Key Implications of Corruption

Even though the level and effects of corruption are notoriously difficult to quantify, there is a small but growing literature analysing the impact of widespread corruption. It is important to ascertain the causality and consequences of corruption, so that reforms can be implemented to nullify any potential socioeconomic distortions. This chapter will analyse the literature regarding the economic, social and political implications of corruption.

2.1 – Economic Impact of Corruption

There are theoretical arguments supporting both corruption as a detriment to economic performance, and also as a positive influence upon the economy. There is a theory for corruption acting as‘efficient grease’, enhancing economic growth (Braguinsky,1996 ; Kaufmann and Wei, 2000) by alleviating inefficiencies and shortcomings within government legislation (Leff, 1989).

It could be argued that this is especially relevant for transition economies, as due to the enormity of the administrative and legislative amendments required during the transition process, governmental errors of judgement were inevitable. This results in the implementation of inefficient policies, leading to unfavourable business conditions. The evidence suggests that corruption could help to overcome these barriers and improve efficiency (Bardhan, 1997), with Cheloukhine and King (2007) reporting that the majority of Russian businessmen agreed that corruption was beneficial for economic activity, as a result of helping to overcome the exceptionally large transaction costs of the complicated Russian legal and administrative systems.

There is also a theoretical argument that corruption can help lubricate borrowing within the banking industry, as Stiglitz and Weiss (1981) have argued that adverse selection due to asymmetrical information between banks and borrowers can result in credit rationing, as banks can not differentiate ‘bad’ borrowers from ‘good’ borrowers. Due to this, some borrowers are willing to pay above the official loan rate, and will use bribery to facilitate this. This could result in corruption promoting economic growth, due to a greater level of credit being approved (Weill, 2010). However, Weill (2010) also argues that the bribing of bank officials for loans can also result in a reduction in bank lending, as it creates a tax upon the borrower, therefore becoming an obstacle to gaining credit. Therefore it could be argued that the borrowers who are not willing to bribe, either due to the extra costs, or for moral justifications, will be impacted upon the greatest or may not be able to gain credit, potentially limiting economic growth.

Even though there are some interesting points linking corruption and economic growth, there is greater evidence highlighting the negative impact of corruption upon economic performance. Corruption can be responsible for a lack of effort by the bureaucracy, creating inefficiencies, leading to a lack of productivity and poor quality public investments and services(Bardhan, 1997). It could be argued that if the public become aware of the reduced effort , this could result in poor policy credibility, therefore resulting in a distinct lack of trust of the state. This could breed political instability and the lack of credible commitment could result in the public potentially disregarding future state policies.

Loayza (1996) and Johnson et.al (1997,1998) have found that corruption can fuel tax evasion and the growth of the shadow economy, due to corruption straining the relationship between taxes and public sector services and goods. This is supported by Tanzi and Davoodi (2001) who claim that increasing corruption by 1 point reduces the ratio of tax revenues to GDP by 2.7%.

Tax evasion and the promotion of the shadow economy can also occur if more competitive agents miss out on opportunities as a result of other individuals gaining an unfair advantage as a consequence of nepotism. This could lead to people becoming disenchanted with market competition (Levin, Satarov ,2000) and therefore could result in the neglection of the official market. If individuals reject the official market, they could be encouraged to operate within the shadow economy, resulting in a reduction of tax receipts for the state, with Johnson et. al (1998) and Goel and Nelson (2005) presenting empirical evidence linking corruption with the growth of the unofficial economy. This leads to a vicious circle, as the reduction in tax collections weakens the government budget, therefore resulting in fewer resources for the government to regulate and fight corruption.

There are also vast economic ramifications due to the extra overheads many businesses have to absorb as a result of corrupt practices. Levin and Satarov (2000) claim that 10% of revenue for small and medium sized Russian businesses is lost due to corruption. This serves to alienate the business owners, with businesspeople becoming embittered with the business environment, leading to social and political tension as they become exasperated with the efforts of the state to provide fair market conditions, again enticing individuals to operate within the unofficial economy.

There is also interesting empirical data analysing the effects of corruption on Gross Domestic Product (GDP) growth. Tanzi and Davoodi (2001) have presented evidence using Transparency International’s Corruption Perceptions Index that for a cross section of ninety seven countries, corruption has lowered GDP growth. Mauro (1997), Meon and Sekkat (2005), Ali and Isse (2003), Leite and Weidemann (1999) and Poirson (1998) have all found that there is powerful evidence linking corruption with a negative impact on GDP growth. However other studies such as Abed and Davoodi (2002), found using a cross section of twenty five transition countries, with the inclusion of an index of structural reforms, that there was no significance between corruption and GDP growth. There is also uncertainty relating to the direction of causality between corruption and GDP growth, as even though empirical studies have found that corruption can limit GDP growth, it could also be argued that poorer countries who already suffer from low GDP growth, may not have adequate resources to effectively fight corruption (Paldam, 2002). Recent literature has supported the hypothesis that corruption lowers GDP growth, however there are still shortcomings within the literature, due to the lack of a theoretical consensus associating corruption with GDP growth, and therefore it could be argued that the evidence fully linking corruption with negative GDP growth cannot be fully substantiated.

Another considerable economic ramification of corruption during the transition period relates to the gargantuan level of capital flight transition economies have encountered. This has been stimulated by corruption infiltrating and weakening the banking sector during the process of financial deregulation, with the banking sector being targeted due to the vast amounts of money in this sector (Mulino, 2002). This problem has been exacerbated due to the fact that organised crime groups have also infiltrated financial institutions, and even though it is staggering to believe, unofficial sources state that an enormous 80% of Russian banks are controlled either directly or indirectly by criminals****.

This has served to fuel an environment where corruption has prospered, as corrupt officials have found that with relative ease, illicitly obtained proceeds from corruption can be laundered overseas, with the main destinations being Switzerland and Liechtenstein.***BBC. Due to the illicit nature of the funds, it seems unlikely that any earnings on the stock of these funds will return to the country of origin, therefore resulting in permanent capital flight. Due to the involvement of organised crime groups in financial institutions, it could be argued that corruption has been encouraged, as a result of the new found ability to launder illicit funds; it could be argued that corrupt officials could perceive a reduction in the risk of domestic detection and prosecution, providing further encouragement to partake in corrupt activities.

In the case of Russia, due to the banking industry being characterised by criminal involvement and corruption, businesspeople have resorted to offshore banking to combat the risk and uncertainty that this corrupt environment has created, resulting in further capital flight from the Russian economy (Kranz and Coker, 1999). There are many studies that have estimated the level of capital flight from certain transition countries, and the evidence suggests that it has been substantial, with Fitch IBCA, a London based credit-ratings agency publishing that $136 billion was removed from Russia between 1993 and 1998, with Moscow based Troika Dialog investment bank estimating that the total may well be as high as $500 billion in the same period (Kranz and Coker, 1999). These figures show that it is hard to accurately quantify the level of capital flight as the estimates of capital flight do vary, however, there is conclusive evidence that the transition process has been characterised by large volumes of capital flight. This has resulted in great economic consequences as Tikhomirov (1997) has estimated that in the first few years of transition, Russia lost the equivalent of one-third of its gross foreign debt due to capital flight, and even though it will be difficult to ascertain, respective governments would have also lost a great amount of tax revenue due to tax evasion associated with capital flight.

Corruption can have a positive ‘greasing’ effect on the economy, allowing transactions to overcome institutional weaknesses caused by the transition process, however the evidence suggests that corruption breeds inefficiencies and instability and can have far reaching negative economic consequences. Corruption encourages illegal capital flight, the promotion of the shadow economy and tax evasion, and potentially affects the level of GDP growth. Ultimately, corruption compromises economic performance and limits government revenues, helping to fuel a vicious circle where the government struggles to control corruption and its consequences.

Social impact of Corruption

As well as undermining economic performance, corruption can also impinge upon social development and political stability. Corruption has been associated with increasing income inequality with Gupta et. al (2002) identifying a notable correlation between corruption and income inequality, as measured by the gini coefficient. This relationship can by highlighted by Russia’s privatisation process of the 1990’s, in which corruption facilitated the unfair distribution of state assets, resulting in special interest groups becoming exceptionally rich at the expense of others. It is also important to note that inequality can be seen not just as a consequence of corruption, but also as a causation of corruption. Income inequality can entice individuals into corruption as a means of boosting their income, with Khagram and You (2005) also reasoning that income inequality provokes corruption as the poor do not have the resources to hold the rich and powerful accountable, and therefore it could be argued that there is a vicious circle linking corruption and income inequality, as they can be both be a causation and a consequence of each other.

One of the more visible consequences of corruption during the transition phase has been the meteoric rise of organised crime groups. Even though organised crime groups started to grow in importance during the Brezhnev era of the Socialist Economic System (Tomass, 1998), the transition process has been characterised by a terrifying rise in the number and influence of organised crime groups, and by 1996 there was estimated to be 8000 organised crime groups in Russia, each with memberships between 50 and 1000***BBC. Corrupt officials and corruption within law enforcement bodies has strengthened organised crime, as it has allowed criminal groups to gain power within many economic spheres, with the Mafia believed to have control over 70-80% of all business activity within Russia (Goldman, 1996). This has served to exacerbate social tensions, due to the willingness of crime groups to resort to violence, as well as breeding political instability and threatening democracy, as the evidence suggests that the Russian government appears to be fighting a losing battle in controlling the influence of corruption and organised crime activity. These consequences of corruption will result in more ordinary people become disillusioned with democratic values, challenging democratic institutions and ultimately will provoke political instability*****24.

One of the economic consequences of public sector corruption was government inefficiency, leading to the provision of poor quality government services (Bardhan 1997). This can also have a great social impact, as Gupta et. al (2001) found using proxies for government services, infant mortality, and the proportion of low birth weight babies, that there was a strong positive correlation between these variables and corruption, with infant mortality rates a massive 33% higher in countries with high corruption in comparison with low corruption nations. It could be argued though, that there are many social, economic, political and geographical factors which could impact upon infant mortality, and even though Gupta et. al (2001) have found a link, it is very hard to find a direct causation between the level of corruption and infant mortality rates.

There is also evidence linking corruption with adverse environmental developments. Esty and Porter (2002), found that countries characterised by high levels of corruption have lower levels of environmental quality, this could be apparent due to the links between high levels of corruption and a poor regulatory framework, with Welsch (2004) arguing that this link has resulted in greater levels of pollution. There is also conclusive evidence linking corruption with a reduction in government expenditure on education. Mauro (1998) argues that this occurs as other expenditure streams provide greater opportunities for officials to collect bribes, and therefore corrupt bureaucrats will assign a smaller budget to the education sector in order to promote the possibility of receiving bribes elsewhere, with Mauro’s results holding for various specifications. This could lead to great long term effects, as a lacking infrastructure in education could negatively impact upon literacy rates and the level of students participating in higher education, leading to future detrimental socioeconomic effects.

Concluding, the evidence suggests that corruption can have a profound effect in exacerbating social tensions, provoking political instability. Corruption has been associated with adversely affecting many other social indicators, such as the level of income inequality, the promotion of an environment where organised crime groups can flourish, as well as being linked with impairing environmental, healthcare and educational qualities.

The Impact of Corruption on Foreign Direct Investment (FDI)

In this paper I will be empirically analysing whether there is a link between the level of corruption and the extent of FDI per capita attracted. Theoretical arguments propose that corruption can actually increase the level of FDI attracted, as it can act as a’grease’ within the economy (Huntington, 1968), overcoming the limitations of weak regulatory frameworks. It could be argued that this is especially relevant for transition economies, which have been typified by lacking strong institutional and regulatory structures. I also argue that corruption could increase FDI, especially if investors believe that they could potentially collude with corrupt officials to take a share of the proceeds of corrupt activities, although it could be reasoned that many investors will not be willing to embark upon such an illegal and dangerous decision.

However, the majority of economists propose that corruption acts as a deterrent to the level of FDI attracted. This is due to corruption creating an unstable economic environment resulting in expected lower returns for investors. The instability corruption creates can potentially increase the costs of operation, as well as producing a greater level of risk, resulting in a dispersion of investment outcomes (Johnson et.al 2000). This is the argument that corruption acts as ‘sand in the wheels’ for investors, as corruption represents an additional tax on investors (Shleifer and Vishny, 1993;Wei, 2000). Investors have to devote resources to deal with bribery, which could have been utilised more profitably (Kaufmann, 1997). If the economic environment presents the opportunity for officials to receive bribes, then this could result in officials purposely creating additional regulations and rules, to increase the possibility of bribe extraction, further exacerbating the costs imposed on investors, ultimately acting as a deterrent upon the level of FDI attracted (De Soto, 1989; Krueger, 1993).

Empirical studies assessing the impact of corruption upon FDI have so far provided varying results. Alesina and Weder (1999) using FDI data from 1970-1995, reported that using a variety of corruption indicators there was little significance between corruption and FDI, with many of the apparent determinants of FDI insignificant to the regression, potentially highlighting that there may be other variables of significance, such as governance indicators, which were overlooked in this study. It could also be argued that the importance and attentiveness shown to both FDI and corruption has amplified since 1995, and therefore the importance of these results should not be overestimated.