Corruption Alexander Tabarrok December 2005

• Corruption is common around the world. Corruption includes bribes, kickbacks, nepotism, siphoning of revenue etc. • Corruption can occur at the highest levels of government as in the Phillipines which Marcos ran like a monarchy or at the lowest levels as when a government official needs to be bribed to do his job. • Corruption aint just something that happens to poor countries. – Between 1990 and 2002 federal prosecutors convicted more than 10, 000 US government officials of corruption. – Corruption is more common in developing countries but not limited to developing countries.

Measuring Corruption Least Corrupt Most Corrupt • • 9. 7 …Indonesia 2. 2 Finland 9. 6 Iraq 2. 2 New Zealand 9. 6 Liberia 2. 2 Denmark 9. 5 Uzbekistan 2. 2 Singapore 9. 4 Congo, Dem. Republic 2. 1 Sweden 9. 2 Kenya 2. 1 Switzerland 9. 1 Pakistan 2. 1 Norway 8. 9 Paraguay 2. 1 Australia • Iceland 8. 8 Somalia 2. 1 According to the Corruptions Perceptions Index of Transparency International the least and most corrupt countries as listed (10 pt scale with a higher number being less corrupt). Austria 8. 7 Sudan 2. 1 Netherlands 8. 6 Tajikistan 2. 1 United Kingdom 8. 6 Angola 2. 0 Luxembourg 8. 5 Cote d'Ivoire 1. 9 Canada 8. 4 1. 9 Hong Kong 8. 3 Equatorial Guinea Nigeria Germany 8. 2 Haiti 1. 8 USA 7. 6 Myanmar 1. 8 Source: http: //www. transparency. org/cpi/2 005/cpi 2005. sources. en. html#sou rces France 7. 5 Turkmenistan 1. 8 Belgium 7. 4 Bangladesh 1. 7 Ireland 7. 4 Chad 1. 7 The most common measures of corruption use surveys of international businesses and other observers to ordinally rank countries. 1. 9

Corruption is Correlated with Low GDP (Note that in this graph the X axis is Control of Corruption) Source: Acemoglu (2004) In international studies corruption is correlated with low GDP, reduced investment, low growth (weakly), low education, and increased fractionalization. It’s not always clear which is cause and which effect – probably both – more on this in a later slide.

Note that the more corrupt countries are political instable. The causal relationship could go either way.

Corruption in the United States • In 2003 USA Today (Dec. 18, 2003) had this to say about former Illinois governor Mark Ryan: “The indictment alleges that Ryan, a Republican, awarded lucrative government contracts and leases to family and associates; accepted cash payments, vacations and gifts from state contractors, and lied to FBI agents in an effort to obstruct the investigation. The indictment alleges the acts spanned his career as secretary of state and governor. "Basically, the state of Illinois was for sale to family and friends, " U. S. Attorney Patrick Fitzgerald said…. ” • And here is the Associated Press (Nov. 28, 2005) on Representative Randy Cunnigham: “Rep. Randy "Duke" Cunningham tearfully resigned Monday after pleading guilty to bribery and admitting he took $2. 4 million to steer defense contracts to conspirators using his leadership position on a congressional subcommittee. ”

Most and Least Corrupt States in the United States (as measured by Federal convictions per capita, 1976 -2002) Glaeser and Saks (2005) in Global Corruption Report 2005.

Problem of Reverse Causality • Problem of reverse-causality. Could a poor economy generate corruption? Yes. Suppose, for example, that: 1. The efficiency of the bureaucracy rises with government wages. This could occur, for example, because you have to pay government workers high relative wages to get them to say no to corruption. 2. Poor countries have particulary hard times of keeping government wages high relative to corrupt alternatives. 3. Then as a country gets richer it can pay higher government wages and becomes less corrupt but it is better economic conditions that create higher wages not the reverse. • • Mauro thus introduces Ethno-linguistic fractionalization as an instrument. Ethno-linguistic fractionalization measures how diverse a country is in terms of language – probability that two randomly chosen citizens will speak different language. Idea is that ethno-linguistic fractionalization causes corruption but is not itself caused by economic growth. Thus if ethno-linguistic fractionalization can be shown to reduce growth rates then this is evidence that corruption causes lower growth and this evidence is free of reverse causality. Does ethno-linguistic fractionalization cause corruption? Yes – it is correlated and recall the SV argument that competitive serial corruption is the worse kind and this is the kind of corruption that ethno-linguistic fractionalization is likely to support. Does ethno-linguistic fractionalization reduce growth? Yes, thus this suggests that there is some link between corruption and reduced growth.

Problem of Reverse Causality 2 • Using data from the United States Glaeser and Saks (2004) show that states which are richer and better educated (and hence better monitors of the government) have less corruption. States which are more homogeneous also have less corruption (hetreogenity increases divisiveness ala Olson and may promote corruption as a form of pie dividing, also less common goals more power centers in hetereogeneous societies). – To control for the possibility of reverse causality Glaeser and Saks show that corruption in the 1990 s is lower in states that had high education levels in the 1920 s and high per capita income in the 1940 s • The idea is that education in the 1920 s could have an effect on corruption today because it is correlated with education today but education in the 1920 s cannot be affected by corruption today. (Same with per capita income in the 40 s) • • • Glaeser and Saks find weak evidence that corruption lowers state economic growth. Thus a strong causal effect appears to run from growth, especially in the form of higher income and better education, to less corruption but the effect of corruption on growth is relatively weak. We should be careful about drawing too many conclusions about the rest of the world from studies of the United States. As we will discuss later in the United States we have corruption of politics by economics elsewhere we have corruption of economics by politics which is much more serious.

Measuring Corruption: Micro Studies • • In Uganda, Reinikka and Svensson (2004) compared the amount of money given out to schools with money received and found that almost 90% of the money disappeared in the transfer – most of the money went to government officials and politicians. In Indonesia the government subsidized rice to be given to the poor. Olken (2005) compared administrative data on the rice given out with survey data on the rice received. He found that on average there was an 18% loss (interestingly most of the loss came from a few districts with ethnically heterogeneous populations and low population densities – Why? ) – Taking into account the loss from corruption and the cost of taxation may make the program welfare reducing instead of welfare enhancing. Hence corruption can make redistribution very difficult. • In the United States corruption is more difficult to document. Obviously, we see corruption when corrupt officials are caught. It is very difficult, however, to draw a direct connection between dollar donations and votes once one controls for ideology and district characteristics. – It is illegal to buy votes but it is not illegal to buy candidates! • Indirect evidence, however, is suggestive that many things matter other than votes. For example, in May of 2001 the political world was rocked when Jim Jeffords switched parties from Republican to Independent thereby throwing the Senate from the Republicans to the Democrats. As the switch became known the stock market returns of those firms that had given heavily to Republicans fell significantly relative to those firms that had given to Democrats.

Why Corruption is Bad • Corruption reduces wealth because it acts as a tax on productive activity. Government spending is often wasteful but the corruption tax has zero offsetting beneficial expenditures. • The tax is highest in the case of serial competitive competition when the double monopoly problem can create severe welfare losses. • Corruption encourages government control over the economy. • Corruption distorts the direction of economic activity (recall our discussion of Olson) encouraging people to exit the productive areas of the economy and enter the corruption sector.

Types of Corruption 1 Corruption with Theft vs. Corruption w/out Theft (Shleifer and Vishny, 1993) • Corruption without Theft – There is a government bureau responsible for issuing a passport, license, permit etc. – There is an official cost. – In corruption without theft the official price must be paid no matter what. – Thus, for corruption without theft the total price is always higher than the official price. • Corruption with Theft – The bureau accepts a bribe and issues the permit but does not record the transaction. In this case the total price may be, but is not necessarily, below the official price.

Analysis • • Buyers prefer corruption with theft because of the possibility of lower prices. Could corruption with theft be welfare enhancing? Partial effect is good but total effect could be very bad. – – – • Corruption with theft unites briber and bribee in secrecy against the government so it is difficult to police. Corruption with theft is self-reinforcing. Every corrupt firm makes it more difficult for other corrupt firms to operate. Thus corruption with theft is likely to grow. Corruption with theft pits government against briber and bribee. Since it raises price, corruption without theft, tends to pit briber against bribee. Corruption without theft, therefore, has some natural limits. Total effect of corruption with theft could be worse even when partial effect is beneficial. Hence S. and V. suggest “the first step to reduce corruption should be to create an accounting system that prevents theft from government. ”

Types of Corruption Monopoly Corruption A monopolist controls corruption at all levels. • • • Kingdoms Marcos’s Phillipines Communist dictatorships. Serial Corruption More than one government or part of government each of which must be paid. • Post communist Russia. • Some African countries without strong government. Leads to double-monopoly problem – toll booth analogy. Free Entry makes the situation worse. Competitive Corruption There is more than one seller of favors. Parallel Competition Multiple officials each of whom can provide the same good. • The United States – sometimes. • Federalism Leads to Bertrand competition. Free entry makes the situation better.

• Competitive corruption can be a lot worse than monopoly corruption, especially serial competitive corruption. – Thus, anarchic government can be worse than strong unitary government. • What accounts for which societies have which types of corruption? – Open question! Here are some ideas. – Monopoly corruption needs to be enforced – easier in small, homogeneous society with few rulers. Harder in societies where other natural bases of support exist such as tribes, religious groups etc. – Autocratic regimes can enforce monopoly corruption. Huntington (1968) has argued that corruption increases with democracy. Makes sense if democracy comes with a weak regime and we are talking about a shift from monopoly to serial corruption. • Appropriate policy: Create competition in the provision of government goods while intensively monitoring theft.

• Corruption increases the incentive to create welfare reducing monopolies! • The theory is supported in the data, corrupt countries have greater regulation of entry and less free trade. • In the free-market democracies we tend to think of corruption as corruption of politics by economics. But in many corrupt countries what we are really talking about is corruption of economics by politics. • Interesting implication of the bribe model: What happens when the official price rises?

Corruption/Rent Seeking and Innovation • • • Is rent-seeking likely to attack the innovation sector or the production sector more severely? Private rent seeking such as crime will go for where the money is, it will go after existing stocks of wealth. Quoting MSV “Bandits steal crops, lawyers sue deep-pocket corporations, and armies invade rich countries. ” In contast public rent seeking will to a larger extent go after innovation. Innovation by definition is new and often requires permission, permits, licenses, import quotes and so on. Innovators have demand for these government provided goods. Established firms do not need so many of these goods since they have bought them already. In addition, the innovators are typically not part of the existing elite. The established producers are insiders and will likely want to prevent the innovators from disrupting their own good life. Innovators often have risky projects which makes them especially vulnerable to rent-seeking. If the project is succesful the government expropriates. If it is unsuccesful the innovator bears the loss. Tails I win, heads you lose. Thus corruption/rent-seeking can be particulary bad for innovators.

Corruption/Rent-Seeking/Depredation and the Self-Fulfilling Bad Equilibrium From Murphy, Shleifer and Vishny (1993). • Consider the following model. There are three activities. 1. Produce a cash-crop, i. e. produce a crop for market sale – this pays alpha. 2. Subsistence production – i. e. product for your own family only or produce a crop that will feed you but has negligible market value (e. g. potoatoes) – pays gamma. 3. Rent-seek, ie. tax or steal from the producers of the cash-crop. You cannot rent-seek from subsistence farmers. • • Note that if more and more people choose rent-seeking then the returns to the cash-crop will fall. What can happen in this model? n is the number of rent-seekers.

Case 1: Property Rights are Well Protected

Case 2: Property Rights are Poorly Protected

Case 3: Multiple Equilibria

Well Protected Property Rights Multiple Equilibria Poorly Protected Property Rights