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GROWTH AND DEVELOPMENT Topic 6: Governance, Corruption and Development

Dr. Gonzalo Forgues-Puccio E-mail: gff2@st-andrews.ac.uk (MSc Autumn Term 2011-12)

Lecture Outline
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The Importance of Good Governance Controlling Corruption to Improve Governance Definition and Types of Corruption Measuring Corruption The Economics of Corruption
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A simple agency model of corruption A monopoly model of corruption How corruption may corrupt

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Fighting Corruption Corruption and Development
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The Importance of Good Governance

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the capacity of the government to effectively manage its resources and implement sound policies.worldbank. and the respect of citizens and the state for the institutions that govern economic and social interactions among them. This includes:  the process by which those in authority are selected.”   Source: World Bank.org/MKOGR258V0 (permanent link) 4 . http://go. monitored and replaced. The World Bank defines governance as “the traditions and institutions by which authority in a country is exercised for the common good.

 To many economists the gap between rich and poor nations can be explained by the economic environment in which their citizens operate. For example.  5 . 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.

Source: Global Monitoring Report 2006 6 .

and free media.  Government effectiveness: quality of public services. as well as freedom of expression. quality of civil service and degree of its independence from political pressures.  Political stability and absence of violence: perceptions of the likelihood that the government will be destabilized or overthrown by unconstitutional or violent means. and credibility of the government’s commitment to such policies. freedom of association.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. quality of policy formulation and implementation. including political violence and terrorism. 7 .

including both petty and grand forms of corruption. and the courts. 8 .  Rule of law: extent to which agents have confidence in and abide by the rules of society. the police.  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. as well as the likelihood of crime and violence. and in particular the quality of contract enforcement. as well as “capture” of the state by elites and private interests.

Controlling Corruption to Improve Governance 9 .

2011 Worldwide Governance Indicators 10 .Source: World Bank.

2011 Worldwide Governance Indicators .11 Source: World Bank.

There are many channels through which corruption affect the progress of nations. This view is supported by a large number of empirical analyses that find a significant negative relationship between corruption and development. According to the World Bank public sector corruption is one of the greatest obstacles to economic and social development.   12 .

g. 2002). 2008) distorts public expenditure decisions (e.g. Mauro..Some of the most important findings to date demonstrate that corruption:  reduces investment (e.. causes higher inequality (e. disincentives innovation (e.Gupta et al..g.g.. and reduces foreign investment (e.. 1995). 2000)     13 . Wei. Tanzi and Davoodi 1997).g. Mahagaonkar..

Definition and Types of Corruption 14 .

 Large debate between economists. Rather because the public sector has the ability to distribute benefits and impose costs on members of a society. Most definitions based on public sector corruption.   15 . sociologists and political scientists about definition of corruption. Not because corruption is absent in the private sector.

acts on the part of public officials who abuse their positions of authority to make personal gains.  Examples of corruption are:     Bribery Embezzlement Fraud Nepotism 16 . public sector corruption refers to illegal. Generally speaking. A very popular definition is due to Bardhan (1997) who defines corruption as the “use of public office for private gain”. or unauthorised.

properties abroad. 17 .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).   Political corruption sometimes is hard to detect given that normally there is no explicit bribe involved. etc. expensive holidays. Bribes take the form of very well paid executive positions in the private sector. Political or “Grand” Corruption: The political elite can design or change public policies for their own benefit at the expense of the populace.

Can we measure corruption? 18 .

There have been some unsuccessful efforts to use this objective measure of corruption in empirical analyses. Only objective and measurable information available: cases of unlucky bureaucrats discovered and convicted for engaging in corrupt deals. They have failed because there are some obvious problems with this approach: 19    . Corruption is very difficult to quantify due to the intrinsic secrecy of illegal acts.

there is an increasing consensus that “perceptions” are perhaps the best way to measure corruption. and most fundamentally. we end up measuring other factors like the quality of policing or the judiciary instead of the level of corruption. Second. we only have information about the fraction of corruption that is exposed and not about the aggregate level of corruption. Given these problems. First. 20   .

public availability. 21    . methodology and country coverage. In spite of their differences they are highly correlated with each other. The various “Corruption Indices” differ from each other in three fundamental ways . Recently many “Corruption Indices” have been developed due to globalisation and an increase in the demand for anti-corruption policies. These indices are based on surveys about corruption perceptions of entrepreneurs. citizens and experts in industrial and developing countries.

published by Political Risk Services Inc.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 .

The Economics of Corruption 23 .

 Corruption arises naturally in the public sector due to transfer of responsibility and imperfect monitoring..g. and between the populace and the political elite. An agent responsible for certain tasks (e. tax collection or policy design) may profit from his position in the knowledge that he cannot be perfectly monitored by the principal. This generates a principal-agent relationship between the government and its bureaucracy.   24 .

A simple agency model of corruption 25 .

26 . • 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.

he has to pay the penalty • In the same manner the firm that is discovered engaging in tax evasion pays the penalty . is the probability of succeeding in corruption.• Firms tax liability is where . Hence. • We assume that. p. the government (the principal) discovers corrupt acts with probability (1-p). 27 . In addition. • Corruption exposure results in the dismissal of the tax collector involved.

We assume that a fraction are corruptible and are honest. possible because of internalised moral costs. • All parties are risk neutral. w. in the private sector.• The tax collector earns the wage. 28 . and can get the wage. • Some tax collectors are more honest than others.

• 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. 31 .• 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.

We model this in terms of the cost function: .β(b)* w0 Caught with prob (1-p) not to be corrupt -f w * The need for secrecy imply high transaction costs. p to be corrupt w + b .Decision Tree for a Potentially Corrupt Agent Succeeds with prob.

33 . if the expected benefit from corruption is higher than the expected cost. a corruptible bureaucrat is willing to accept a bribe.• 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.

34 .• The incidence of corruption in this model is a function of government policies in terms of: • Public sector wages. f and g. p • And legal punishments. w • Monitoring.

1993) 35 .A monopoly model of corruption (Shleifer and Vishny.

p. and when accountability of agents to the principal is weak. when agents have great discretion. 75) 36 . A stylised equation holds: CORRUPTION = MONOPOLY + DISCRETION .ACCOUNTABILITY Source: Klitgaard (1991.The Basic Ingredients of Corruption Illicit behaviour flourishes when agents have monopoly power over clients.

g. No risk of detection. We assume that this good is homogeneous and that there is a demand curve for this good D(P). This good is sold by a public official who can restrict the quantity of the good (official has monopoly power). 37     . The official price of this good is P. a passport or a license).Assumptions:  There is only one governmental good (e.

However. Corruption with theft – the official does not turn over anything to the government. The marginal cost to the bureaucrat in this case is P. to the government.  38 .the official actually turns over the official price of the good. But. Hence. marginal cost in this case is zero. asks for a bribe on top of the price. what is the marginal cost to the official of providing this good? Two cases:  Corruption without theft . Sells the good in exchange for a bribe that is below P. P .The cost of producing the good is immaterial to the public servant.

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 .

an agent needs several complementary governmental goods supplied by various officials with monopoly power on the goods that they provide. the way in which these agencies organize for the provision of goods is a key determinant of the impact of corruption on the economy. l 41 .l Sometimes. In this case.

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. if bureaucrats act as a joint monopoly.l If bureaucrats act as independent monopolists. l 42 . then they will set the value of bribes in such a way as to maximise their aggregate bribe revenue. In contrast. internalising negative externalities.

decentralised (or competitive) corruption may be less harmful than centralised (or monopolistic) corruption. 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. If instead. each governmental good was provided by several public officials. competition would eventually bring bribes to zero. In this case.

How Corruption may Corrupt 44 .

In most developed countries in spite of the low probability of being caught and sporadic monitoring the great majority of officials are honest. Many authors have pointed out that significantly different levels of corruption can be observed in countries that have public sectors with similar characteristics. A plausible explanation attributed to Andvig (1991) is that corruption may corrupt. the expected benefit of engaging in a corrupt deal depends on the incidence of corruption. 45   . In other words.

How corruption may corrupt • The horizontal axis measures the number of corrupt officials. Source: Andvig et al (2000 ) . • The vertical axis measures the official’s payoffs.

Conversely. 47    . In relatively transparent societies corruption is highly condemned and the legal sanctions are severe. social sanctions are low and an official that is caught can always pay a bribe to avoid legal sanctions. The decreasing curve depicts all the possible combinations of payoffs and incidence of corruption than an honest official can have. It is intentionally drawn to show a negative relationship. if corruption is widespread.

 The inverted-U shape curve depicts all the possible combinations of payoffs and incidence of corruption for a corrupt official. However. As the incidence of corruption increases the cost of incurring in corrupt practices decreases in term of legal and social sanctions. 48   . where it becomes decreasing. 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.

B and C. we can identify three equilibria in the previous figure: points A. At point A. the payoffs for being honest have turned negative so all the officials choose to be corrupt. the payoffs for being honest are higher than for being corrupt. If we define equilibrium as a situation in which individual actors have no incentives to change their behaviour. At point C. Consequently there are no incentives to move from this point.   49 .

 Notice that A and C are stable in the sense that the marginal decisions of an additional official will not affect the outcome.   50 . Therefore. B is an unstable equilibrium. However. the rest of the agents will choose to move from this point. officials are indifferent between being honest or corrupt. if just one additional official chooses to be honest or corrupt. But what about point B? At point B.

For instance. if the economy is located at a point between B and C. if an economy is at a point between A and B. On the contrary. it will converge to A. it will converge to C. The attractiveness of this simple model is its ability to explain that the level of corruption depends on initial conditions. where honesty does not pay.   51 . where the payoffs for being honest are higher than the payoffs for being corrupt.

Fighting Corruption 52 .

But as this sad fact does not keep us from attempting to reduce disease. Corruption involves questions of degree…’ Klitgaard (1991.‘Like illness. corruption will always be with us. neither should it paralyse efforts to reduce corruption. p. 7) 53 .

But.   The very fist unit of corruption may produce modest additional social cost. the marginal social cost of corruption may be increasing in the quantity of corruption.   If corrupt activity is low. Hence. we can imagine that the marginal social cost of removing corruption is a decreasing function of the quantity of corruption. let us think about a function that relates the marginal social cost of removing corruption with the total amount of corruption. Hence. 54 . But as corruption increases each extra unit may bring greater costs to society. Let us try to think about a function that relates the marginal social cost of corruption with the total amount of corruption. if corruption is widespread. then it may be very costly to detect. then detection becomes increasingly easier (and cheaper).  Also.

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. p.

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 .

technical assistance. It has since developed a full program of analytic work. 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. 57 . TI bring together relevant players from government. The WB has taken the lead in the fight against corruption globally. public administration. training programs and lending instruments targeted towards reducing corruption. business and the media to promote transparency in elections.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. procurement and business.

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).

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Corruption and Development

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The graph illustrates two points: • Richer countries have lower corruption. • Corruption varies greatly across countries. Source: Svensson (2005) .

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 .

we have taxation reducing disposable income and hence savings and investment. Second. we have government expenditure increasing the productivity of the factors of production. In equation (5) we have two new terms:   First. Generally speaking.  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. 64  .

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 .

1991. 19(3). • Klitgaard. 69 . • Jain. 599-617. 2001. Causes and consequences of corruption: What do we know from a cross-section of countries? In: Rose-Ackerman. J. Eight questions about corruption. 71-121. F632-F652. R. Quarterly Journal of Economics. 3-51. Vishny. Corruption. London (paperback).). 2006. 15. Economic Journal.G.K. Corruption: a review. J.References • Aidt.S.. Controlling Corruption. University of California Press. • Lambsdorff. International Handbook on the Economics of Corruption. S.. 113 (491). 1993. and R.. 108. T. • Shleifer. Journal of Economic Perspectives. Economic analysis of corruption: a survey. A. • Svensson. Journal of Economic Surveys. 19-42. 2005.. A. Edward Elgar Publishing Limited. 2003. (Ed. Cheltenham..