Elsevier

Economic Modelling

Volume 37, February 2014, Pages 202-215
Economic Modelling

Corruption and growth: The role of governance, public spending, and economic development

https://doi.org/10.1016/j.econmod.2013.11.007Get rights and content

Highlights

  • We study how governance and development affect the corruption-growth nexus.

  • Governance affects corruption-growth nexus via the efficiency of public spending.

  • Corruption improves growth if the government size is above the optimal level.

  • Economic development reduces corruption by raising rent seeking costs.

  • The policies reducing tax evasion mitigates corruption and enhances growth.

Abstract

This paper analyses how the quality of governance, the size of public spending, and economic development affect the relationship between bureaucratic corruption and economic growth. The analysis shows that the interaction between corruption and governance shapes the efficiency of public spending, which in turn, determines the growth effects of corruption. Specifically, corruption improves economic efficiency only when the actual government size is above the optimal level. It implies that a growth-maximising level of corruption is possible. This paper also finds that the incidence of corruption declines with economic development. This is because with economic development the wage rate rises and makes private rent seeking costs higher, thereby, discouraging corruption. The main policy implication is that targeting tax evaders instead of bureaucrats is more effective in terms of both reducing corruption and improving the growth potential of an economy.

Introduction

When the public and private sectors interact, bureaucrats may abuse their public position for private gains by accepting bribes or even actively extorting them. This behaviour is defined as an act of bureaucratic corruption. Examining the effects of bureaucratic corruption on economic growth and more importantly, how this relationship is influenced by the quality of governance, the size of public spending, and economic development is the primary focus of this paper.

Notably, the extant literature finds that corruption either may facilitate growth by helping firms circumvent the burden of the public sector or may retard it by increasing this burden and reducing the efficiency of public spending that contributes to productivity.1 The literature highlights that whether the positive or negative effect dominates depends on the quality of governance, the size of the public sector, and the level of economic development; as these factors play a significant role in corruption outcomes. However, there are some inconsistencies and gaps in the literature in explaining the dependence of the corruption-growth nexus on these factors, which merit a further investigation.

First, the literature is not clear about how the quality and structure of underlying institutions influence the relationship between corruption and economic performance. One line of reasoning in this literature is based on the idea that corruption is driven by the institutional setting.2 According to this rationale, the institutional structure determines the degree of organisation of corruption, which then impacts on the income uncertainty faced by the private agents and thus on the economic performance (Blackburn and Forgues-Puccio, 2009, Shleifer and Vishny, 1993). On the contrary, the other line of reasoning assumes that corruption alters the effects of institutions on the economy, such as the burden imposed or the productivity input provided by the public sector, thereby, impacts on economic growth (for example, see (Acemoglu and Verdier, 2000, Aidt, 2009, de Vaal and Ebben, 2011, Keefer and Knack, 1997, Knack and Keefer, 1995, Rajkumar and Swaroop, 2008).

Although offering useful insights, the analysis in the aforementioned literature provides us with a limited understanding of the issue, as it focuses on narrowly defined transmission mechanisms of the effects of corruption. The lack of a systematic explanation of the role of governance in the corruption-growth nexus is evident also from the existing inconclusive empirical findings. For example, Méon and Weill (2010) and, Aidt et al. (2008) find that corruption is less detrimental to efficiency and growth in countries where institutions are weak. Méon and Sekkat (2005) contradict the above-mentioned authors, and report that corruption is most harmful to growth where governance is weak. In the same vein, Méndez and Sepúlveda (2006), and Aidt (2009) demonstrate empirically that in countries with high political freedom and low level of corruption, the beneficial effects of corruption outweigh the detrimental effects, and vice versa.3

Second, there is another inconsistency in the literature with respect to the relationship between government size and corruption. In particular, if government size is related to the degree of government intervention and the inefficiencies induced by it, then, an increase in government size creates more room for rent-seeking and corruption (for example, see Alesina and Angeletos, 2005, Goel and Nelson, 1998, Rose-Ackerman, 1999). However, if the government size reflects its control of corruption and accountability, an increase in government size should curb corruption. La Porta et al. (1999) and Billger and Goel (2009) find evidence supporting the latter hypothesis for Scandinavian countries. Intuitively, the inconsistency in this case stems from ignoring the interaction of the quality of governance with both corruption and government size.

Third, there is strong evidence indicating that the incidence of corruption is related to the level of economic development. For example, studies by Mauro (1995), Knack and Keefer (1995), Keefer and Knack (1997), Fisman and Gatti (2002), Rauch and Evans (2000), Blackburn and Forgues-Puccio (2007) find that there is a significant negative relationship between the level of corruption and the level of economic development of countries. Blackburn et al., 2006, Blackburn et al., 2010 and Haque and Kneller (2009) explain this link between development and corruption by suggesting that the expected losses of corrupt bureaucrats increase with income levels. Intuitively, one can also relate the cost of corrupt rent seeking to the cost stemming from concealment of illicit income gained from corruption. In fact, analysing tax evasion Cowell (1990), Chen (2003), and Hillman (2009) explain that rent seeking costs arise because tax evaders have to hire experts and lawyers to conceal their illegally obtained income. The relevance of this rationale to corrupt activities has also been emphasised by Barreto (2000) and Blackburn et al. (2006), who link the cost of corrupt behaviour to the incidence of corruption.4 Despite being highlighted as an important channel, the possible implications of the link between rent seeking costs and the wage rate driven by the level of economic development on corruption outcomes, have not been thoroughly examined in the literature.

To summarise, the existing literature lacks a more general approach for interpreting the role of governance, the size of government, and the level of development in the relationship between corruption and growth. This paper attempts to address this issue. A formal analysis of how these factors affect the relationship between corruption and growth in a more general framework is important for a number of reasons. First, by gaining insights into this issue one will be better capable in interpreting the above controversial empirical results. Second, this is important because by ascertaining how these factors alter the corruption-growth nexus will help one to assess the growth effects of corruption more accurately. Moreover, a good understanding of how corruption impacts economic performance is essential for formulating and implementing effective development policies.

This paper attempts to shed a new light on the issues raised above by considering the link between governance, the size of the public sector, and corruption from a broader perspective. Specifically, the analytical framework employed in this study integrates the aforementioned approaches, thereby making it more general.5 First, following Andvig and Moene (1990), Ryvkin and Serra (2012), Haque and Kneller (2009), and Blackburn et al. (2006), the framework incorporates the idea that the ability of the government to contain corruption is driven by the quality of governance. The statistical evidence by Butkiewicz and Yanikkaya (2006) supports this tenet by demonstrating that the correlation between corruption and different measures of the quality of governance is consistently negative. In the model, this aspect of governance is captured by the parameters that affect compliance and bribery. Second, the quality of institutions also drives the efficiency of the public sector, and hence it determines the optimal size of public spending.6 Another key element in the workings of the corruption-growth nexus is that corruption distorts both the burden of the public sector driven by the quality of institutions and the productive inputs generated by the government.7 This implies that corruption affects economic performance also through the (in)efficiency of public spending, driving a disparity between actual and optimal government sizes. Thus, the relationship between corruption and growth depends directly on governance as this drives the level of corruption; and indirectly through the interactions between the efficiency of government spending and the distortions caused by corruption in the cost–benefit balance of the public sector.

Another distinctive feature of the analysis in this paper is that it emphasizes that the cost of rent seeking is an important factor driving the incidence of corruption. Explaining this link helps to establish a new channel through which the level of development affects the incidence of corruption. In this respect, by adopting a different view to the current literature, this paper postulates that the negative relationship between the incidence of corruption and the level of development is driven by rent-seeking costs which rise with the wage rate. This is because this cost depends on the effort to conceal the illegally obtained income; and hence, this effort should be costlier as the wage rate increases, which in turn increases with the level of economic development. Thus, by accounting for the rent seeking costs, this paper addresses another aspect of corruption that has not been thoroughly examined in the corruption literature.

It is worthwhile to note that the analysis conducted in this paper differs from the closely related papers in several aspects. In particular, Blackburn and Forgues-Puccio (2009) and Shleifer and Vishny (1993) focus on how the structure of governance drives corruption, but do not consider how corruption affects public productive inputs and tax evasion. Keefer and Knack (1997); Rajkumar and Swaroop (2008); Knack and Keefer (1995), and Aidt (2009) only empirically examine the effect of governance on the relationship between corruption and the efficiency of public spending. Unlike the paper of de Vaal and Ebben (2011), Blackburn et al. (2010), and Haque and Kneller (2009), where they model corruption as embezzlement of public funds by corrupt bureaucrats, this paper considers corruption strategies between private agents and bureaucrats. This approach allows us to underpin behavioural patterns of both private agents and bureaucrats, thereby allowing to gain useful insights for policy formulation. Finally, de Vaal and Ebben (2011) assume a ‘reduced form’ approach by treating the quality of institutions as a factor directly augmenting productivity. Unlike them, in this study, it is rather a factor that affects the economic performance through its effect on corruption outcomes and the public sector burden and benefit.

The analysis along these lines yields the following results: (i) the effect of corruption on the economy depends on the trade-off between the burden of regulations and the efficiency of productive public inputs; (ii) if the gain through decreased public sector burden is greater than the loss in public productive inputs, collusive corruption might have positive growth effects; (iii) the cost of corruption increases with the wage rate, thus, development and corruption are negatively correlated; (iv), this paper gains some insights into the effectiveness of anti-corruption policies in terms of reducing the incidence of corruption and enhancing growth simultaneously. Namely, it is found that targeting tax evaders instead of bureaucrats is more effective in terms of both reducing corruption and improving the growth potential of the economy. A calibration of the model and a simulation analysis yields numerical patterns supportive of the theoretical conjectures stemming from the model.

The rest of the paper is structured as follows: Section 2 presents the model and its solution, whereas Section 3 discusses growth implications of corruption. Section 4 discusses the results and concludes the analysis.

Section snippets

The model

The model developed in this section draws on the endogenous growth model developed in Barro (1990). In general, the public sector interacts with the private sector in two broad fields: taxation and public goods provision. Barro (1990) generalizes this idea by expressing the burden of regulations as an average tax rate, τ, and the benefit of public goods as the productive input per worker, g(t). With imperfect monitoring, private agents have an incentive not to comply to taxation and to increase

The effect of corruption on growth

Having solved the problems of agent interaction in the model economy, one can proceed to the analysis of the effect of corruption on economic growth. To address this problem, first the state of equilibrium is defined and then the equilibrium growth rate is derived. Since, the effect of corruption on the economy is transmitted through the public sector, how the incidence of corruption alters the burden and the productive inputs created by the public sector is considered. Next, based on these

Discussion of the results and conclusion

The results obtained in this paper can be summarised as follows. First, the results point out that corruption affects the economy by altering both the burden of regulations and the efficiency of productive public inputs. Therefore, its overall effect on growth depends on the combined impact on private productivity as a result of the changes in the burden of regulations and the productivity-enhancing inputs provided by the government. The role of governance in shaping the relationship between

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    I thank Arye Hillman, Yew-Kwang Ng, Keith Blackburn, Been-Lon Chen, and participants of workshops at ANU and Monash University for the useful comments. I also would like to thank two anonymous referees for their insightful comments.

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