-revenue maximization:
max B = λ · b(λ).
λ
FOC:
b(λ)
b(λ) + λb 0 (λ) = 0 ⇒ λ = λL ≡ −
b 0 (λ)

The IO of corruption.
Frequently entrepreneurs need several licences to set up a firm.
Suppose the need just 2.
The 2 licences are complements, e.g.
I one for serving food
I another one for serving alcoholic beverages.
i.e.
∂bi
> 0, i, j = 1, 2.
∂λj
1. Case: both licences are issued by the same official. He maximizes
max λ1 b1 (λ1 , λ2 ) + λ2 b2 (λ1 , λ2 ).

λ1 ,λ2
FOCs
∂b1 ∂b2
b1 + λ1 + λ2 =0
∂λ1 ∂λ1
and a similar one for λ2 .
Case 2: The licences are issued by 2 independent authorities. Official 1 maximizes

B1 = b1 λ and follows the FOC:
∂b1
b1 + λ1 = 0.
∂λ1
Official 2 acts symmetrically.
Observe
Officials do not take into account the increase of value of the other licence when a
licence is issued.
They supply too few licences (compared to the monopoly).
For efficiency reasons it’s better to have bureaucracy monopolized.
The entrepreneurs are better off under a licence monopoly.
Both officials are also better off. Under oligopoly they drive quantity so far down
that total revenues are lower.
The example was from Shleifer and Vishny (1993). They further argue:
Russia under communism succeeded in monopolizing bribery.
This way it was more efficient than today and than many other LDCs.
E.g. India today: if you take a road between 2 cities you have to pay a bribe/toll in
every village.
Uncertainty aggravates the problem: just after having paid 2 bribes one learns that
there is a 3rd to be paid,...
Yet, why call SV this activity corruption?

The point is that the cost of providing the good is 0 and bribe revenue does not
enter the treasury (unless ruler = bribe recipient).
Suppose there is indeed a cost of providing the government service.
And marginal cost = fee = p.
SV distinguish corruption
I without theft
I with theft
Corruption without theft: the official maximizes

max b(λ)λ − pλ
λ
FOC
b0 λ + b = p
i.e. MR = MC. The bribe operates like a revenue maximizing tax. Only, the tax
collection does not enter the treasury.
[Insert: Corruption without theft]

Now consider corruption with theft: the official keeps the bribe and the fee.
[Insert: Corruption with theft]

i.e. back to our original example where the FOC was
b0 λ + b = 0
Conclude:
with theft: lower price and higher supply.
bribers/entrepreneurs will find corruption with theft more attractive.
the likelihood to be detected is smaller with theft.
incentive for corruption with theft for everybody is higher.
→ first priority for honest policymakers: reduce corruption with theft.

The problem of hierarchical structures.

Suppose one have to buy a licence to become a licence seller.
And then a licence to become a seller of licences for licence sellers....
The licence at the bottom has to finance a chain of jobs.
Suppose 2-level hierarchy (politician vs bureaucrat).

In the absence of incentives the bureaucrat at the bottom set λL .
Suppose the politician can
I observe λ
I raise taxes to finance the bureaucrats wage.
i.e. he has the power to design an incentive contract.
⇒ A non-corrupt politician will pay w = B(λL ) and ask the bureaucrat to issue λH
licences.
⇒ Yet, the corrupt politician will do nothing and asks to share the bribe.

Does democracy help?

A theoretical argument. Suppose
corrupt officials can be kicked out of office.
median voter prefers λH .
election every period. Infinite time horizon, discount factor β.
voters ask the politician to issue λ̄ if he wants to get re-elected.
Payoff of honesty:
∞
X 1
β t λ̄b(λ̄) = λb(λ̄).
t=0
1−β
Payoff of corruption:
λL b(λL ).
λ̄ should make the politician just indifferent:

1
λL b(λL ) = λb(λ̄)
1−β
i.e. λ̄ ∈ (λL , λH ) and β ↓ → λ̄ ↓ .

Even if corruption is perfectly visible: λ̄ < λH .
Intuition: no incentive to be re-elected with zero-tolerance rule.

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PhD Course: Development Economics – Macro Aspects Chapter 3.

Corruption and Efficiency

Corruption and Efficiency

Economic analysis of state behavior (public governance) is multi-dimensional

I (Non-) Efficiency of the bureaucracy.

Here: on one aspect of the last item: corruption.

3 Conditions for corruption to arise and persist:

Professor Dr. Holger Strulik 2 / 28

Professor Dr. Holger Strulik

Rank Country/territory Score*

Professor Dr. Holger Strulik

And bottom countries (Average: 5.0: Italy)

155 Haiti 1.8

Governance indicator Rule of law

ln(Real per capita GDP at PPP, 1995)

Governance indicator Control of corruption

ln(Real per capita GDP at PPP, 1995)

Governance indicator Government effectiveness

2.0 y = 0.6815x - 5.3762

ln(Real per capita GDP at PPP, 1995)

Indicators for quality of the bureaucracy, bureaucratic delays, competence of civil

T A B L E 4 . Regression Results Using Other Dimensions of Governancea

Why is corruption harmful?

An alternative view: Efficient corruption (Greasing the wheels):

What’s wrong with this view?

Professor Dr. Holger Strulik 9 / 28

Competition over government services wastes resources (rent-seeking literature).

And most importantly:

Corruption with a benevolent principal.

A simple model of tax collection. 3 actors:

I penalty g for firm.

Collector’s wage: w . Reservation wage: w0 .

Suppose profits before inspection π > 0. Expected profits:

b = max (k(π − pg ), 0) . (1)

The collector will not accept the bribe if

The policymaker controls:

⇒ an alternative, cost-saving incentive scheme (for poor LDCs):

Professor Dr. Holger Strulik 13 / 28

Optimal policy choice.

A fraction h of firms earns positive profits.

Suppose: the derivative with respect to t is negative (for all t),

Suppose the collector observes a noisy signal:

Social welfare if the gov. could observe the signal directly:

up =  · h · π + α · uf · h = h [π + α { · 0 + (1 − ) · π}] = h [απ + (1 − α) ·  · π]

Professor Dr. Holger Strulik 15 / 28

u NC = h · (t − w ) + α [ut + (1 − )π] = h(1 − k)π + α [kπ + (1 − )π] h

Now, compare with tolerated corruption:

Professor Dr. Holger Strulik 16 / 28

Social loss because of

[Insert: Welfare with and without corruption]

This seems somewhat counter-intuitive. Something is missing.

2 Collective reputation (Tirole, 1996): honesty can only be observed imperfectly. It

We consider only the last item. Suppose:

( “In the end everybody is corruptible. It’s just a matter of price.”)

Professor Dr. Holger Strulik 19 / 28

Suppose the (moral) costs c of withholding information are distributed according to a

[Insert: Cost of being corrupt]

(1 − p)(w + b) + p [(1 − γ)w + γ · 0] − c > w (4)

To see this better write

[Insert: Multiple equilibria of corruption]

Yet, there is one serious further problem:

Corruption with non-benevolent principals.

up = · h · π + α · uf · h = h [π + α { · 0 + (1 − ) · π}] = h [απ + (1 − α) · · π]

u NC = h · (t − w ) + α [ut + (1 − )π] = h(1 − k)π + α [kπ + (1 − )π] h