analySEEs Report: Impact of Corruption on Economic Growth Performance in Developing Countries

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analySEEs

2008

Impact of Corruption on Economic Growth Performance in Developing Countries

Quamrul Mahmud

www.analySEEs.co.uk

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Introduction

Economic development is a multidimensional process which requires many factors working efficiently in an interrelated system. From the inception of country concept, all countries in the world have been trying to increase economic growth. But economic history tells that only few countries have been

successful to achieve desired economic growth while many other countries are lagging behind their economic goals.

During the post war period, when trade liberalisation and economic integration were emerging issues, there was a major positive change in economic growth performance in different parts of the world. In this period many developing countries, especially in East Asia, have shown tremendous success in developing their economic conditions from a lower-income country to a higher-income country. But at the same time many developing countries, mostly in Sub-Saharan Africa, Central and South Asia and Latin America, have not yet been successful to break the vicious circle of poverty.

Post war period, East Asian countries have shown tremendous success in developing their economic conditions from a lower-income country to a higher-income country


Cross-country difference in economic growth performance in developing countries is caused by many

factors such as institutional inefficiency, environment degradation, negative impact of globalisation and

trade liberalisation, misuse of foreign

aid, technological backwardness,

inefficient market structure and

resource allocation, non-competitive

financial sector, inefficient utilisation

of natural resources and, above all,

government failure and corruption.

This essay explains how corruption

can be attributed as an important

factor for cross-country differences in economic growth performance in developing countries. It will be

argued that corruption is a major reason for decrease in investment, misallocation of resources,

inefficiency of public and social services, international terrorism and income inequality.


Impact of corruption on investment

Corruption hits economic growth through its negative relation with investment. Vaclav Havel, former

Czech President (October 2001), argues, ‘corruption may either deter investment or render it less

productive through its adverse impact on the risk and cost of doing business’ (Mauro 1995). Economic

growth is lowered by corruption because investment is negatively correlated with corruption, especially

when dishonest bureaucracies delay the distribution of permits and licenses for investment (Mauro

1995). Mauro (1995) also considers

that negative association between

corruption and investment is

significant, both in a statistical and

in an economic sense. For example,

if Bangladesh were to improve the

integrity and efficiency of its

bureaucracy to the level of that of

Uruguay, its investment rate would

rise by almost five percentage points and its yearly GDP growth rate would rise by over half a

percentage point.

Furthermore, corruption hinders investment by increasing cost of production and transactions because

corrupt practices are conducted in secrecy and contracts are not legally enforceable (Brempong and

Camacho 2006). Likewise, institutional inefficiency, as an ultimate consequence of corruption, also

discourages both local and foreign investment.


The magnitude of this

effect is noteworthy: a

one-standard-

deviation increase (an

improvement) in the

corruption index is

associated with an

increase in the

investment rate by 2.9

percent of GDP

(Mauro 1995).

Moreover, foreign

direct investment

(FDI), a positive

instrument for

economic growth, is

deteriorated by

corruption which has

resulted in capital

flight in many parts of

the world (Wei 2000).

So, corruption reduces economic growth because it decreases the marginal rate (MR) of return on

investment (ROI).


Corruption and misallocation of resources

Corruption is a vital reason for misallocation of both physical and human resources. Open economic

concept of perfect competition is severely hindered by corruption. Brempong and Camacho (2006)

demonstrate in their study that corruption prevents economic growth because it distorts incentives and

Market signals leading to misallocation of resources.

Moreover, corruption in developing world, where it has degenerative impact, destroys the productive

capacity of local talent and entrepreneurs. The opportunities for corrupt practices lead to resources,

especially human resources, being channelled into rent seeking rather than productive activities

(Shleifer & Vishny 1993; Berthelemy et al. 2000 and Gupta et al. 2000). Entrepreneurial and academic

skills may be attracted to public sectors to earn extra benefit through corruption.


Furthermore, when corruption is widespread and institutionalized, some firms may devote resources to

obtaining valuable licenses and preferential market access (Murphy, Shleifer and Vishny 1991) which

leads to imperfect competition and monopoly in the market and inefficient allocation of valuable

resources. In the extreme, it may be financially more rewarding for an entrepreneur to leave the private

sector altogether and instead become a corrupt public official (Svensson 2005). Consequently, growth of

private sector is reduced.

Corruption and public services

Corruption reduces

efficiency of both

bureaucrats and national

institutions. It paralyses

public services and

increases suffering of

common people. It distorts

the proper functioning of

state institutions allowing a

few interest groups to seize these institutions for their private interest (Hellman et al.2000).Corruption

increases uncertainty, especially in the case of decentralized corruption. This results in decreasing

investment in both physical and human capital (Wei 2000; Alesina and Weder 2000).


Furthermore, bureaucrats in developing and poor countries, where public expenditure is a major source

of corruption, frequently invest in non-productive sectors, including national defence or infrastructure

where misappropriation is relatively easier than other sectors. Abbey (2005) demonstrates in his

research: ‘experience with public sector projects is replete with stories about roads that are pocked with

potholes soon after completion, power plants that experience regular blackouts and sewerage systems

that simply do not work’. Empirical study conducted by Abbey (2005) also shows that corruption and

fraud in public procurement of Ghana, accounting for 50 to 70 percent of government expenditure,

impact on governance, economic growth and development.

Furthermore, Easterly (2003) demonstrates that bureaucratic inefficiency caused by corruption affects

growth indirectly by lowering investment rate and directly by leading to misallocation of investment

among sectors. For example, a one standard deviation improvement in the bureaucratic efficiency index

is associated with a 1.3 percentage point (absolute) increase in the annual growth rate of GDP per capita

(Easterly 2003).


Moreover, impact of corruption of public servants on micro level or firm level is noteworthy. Fisman and

Svensson (2001) use firm-survey data of estimated bribe payments of Ugandan firms to study the

relationship between bribe payments to government officials, taxes and firm growth which reveal that

both the rate of taxation and bribery are negatively correlated with firm growth. For the full data set, a 1

percentage point increase in the bribery rate is associated with a reduction in firm growth of 3

percentage points, an effect that is about three times greater than that of taxation (Fisman and

Svensson 2001).In addition, political corruption associated with civil and military bureaucrats, is

assumed to have tremendous influence on other sectors of

economy. Political corruption is defined by Transparency

International (TI Report 2007), the world wide anti-

corruption advocacy organization, as: ‘the abuse of entrusted

power by political leaders for private gain, with the objective

of increasing power or wealth.’ Abbey (2005) states that

political corruption may not involve money changing hands;

it may take the form of ‘trading influence’ or granting favours

that poison politics and threaten democracy.

Abbey (2005) also demonstrates that corrupt politicians, with the help of corrupt bureaucrats, over the

world tend to choose investment projects not on the basis of their intrinsic economic worth but on the

opportunity for bribes and kickbacks these projects present and the ultimate sufferers are common

people. So, political corruption has long-term impact on economic growth because politicians are

supposed to lead the country for economic prosperity.

‘The abuse of entrusted power by political leaders for private gain, with the objective of increasing power or wealth’ -Political corruption is defined by Transparency International (TI Report 2007)


Impact on poverty and terrorism

It is argued that corruption distorts income distribution and increases inequality among nations (Abbey

2005). A study by Brempong and Camacho (2006) reveals that there are statistically significant regional

differences in income and growth performance due to corruption. For example, 1 percentage increase in

corruption decreases growth rate of per capita income by about 1.7 percentages in OECD and Asian

countries, by about 2.6 percentages in Latin American countries, and by 2.8 percentages in African

countries. A 1 standard deviation increase in corruption increases the gini coefficient of income

inequality between 0.05 and 0.33 points (Brempong and Camacho 2006). So, corruption increases the

difference between rich and poor which is a major cause of social unrest in developing countries.


Furthermore, it is evident that there is a strong relationship between corruption and economic under

development which ultimately results in social unrest (Abbey 2005). It is also established that poverty,

which creates hopelessness among poor, is one of the causes of international terrorism. Abbey (2005)

says that corruption in poor countries is perceived as a direct threat to the security of richer countries

which therefore have a stake in the fight to stamp out corruption and alleviate poverty and terrorism.

Fighting corruption is also fighting terrorism as without corruption the attacks of September 11 could

not have taken place, as argued by Peter Eigan (2005), Chairman of Transparency International (TI).

Corruption of social services and cross-country impact

A major source of corruption in developing countries is social services and non- government

organizations. Many non-government organizations, which are supposed to provide social services on a

not-for-profit basis, are actually engaged in business for their own benefit at the expense of the poor.

This is why Brempong and Camacho (2006) argue that corruption decreases the quantity as well as the

effectiveness of resources spent on social programs that benefit the poor. Even when resources spent

on social programs are not reduced, corruption changes the distribution of this spending to benefit the

rich at the expense of the poor (Gupta et al. 2000; Tanzi and Davoodi 1997). For example, health care

expenditure may be tilted toward building modern hospitals that cater only to the rich at the expense of

preventive health care that benefits the poor. In the same way, education spending could be skewed

towards subsidizing higher education for the rich rather than towards primary and secondary education

that benefit the poor. This is why corruption of social service organizations needs to be reduced to

ensure economic growth of developing countries.


Notably, there are differences in the magnitude of the impact of corruption among different countries

and regions. Brempong and Camacho (2006) find significant regional differences in the effects of

corruption on economic growth and income distribution. The largest negative effect of corruption on

growth rate of income is found in Africa while the largest negative impact of corruption on income

distribution occurs in Latin America (Brempong and Camacho 2006). Their study (2006) also reveals that

impact of corruption on economic growth is minimal in OECD and Far East Asia, and most interestingly in

China where corruption and economic growth both are increasing. Brempong and Camacho (2006) term

this kind of corruption as developmental corruption which is also called centralised or coordinated

corruption where corruption has positive correlation with development. Another form of corruption

they term as degenerative or uncoordinated corruption, which is prevalent in Africa and Latin America,

has negative relation with economic growth. So decentralised corruption -pervasive corruption- is more

detrimental than centralised corruption -one-point corruption- for economic growth of a country.


Conclusion

The analysis of different indicators of economic growth offered in this report indicates that corruption is

a vital factor which negatively affects all aspects of economic growth. There may be different reasons for

cross-country differences in economic growth performance but the impact of corruption is most

pervasive for both short-term and long-term economic goals.

Though the impact of corruption is not homogeneous across different regions of the world, corruption

can be reduced, if not possible to eliminate at all, to sustain growth in the long run.

Indeed, economic growth is a complex issue involving many interlinked factors which deserves analysis

and reducing corruption is indispensable to minimize the gap between rich and poor nations.


References

• Abbey, J., 2005. The Growth and Corruption: It’s Impact on the Achievement of Middle Income Status, Centre for Policy Analysis, Accra, Ghana

• Brempong, K. G. and Camacho, S. M., 2006. Corruption, Growth, and Income Distribution, Springer-Verlag, Paris.

• Easterly, W., 2003. Elusive Quest for Growth: Economic Adventures and Misadventures in the Tropics, MIT Press, Cambridge, Massachusetts: 241-253

• Mauro, P., 1995. ‘Corruption and Growth’, The Quarterly Journal of Economics, 110(3): 681-712

• Mauro, P., 1996. ‘The Effects of Corruption on Growth, Investment and Government Expenditure’ IMF Working Paper No. 96/98

• Olken, B., 2003. Corruption and the Costs of Redistribution: Micro Evidence from Indonesia, Manuscript, Harvard University Press

• Svensson, J., 2005. ‘Eight Questions about Corruption’, Journal of Economic Perspectives, 19(3):19–42

• Shleifer, A. and Vishny, R.W., 1993. ‘Corruption’, Quarterly Journal of Economics, 108: 599-618

• Transparency International, 2007. ‘Corruption Perceptions Index’,

http://www.transparency.org.html (Access: 15/05/08)


Contents

• INTRODUCTION PAGE 2

• IMPACT OF CORRUPTION ON INVESTMENT PAGE 4 • CORRUPTION AND MISALLOCATION OF RESOURCES PAGE 6

• CORRUPTION AND PUBLIC SERVICES PAGE 7

• IMPACT ON POVERTY AND TERRORISM PAGE 10 • CORRUPTION OF SOCIAL SERVICES AND CROSS-COUNTRY IMPACT PAGE 11 • CONCLUSION PAGE 13

• REFERENCES PAGE 14

• ABOUT ANALYSEES PAGE 17 • CONTACTS PAGE 18


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Edited By: Mamun Ahmed

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analySEEs Report: Impact of Corruption on Economic Growth Performance in Developing Countries