The Impact Of Corruption On Economic Growth Economics Essay

The purpose of the paper is to analysis whether bureaucratic corruption is sanding or greasing the wheels of economic growth. A number of cross country studies have found that corruption is harmful to economic growth, but the findings are not universally valid due to political institutional quality and country culture. Not all areas of institutional quality affect the corruption and growth relationship equally in country culture context. Corruption has a significant effect on the growth. This effect is non linear.

Keywords: Bureaucratic Corruption, Economic Growth, political institutional quality

Introduction:

Corruption is widely regarded as one of the biggest challenges of the 21st century. Corruption is a complex social, political and economic phenomenon that affects all countries. The common conception of corruption is that it hampers economic growth, brings about political instability, disproportionately burdens the poor and undermines the effectiveness of foreign investments and human capital (2012, Freckleton et al). Corruption attacks the foundation of democratic institutions by distorting electoral processes, perverting the rule of law and creating bureaucratic quagmire whose only reason for existing is the soliciting of bribes (2012, UNODC).

The issue of corruption and how to fight it has assumed ever more importance in recent years. Not only has there been a significant growth in academic research on corruption, but media attention has also focused far more on corruption scandals, and governments, international financial institutions and non-governmental organisations (NGOs) have devoted increasing resources to combating corruption. Between $1 trillion and $1.6 trillion dollars are lost globally each year to illegal activities, according to World Bank 2001 estimates. Corruption decreases the amount of wealth in a country and lowers the standard of living. Bureaucratic Corruption impact on economic growth, measure it in two way direct consider GDP growth rate and indirect considers human development, capital inflows (out flows and inflows).

In fact, most economists view corruption as a major obstacle to economic growth. It is seen as one of the causes of low income and is believed to play a critical role in generating poverty traps. There are two schools of thought in economies about impact of corruption on growth. One is “The Sanders” and second is “The Greasers”.

According to “Sanders” Corruption is a major obstacle to development and a cause of under development and absence of growth. Corruption prevents economic and legal systems from functioning properly. Corruption leads to misallocation of talent (human development), Corruption reduces the incentive to accumulate “capital” (cash flows) (e.g. 2005, Meon and Sekkat; 2009, Mobolaji and Omoteso; 2010, Campos et al; 2011, Hodge et al; 2012, Freckleton et al) according to this view, ‘sands’ the wheels of growth or negative relationship between corruption and growth and it makes economic and political transitions difficult.

According to “Greasers” Corruption fosters development by allowing agents to overcome government failure. Corruption lubricates economic systems by allowing agents to circumvent cumbersome and time consuming regulations. Corruption is like a competitive auction: those who want a service the most get it and the result is an efficient allocation of resources. They argue that corruption ‘greases’ the wheels of development or positive relationship between growth and corruption and through that fosters growth (e.g. 2009, Kutan et al; 2010, Meon and Weill; 2010, Heckelman and Powell; 2011, Dreher and Gassebner). The general idea is that corruption facilitates beneficial trades that would otherwise not have taken place. In doing so, it promotes efficiency by allowing individuals in the private sector to correct or circumvent pre existing government failures of various sorts.

Both approaches have merits, In fact many economists argue that there is a nonlinear relationship between corruption and growth (e.g. 2006, Mendez and Sepulveda; 2009, Aidt; 2008, Aidt et al; 2011, Swaleheen) studies they support both schools of thought, they view corruption as on part that may be effect the growth, there are many other things (law and order situation, institutions quality and cultural) that also effect economic growth of any country. These researches find that studies time period and level of investigation (micro /macro) play a vital role to find out the relationship between the corruption and growth. According to Corruption Perceptions Index measures 2012 world’s fastest growing economies score less than 40 out of 100. In which includes China, Indonesia, Thailand, India, Japan and South Korea, means that corruption and growth exist simultaneously.

This paper seeks to establish the relationship between corruption and economic growth and takes a critical look at the link between corruption and economic growth. The analysis centers on whether corruption is sanding or greasing the wheels of growth. Researcher presents the detailed narrative synthesis of the findings with respect to direct and indirect effects of corruption on growth. In doing this, Researcher will demonstrate how bureaucratic corruption interacts with mediating political economy factors to generate a wide-ranging array of direct and indirect effects on growth. This research also differs from these studies by considering both short run and long run growth rates and by using helpful variables to deal with the problem of reverse causality.

Hypothesis 1: corruption will affect economic growth.

The paper is organized as follows: Section 2 provides a review of the theoretical and empirical literature on corruption and growth. The conceptual model and its methodology are discussed in Section 3. Finally, Section 4 makes some conclusions.

Literature review:

Corruption commonly defined as “the abuse of public power for private gain”. Using this definition, it is not clear that corruption is bad for a country’s overall welfare. Bureaucratic Corruption, depending on the amounts of money lost and the sector where it occurs (TI, 2012) and bureaucratic corruption include bribe to judges, payments in commercial and criminal courts, payoffs to official inspectors for overlooking violations of existing regulations such as those relating to tax evasion, and grease payments to obtain licenses, to obtain property rights in the privatization process, to smooth customs procedures, and to win public procurement contracts (Shera, 2011).There is no international legal definition of corruption (GIACC’s, 2012).

Few researchers proposed parallels of corruption such as tax or a fee; bribing and lobbying might reveal the nature, but none of these equivalents capture the phenomenon of corruption perfectly. Considers rules, whether beneficial or harmful to be a possible cause of corruption and that presence of corruption expose actual condition of legal, economic, cultural and political institutions of a country. Corruption retards growth, but country like China is puzzling for being one of the most corrupt on one hand and also being amongst the fastest growing economies(2010,Ahmed et al). Bribery, misappropriations of public goods, nepotism (favoring family members for jobs and contracts), and influencing the formulation of laws or regulations for private gain are common examples of corruption (World Bank 2012).

Bureaucratic corruption and impacts on growth:

As indicated above, studies of bureaucratic corruption predict three possible effects of corruption on growth: (1) a negative effect due to distorted incentives and higher transaction costs; (2) a non-linear effect, which may be negative or positive depending on political economy factors or institutional quality; and (3) a positive effect due to centralized organization of corruption.

Figure 1: Hypothesized framework

Political institutes

Economic growth

GDP

Capital flows

Human development

Corruption

Bureaucratic

Independent

Mediating

Dependent

2.1.1. Negative impact of bureaucratic corruption on growth:

Bureaucratic corruption may cause a misallocation of talent and skills away from productive (entrepreneurial) activities towards non-productive (rent-seeking) activities. Therefore Méon and Sekkat (2005) propose an interesting test of the “greasing the wheels” versus “sand in the wheels” hypothesis of corruption. Using interactions between indicators of the quality of institutions and corruption, they report that corruption is most harmful to growth where governance is weak. The main difference between this approach and current research is we employ allows all parameters of the model to differ across regimes and to be discretely different, while the “interaction methodology” employed by Méon and Sekkat (2005) pre supposes that corruption is a smooth function of the key used to measure the quality of institutions.

Mobolaji and Omoteso (2009) empirical study those analyses the impact of corruption on the economic growth in seven transitional economies for the period of 1990-2004 using a panel data framework. The diagnostic tests suggest that the models are well specified and the estimation techniques were appropriate for the study. The paper finds empirical support for “sand in the wheels” hypothesis of corruption, that corruption impacts negatively on economic growth while rule of law, democratic accountability and bureaucratic quality may have positive impact on the economies. The paper also finds that combining rule of law and democratic accountability would further enhance the growth potentials in these economies and limit the negative impacts of corruption.

Table 1: Negative impact of bureaucratic corruption on growth

Research study

Countries

Time period

Political institutions

Meon and Sekkat, 2005

Cross section of 63 to 71

1970 – 1998.

institutional quality decreases corruption

Mobolaji and Omoteso, 2009

Central Asia and Europe (8)

1990-2004

institutional quality decreases corruption

Hodge et al, 2011

Cross section of 81

1984-2005

low governance levels or a high degree of regulation

Freckleton et al, 2012

42 developing and 28 developed

1998-2008

institutional quality decreases corruption

Hodge et al (2011) Corruption itself distorts decisions as to what public goods to produce, and at what level, along with the costs of doing so. It is thus able to exert differential impact on the investment and other channels through which corruption exerts its influence on growth outcomes. Utilizing an econometric methodology that models the link between corruption and economic growth through various transmission channels, a statistically robust negative total effect is found. The sizable negative total effect is driven primarily by the physical capital investment and the political instability channels.

Finally, corruption may limit the extent of a country’s trade openness and reduce inflows of foreign direct investment (FDI), leading to lower growth rates. Freckleton et al, (2012) examine the effects of corruption on investment, trade policy and political stability, and estimate the contribution of the various channels to the overall negative effects of corruption on growth. They conclude that the effects of corruption on growth are both direct and indirect through its impact on investment, schooling, trade openness and political stability.

Their studies show that level of corruption is a significant negative factor for investment, capital formation or growth of the economy. However, the decision of these countries to be more transparent (they signed a treaty in which they agreed to make legal and administrative changes to reduce corruption) has a positive impact on foreign direct investment and capital formation. The fact that the government is taking action to tackle corruption has a more important effect on foreign direct and domestic capital formation. Corruption in Central Asia and Europe is systemic and involves high-level political leadership. Therefore, the decision by the leadership to tackle corruption has an impact on the decision making of the investors.

Hypothesis 2: Political institution will have a mediating effect on the relationship between corruption and economic growth.

2.1.2. Non-linear relationship between bureaucratic corruption and growth:

Three principal theses in institutional economics have helped to clarify the links between corruption and economic growth: (i) that formal rules, informal norms, political institutions and enforcement characteristics shape actor (peoples) expectations and behavior; (ii) that actors make choices using subjective mental models, and thus individuals from different backgrounds may interpret the same evidence differently (cultural impact); and (iii) that institutions are endogenous. These insights have had significant influence on the research that examines how corruption interacts with the wider institutional set-up and actor choices to generate non-linear (differentiated) impacts on growth.

Analyzing the impacts of corruption as a dysfunctional institution, several studies examine the impact of corruption in the context of endogenous growth and corruption with non-benevolent principals (Aidt, 2009; Aidt et al, 2008; Mendez and Sepulveda, 2006; Swaleheen, 2011).

Mendez and Sepulveda (2006) found evidence of a non monotonic relationship between corruption and growth. They show that corruption has a beneficial impact on long run growth at low levels of incidence but is destructive at high levels, indicating that the growth-maximizing level of corruption is significantly greater than zero. This effect, however, was found to be robust only in a subsample of countries that have achieved a high degree of political freedom.

Aidt et al. (2008) undertake a similar study but instead of splitting their sample of countries according to some chosen level of governance quality, they allow the data to determine if two regimes exist. They find two governance regimes. In the regime with high quality institutions, corruption is found to have a significant negative impact on growth, while in the low quality instructional regime no corruption effect on growth is observed.

In sum, these empirical studies show that relatively little is confidently known about the macroeconomic effects of corruption.

Table 2: Non-linear relationship between bureaucratic corruption and growth

Research study

Countries

Time period

Political institutions

Mendez & Sepulveda, 2006

Large sample

1960-2000

Some factors controlled

Aidt et al , 2008

Cross section 67 to 71

(1995-2000) & (1970-2000)

Some factors controlled

Aidt, 2009

Cross-country comparisons

1970-2000

Inefficient institutions

Swaleheen, 2011

Cross-sectional

1984-2007

Efficient institutions

According to Aidt (2009) takes a critical look at categorizing the literature into two rival camps: the ‘sanders’, who argue that corruption is detrimental to growth, and the ‘greasers’, who argue that corruption may aid growth by enabling economic actors to circumvent bureaucratic hold-ups. He concludes that the evidence supporting the ‘greasing the wheels hypothesis’ at micro level study and shows that there is no correlation between a new measure of managers’ actual experience with corruption and GDP growth. Instead, he reports a strong negative relationship between growth in per capita wealth (not per capita GDP) and corruption at macro level, suggesting that corruption may be associated with unsustainable wealth generation even if its effect on GDP is not certain

Finally, Swaleheen (2011) the effect of corruption on the rate of economic growth for a panel of countries during 1984-2007 is investigated using recent improvements in dynamic panel data techniques to control for the endogeneity of corruption and investment. He Present evidence that, ceteris paribus, corruption has a direct effect on growth that is in addition to its indirect effects via investment and other channels, and that this direct effect is negative. To judge the relative importance of the effect of corruption, one can compare the partial effects of a one standard deviation change in the explanatory variables on the growth rate of real GDP per capita. Corruption has a significant effect on the growth rate of real per capita income. This effect is non-linear.

At the other end of the scale, however, political institutions – like voting -allow the citizens of the formal sector to reduce corruption by threatening to replace the incumbent who extracts rent too greedily. The politicians/rulers are willing to reduce current corruption to avoid being replaced and loss of future rent. Therefore, such political institutions have a disciplining effect on political behavior and allow the formal economy to grow, which means that the resource base from which politicians can extract rents expands over time. Therefore, institutions that reduce monitoring costs (i.e. cost of ‘firing’ the political leaders when bureaucratic corruption is high) create a benign feedback loop between economic growth and corruption: high growth reduces corruption, which in turn increases growth. Hence, the existing level of development mediates the impact of corruption on growth.

2.1.3. Positive impact of bureaucratic corruption on growth

In contrast to studies examining the non-linear nature of the corruption and growth relationship, the work on positive growth impacts of corruption is linear and highlights the ways in which corruption may foster growth by enabling the principal to overcome bureaucratic barriers. Aidt’s (2003) survey finds several theoretical justifications for this provocative claim. The leading argument that corruption may confer beneficial effects is known as the “grease the wheels” hypothesis proposed by [1] . It states that corruption may be beneficial in a second best world by improve the distortions caused by ill functioning institutions.

Kutan et al, (2009) look at the impact of corruption and political stability on the level of economic development that is, the level of per capita real GDP as opposed to economic growth. The study covers the ten-year period from 1993 to 2003 and includes a sample of countries in MENA and Latin America. The working hypothesis is that corruption may hurt or improve economic development, depending on the relative magnitudes of its effects as an institutional factor that leads to an inefficient allocation of resources and creates distortions in the economy, or as a tool that oils the wheels of economic activity by alleviating the negative effects of red tape and overly restrictive government regulations on private sector activity. Their empirical results suggest that corruption is positively related to the level of per capita income in the MENA countries they consider.

Meon and Weill (2010) analyze the inter action between aggregate efficiency, corruption, and different dimensions of governance and report a detrimental effect of corruption in economies with effective institutions. Although it was repeatedly found that corruption is less detrimental in countries where the rest of the institutional framework is weaker, these estimations did not always imply that an increase in corruption may be beneficial in at least one country in the sample. However, for each of the five dimensions of governance taken into account, they find evidence of the strong grease the wheels hypothesis, Positive association between corruption and efficiency in economies where institutions are ineffective.

Heckelman and Powell (2010) initial findings are that corruption can have a positive effect on growth, most likely by allowing people to circumvent inefficient public policies. They further find that the benefits of corruption fall as the economic institutional environment improves, utilize the economic freedom index to examine if corruption can facilitate growth by allowing entrepreneurs to avoid inefficient policies and regulations when economic freedom is limited. Using regression analysis, they find that corruption is growth enhancing when economic freedom is most limited but the beneficial impact of corruption decreases as economic freedom increases. Not all areas of economic freedom affect the corruption growth relationship equally.

Table: 3 Positive impact of bureaucratic corruption on growth

Research study

Countries

Time period

political institutions

Kutan et al (2009)

Middle Eastern-North America& Latin America

1993-2003

Inefficient institutions

Meon and Weill (2010)

cross-country comparisons 54

1994-1997

institutions are ineffective

Heckelman and

Powell (2010)

1995-2000

Inefficient institutions

Dreher and Gassebner (2011)

Cross-sectional

2003-2005

efficient institutions

Finally, Dreher and Gassebner (2011) investigate the question of whether corruption might ‘grease the wheels’ of an economy. They investigate whether and to what extent the impact of regulations on entrepreneurship is dependent on corruption. First, test whether regulations robustly deter firm entry into markets. results show that the existence of a larger number of procedures required to start a business, as well as larger minimum capital requirements are detrimental to entrepreneurship. Second, test whether corruption reduces the negative impact of regulations on entrepreneurship in highly regulated economies. Empirical analysis, covering a maximum of 43 countries over the 2003-2005 periods, shows that corruption facilitates firm entry in highly regulated economies. For example, the ‘greasing’ effect of corruption kicks in at around 50 days required to start a new business. Their results thus provide support for the ‘grease the wheels’ hypothesis.

The brief review above enables us to make three observations. First, empirical evidence on the corruption and growth relationship tends to indicate that corruption has a negative effect on growth. Secondly, although the majority of the studies summarized here report a positive relationship between corruption and growth. Thirdly, when non linear models of estimation are used, the effect of corruption tends to be regime or country specific, with higher negative effects in developed countries with good institutions and lower or insignificant effects in less developed countries with weak institutions.

Conceptual Model for corruption and economic growth relationship:

These observations indicate the need to conduct a systematic review in order to create the findings on the basis of models used for estimation, country groups and effect channels. This review addresses this need by providing random effect estimates (weighted averages) of corruption’s direct (GDP) and indirect (capital flows, human capital) effects on growth. Their population represents cultures that are quite different from each other. Developing economies have different cultural and economic characteristics, but they are often plagued by roughly similar levels of corruption. The key is that corruption affects economic growth differently in developing countries located in different parts of the world.

Figure2: Conceptual Model for corruption and economic growth relationship

Corruption

Economic Growth

Political institution

Country Culture context

In this frame work as a researcher I find that there is nonlinear relationship between corruption and economic growth, and institution quality define its relationship more clearly and all this situation is effected by country culture.

3.1. Methodology:

The quantitative research methods are being used in this study to develop the conceptual model. The secondary research is used in which the secondary data collected from the different research papers , books , investment analysts ‘reports ,market research studies ,newspapers , international research organizations like UNO, world bank, transparency international organization ,IMF and credit rating agencies for countries like standard and poor’s ,fitch ,ibca .

Framework synthesis is used for validating the conceptual model .The steps for framework synthesis are as under

Familiarization-immersion in the raw data (or typically a pragmatic selection from the data) by reading transcripts, studying notes and so on, in order to list key ideas and recurrent themes

Identifying a thematic framework-identifying all the key issues, concepts, and themes by which the data can be examined and referenced. This is carried out by drawing on a priori issues and questions derived from the aims and objectives of the study as well as issues raised by the respondents themselves and views or experiences that recur in the data. The end product of this stage is a detailed index of the data, which labels the data into manageable chunks for subsequent retrieval and exploration

Indexing-applying the thematic framework or index systematically to all the data in textual form by annotating the transcripts with numerical codes from the index, usually supported by short text descriptors to elaborate the index heading. Single passages of text can often encompass a large number of different themes, each of which has to be recorded, usually in the margin of the transcript

Charting-rearranging the data according to the appropriate part of the thematic framework to which they relate, and forming charts. For example, there is likely to be a chart for each key subject area or theme with entries for several respondents. Thus the charting process involves a considerable amount of abstraction and synthesis

Mapping and interpretation-using the charts to define concepts, map the range and nature of phenomena, find associations between themes with a view to providing explanations for the findings. The process of mapping and interpretation is influenced by the original research objectives as well as by the themes that have emerged from the data themselves

Analysis & conclusion:

The primary objective of this study is to critically assess the impact of bureaucratic corruption on economic growth. The analysis centers on whether corruption is sanding or greasing the wheels of growth. Researcher presents the detailed narrative synthesis of the findings with respect to direct and indirect effects of corruption on growth. To achieve this broad goal, the core channels through which corruption affects growth were identified in both the literature and empirical studies. These channels include, GDP per capita, cash flows (inflows and out flows), human development. Corruption has an adverse effect on the rate of growth of per capita income is now widely accepted, it is a morally wrong and economically harmful behavior. It is a symptom of a poorly functioning state. However, no economy is corruption free but its occurrence in countries is high possibly due to level of poverty, economic and political insecurity and weak rule of law.

The underlying empirical and theoretical literature, however, suffers from some major deficiencies. First, the previous studies are based mostly on cross-sectional studies which ignore the role of country, specific time invariant factors that affect corruption. Second, the co determination of the rate of growth of per capita income, the incidence of corruption, and the rate of investment is ignored. Third, the persistence of corruption is not taken into consideration. Fourth, the importance of how corruption is organized is overlooked. Fifth, as data collection improves, the opportunity for dynamic analysis expands. The methodology employed here could be extended to model the dynamic structure of the corruption and growth relationship. Sixth, disentangling the effects of the many different types of corruption requires future study.

Corruption can be either harmful or beneficial to growth, depending on the quality of the institutional environment. Several cross country studies have found that corruption slows growth, but these findings are not universally valid or robust. Researcher fined that there is nonlinear relationship between corruption and economic growth, and institution quality define its relationship more clearly and this entire situation is effected by country culture.

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