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Dr. Gonzalo Forgues-Puccio E-mail: firstname.lastname@example.org (MSc Autumn Term 2011-12)
The Importance of Good Governance Controlling Corruption to Improve Governance Definition and Types of Corruption Measuring Corruption The Economics of Corruption
A simple agency model of corruption A monopoly model of corruption How corruption may corrupt
Fighting Corruption Corruption and Development
The Importance of Good Governance
” Source: World Bank. The World Bank defines governance as “the traditions and institutions by which authority in a country is exercised for the common good. This includes: the process by which those in authority are selected. monitored and replaced. the capacity of the government to effectively manage its resources and implement sound policies. and the respect of citizens and the state for the institutions that govern economic and social interactions among them. http://go.worldbank.org/MKOGR258V0 (permanent link) 4 .
Hall and Jones (1999) find that differences in what they define as “social infrastructure” (institutions and government policies that determine the environment within which economic agents operate – proxy for governance) are essential in explaining differences in income per capita. For example. To many economists the gap between rich and poor nations can be explained by the economic environment in which their citizens operate. 5 .
Source: Global Monitoring Report 2006 6 .
including political violence and terrorism. freedom of association. as well as freedom of expression. quality of policy formulation and implementation. and free media. quality of civil service and degree of its independence from political pressures. and credibility of the government’s commitment to such policies. 7 . Political stability and absence of violence: perceptions of the likelihood that the government will be destabilized or overthrown by unconstitutional or violent means. Government effectiveness: quality of public services.Governance can be measured using six dimensions (World Bank Governance Indicators): Voice and accountability: extent to which a country’s citizens are able to participate in selecting their government.
as well as “capture” of the state by elites and private interests. Control of corruption: extent to which public power is exercised for private gain. Regulatory quality: ability of the government to formulate and implement sound policies and regulations that permit and promote private sector development. Rule of law: extent to which agents have confidence in and abide by the rules of society. including both petty and grand forms of corruption. as well as the likelihood of crime and violence. the police. and the courts. and in particular the quality of contract enforcement. 8 .
Controlling Corruption to Improve Governance 9 .
2011 Worldwide Governance Indicators 10 .Source: World Bank.
2011 Worldwide Governance Indicators .11 Source: World Bank.
According to the World Bank public sector corruption is one of the greatest obstacles to economic and social development. This view is supported by a large number of empirical analyses that find a significant negative relationship between corruption and development. 12 . There are many channels through which corruption affect the progress of nations.
g.g. Mahagaonkar.g..Gupta et al.. disincentives innovation (e.g.g. 2002)....Some of the most important findings to date demonstrate that corruption: reduces investment (e. 2000) 13 . Tanzi and Davoodi 1997). Wei. and reduces foreign investment (e. Mauro. 2008) distorts public expenditure decisions (e.. 1995). causes higher inequality (e.
Definition and Types of Corruption 14 .
15 . Not because corruption is absent in the private sector. Most definitions based on public sector corruption. sociologists and political scientists about definition of corruption. Large debate between economists. Rather because the public sector has the ability to distribute benefits and impose costs on members of a society.
or unauthorised. Generally speaking. acts on the part of public officials who abuse their positions of authority to make personal gains. public sector corruption refers to illegal. Examples of corruption are: Bribery Embezzlement Fraud Nepotism 16 . A very popular definition is due to Bardhan (1997) who defines corruption as the “use of public office for private gain”.
Political corruption sometimes is hard to detect given that normally there is no explicit bribe involved. Political or “Grand” Corruption: The political elite can design or change public policies for their own benefit at the expense of the populace. 17 . Bribes take the form of very well paid executive positions in the private sector. etc. expensive holidays.Broadly speaking there are two types of corruption: Bureaucratic or “Petty” Corruption: Subordinate public officials use authority transferred to them by the government to either extract bribes from the private sector or to embezzle public funds (or even commit fraud). properties abroad.
Can we measure corruption? 18 .
Only objective and measurable information available: cases of unlucky bureaucrats discovered and convicted for engaging in corrupt deals. Corruption is very difficult to quantify due to the intrinsic secrecy of illegal acts. They have failed because there are some obvious problems with this approach: 19 . There have been some unsuccessful efforts to use this objective measure of corruption in empirical analyses.
Second. and most fundamentally. Given these problems. we end up measuring other factors like the quality of policing or the judiciary instead of the level of corruption. we only have information about the fraction of corruption that is exposed and not about the aggregate level of corruption. First. 20 . there is an increasing consensus that “perceptions” are perhaps the best way to measure corruption.
citizens and experts in industrial and developing countries.public availability. In spite of their differences they are highly correlated with each other. These indices are based on surveys about corruption perceptions of entrepreneurs. Recently many “Corruption Indices” have been developed due to globalisation and an increase in the demand for anti-corruption policies. The various “Corruption Indices” differ from each other in three fundamental ways . 21 . methodology and country coverage.
The most widely used “Corruption Indices” are: The Transparency International Corruption Perception Index The Control of Corruption Index (part of the World Bank’s Governance Indicators) The Corruption Index of the International Country Risk Guide (ICRG). 22 . published by Political Risk Services Inc.
The Economics of Corruption 23 .
tax collection or policy design) may profit from his position in the knowledge that he cannot be perfectly monitored by the principal. Corruption arises naturally in the public sector due to transfer of responsibility and imperfect monitoring. and between the populace and the political elite. 24 . This generates a principal-agent relationship between the government and its bureaucracy. An agent responsible for certain tasks (e.g..
A simple agency model of corruption 25 .
• Assume that tax collection is delegated to a tax official (agent) responsible to investigate if a firm has tax liabilities.• Let’s consider the classical example of corruption in tax collection. • Firms are only liable to pay taxes if > 0. • Firms in some countries can bribe a corrupt tax official to declare a lower profit in order to avoid or reduce taxation. 26 .
p. 27 . is the probability of succeeding in corruption. the government (the principal) discovers corrupt acts with probability (1-p).• Firms tax liability is where . he has to pay the penalty • In the same manner the firm that is discovered engaging in tax evasion pays the penalty . In addition. Hence. • We assume that. • Corruption exposure results in the dismissal of the tax collector involved.
28 . We assume that a fraction are corruptible and are honest. • All parties are risk neutral.• The tax collector earns the wage. possible because of internalised moral costs. in the private sector. w. • Some tax collectors are more honest than others. and can get the wage.
• What happens if the tax collector is corruptible? Answer: two possibilities… 29 .• What happens if an honest tax collector finds out that a firm is liable for taxation? Answer: The firm pays taxes in full.
p bribe Caught with prob (1-p) not to bribe .Decision Tree for the Firm Succeeds with prob.
is less than the expected savings in taxes.• The firm has the incentive to offer a bribe provided that the expected profit of engaging in corruption is greater than the expected profit of being honest: • Simplifying: • Intuitively. a firm is willing to engage in corruption if the bribe plus the expected penalty from corruption. 31 .
We model this in terms of the cost function: . p to be corrupt w + b .Decision Tree for a Potentially Corrupt Agent Succeeds with prob.β(b)* w0 Caught with prob (1-p) not to be corrupt -f w * The need for secrecy imply high transaction costs.
a corruptible bureaucrat is willing to accept a bribe. 33 .• A corruptible tax collector has the incentive to engage in corruption if the expected income of engaging in corruption is greater than the expected income of being honest: • Simplifying: • Intuitively. if the expected benefit from corruption is higher than the expected cost.
f and g.• The incidence of corruption in this model is a function of government policies in terms of: • Public sector wages. w • Monitoring. p • And legal punishments. 34 .
1993) 35 .A monopoly model of corruption (Shleifer and Vishny.
p. A stylised equation holds: CORRUPTION = MONOPOLY + DISCRETION .The Basic Ingredients of Corruption Illicit behaviour flourishes when agents have monopoly power over clients. and when accountability of agents to the principal is weak.ACCOUNTABILITY Source: Klitgaard (1991. when agents have great discretion. 75) 36 .
Assumptions: There is only one governmental good (e. We assume that this good is homogeneous and that there is a demand curve for this good D(P). a passport or a license). This good is sold by a public official who can restrict the quantity of the good (official has monopoly power).g. 37 . No risk of detection. The official price of this good is P.
asks for a bribe on top of the price. marginal cost in this case is zero. to the government. However.The cost of producing the good is immaterial to the public servant. what is the marginal cost to the official of providing this good? Two cases: Corruption without theft . P . But. 38 .the official actually turns over the official price of the good. The marginal cost to the bureaucrat in this case is P. Corruption with theft – the official does not turn over anything to the government. Hence. Sells the good in exchange for a bribe that is below P.
Corruption without theft P P + Bribe D(P) P MR Qc Source: Shleifer and Vishny (1993) 39 Q* Q .
Corruption with theft P D(P) P Bribe MR Q* Source: Shleifer and Vishny (1993) Qc Q 40 .
In this case. the way in which these agencies organize for the provision of goods is a key determinant of the impact of corruption on the economy. an agent needs several complementary governmental goods supplied by various officials with monopoly power on the goods that they provide. l 41 .l Sometimes.
In contrast. if bureaucrats act as a joint monopoly. internalising negative externalities. then they will set the value of bribes in such a way as to maximise their aggregate bribe revenue. then each of them will set their own bribes by maximising their individual bribe revenue ignoring the effects on the provision of other governmental goods and the bribe taking capacity of other bureaucrats.l If bureaucrats act as independent monopolists. l 42 .
competition would eventually bring bribes to zero. decentralised (or competitive) corruption may be less harmful than centralised (or monopolistic) corruption. If instead. each governmental good was provided by several public officials. In this case. 43 l l .l The assumption that each of these complementary governmental goods is provided only by a single public official is ruling out the possibility of competition among bureaucrats.
How Corruption may Corrupt 44 .
45 . Many authors have pointed out that significantly different levels of corruption can be observed in countries that have public sectors with similar characteristics. the expected benefit of engaging in a corrupt deal depends on the incidence of corruption. A plausible explanation attributed to Andvig (1991) is that corruption may corrupt. In most developed countries in spite of the low probability of being caught and sporadic monitoring the great majority of officials are honest. In other words.
Source: Andvig et al (2000 ) . • The vertical axis measures the official’s payoffs.How corruption may corrupt • The horizontal axis measures the number of corrupt officials.
social sanctions are low and an official that is caught can always pay a bribe to avoid legal sanctions. 47 . Conversely. if corruption is widespread. The decreasing curve depicts all the possible combinations of payoffs and incidence of corruption than an honest official can have. In relatively transparent societies corruption is highly condemned and the legal sanctions are severe. It is intentionally drawn to show a negative relationship.
48 . where it becomes decreasing. The inverted-U shape curve depicts all the possible combinations of payoffs and incidence of corruption for a corrupt official. As the incidence of corruption increases the cost of incurring in corrupt practices decreases in term of legal and social sanctions. However. beyond a certain point corrupt officials start to proliferate and then we observe an excess supply of corrupt favours and lower payoffs. This curve initially increases until the turning point D.
the payoffs for being honest have turned negative so all the officials choose to be corrupt. 49 . If we define equilibrium as a situation in which individual actors have no incentives to change their behaviour. At point A. Consequently there are no incentives to move from this point. At point C. the payoffs for being honest are higher than for being corrupt. B and C. we can identify three equilibria in the previous figure: points A.
Therefore. if just one additional official chooses to be honest or corrupt. However. the rest of the agents will choose to move from this point. officials are indifferent between being honest or corrupt. Notice that A and C are stable in the sense that the marginal decisions of an additional official will not affect the outcome. B is an unstable equilibrium. But what about point B? At point B. 50 .
where the payoffs for being honest are higher than the payoffs for being corrupt. For instance. The attractiveness of this simple model is its ability to explain that the level of corruption depends on initial conditions. if an economy is at a point between A and B. if the economy is located at a point between B and C. it will converge to A. where honesty does not pay. 51 . On the contrary. it will converge to C.
Fighting Corruption 52 .
‘Like illness. Corruption involves questions of degree…’ Klitgaard (1991. p. neither should it paralyse efforts to reduce corruption. But as this sad fact does not keep us from attempting to reduce disease. 7) 53 . corruption will always be with us.
Also. Hence. 54 . But. then detection becomes increasingly easier (and cheaper). Hence. then it may be very costly to detect. Let us try to think about a function that relates the marginal social cost of corruption with the total amount of corruption. If corrupt activity is low. if corruption is widespread. let us think about a function that relates the marginal social cost of removing corruption with the total amount of corruption. The very fist unit of corruption may produce modest additional social cost. But as corruption increases each extra unit may bring greater costs to society. we can imagine that the marginal social cost of removing corruption is a decreasing function of the quantity of corruption. the marginal social cost of corruption may be increasing in the quantity of corruption.
p. 26) quantity of corruption 55 .The Optimal Amount of Corruption Marginal Social Cost cost of corruption MSC* cost of removing corruption Q* Source: Klitgaard (1991.
Heterogeneity of Corruption Marginal Social Cost cost of corruption country A cost of corruption country B MSCA MSCB cost of removing corruption country A and B quantity of corruption 56 .
training programs and lending instruments targeted towards reducing corruption. It has since developed a full program of analytic work. The WB has taken the lead in the fight against corruption globally. civil society. The World Bank’s anticorruption strategy The World Bank in 1997 began its anticorruption efforts in Eastern Europe and Central Asia with the design of diagnostic tools. procurement and business. 57 . technical assistance.International Efforts to Fight Corruption Transparency International Transparency International was founded in 1993 and it is a global network including more than 90 locally established national offices. public administration. TI bring together relevant players from government. business and the media to promote transparency in elections.
International Efforts to Fight Corruption (cont.)
OECD Convention on Combating Bribery of Foreign Public Officials in International Business Transactions
The OECD convention entered into force on 15 February 1999 and requires that bribery of foreign public officials be punishable by criminal penalties comparable to those applicable to their own public officials.
United Nations Convention against Corruption
UNCAC’s main objective is to facilitate international cooperation and technical assistance in the prevention and fight against corruption focusing on assets recovery for the affected countries. It came into force in 14 December 2005. So far 140 countries have signed it and 154 countries have ratified it (States Parties).
Corruption and Development
• Corruption varies greatly across countries. Source: Svensson (2005) .The graph illustrates two points: • Richer countries have lower corruption.
The Solow Model with Government We assume a Cobb Douglas production function augmented by government expenditure: In per capita terms: Expenditure in public goods is financed by a lump-sum tax: 62 .
The capital accumulation path is given by: Disposable Income In per capita terms: For simplicity we normalise population equal to 1. Hence (4) becomes: 63 .
Depending on the magnitudes of these two effects the introduction of government into the model increases or decreases the steady state level of capital. the benefits of having a government are greater than the costs in terms of taxation. Generally speaking. Second. In equation (5) we have two new terms: First. 64 . we have government expenditure increasing the productivity of the factors of production. we have taxation reducing disposable income and hence savings and investment.
The Solow Model with Government 65 .
66 .Corruption in the Solow Model Now assume a fraction of taxes is embezzled and taken offshore (or lost to tax evasion). The rest has been lost to corruption. The capital accumulation path in per capita terms is now: Households are still paying the full amount of their taxes but they only get a fraction of their money in terms of public goods and services.
Corruption in the Solow Model 67 .
The Vicious Circle of Corruption and Development Capital Accumulation DEVELOPMENT CORRUPTION Wages (legal income) 68 .
• Svensson. 113 (491).References • Aidt. 2001. J.. A.G. (Ed. Causes and consequences of corruption: What do we know from a cross-section of countries? In: Rose-Ackerman. T. 108. and R. Corruption. Economic Journal. 2003.. J.. Vishny. • Lambsdorff. 1993.S. London (paperback). Controlling Corruption. Journal of Economic Perspectives. 1991.K.). • Jain. R. A. Economic analysis of corruption: a survey. Journal of Economic Surveys. Cheltenham. 71-121. 2005.. 15. University of California Press. 599-617. • Shleifer. International Handbook on the Economics of Corruption. 19-42. 2006. Corruption: a review. 3-51. S. • Klitgaard. Edward Elgar Publishing Limited. Quarterly Journal of Economics.. 69 . 19(3). Eight questions about corruption. F632-F652.