What is the Impact of Corruption on Economic Development?

Abstract

Corruption, a previously neglected issue, became one of the greatest preoccupations of Western powers trying to bring stability and prosperity to global markets. This essay seeks to establish the relationship between corruption and development. The focus of this paper will be the South East Asian Newly Industrialised Countries (NICs). I suggest that whilst it is difficult to ascertain the exact impact of corruption on development, in the absence of corruption, even greater and more sustained levels of development can flourish. I argue that despite arguments to the contrary, all corruption is inimical to the process of sustainable development. I suggest that the impact of corruption on development is clearly discernable though examination of the Asian Financial Crisis of 1997. This event demonstrated that whilst development and corruption can coexist, corruption creates unsustainable inefficiencies and inherent weakness in the economy for the long term.

Table of Contents

Abstract 2

Introduction 4

Perspectives on Corruption 6

Corruption and Development 7

Influencing Government 7

Predictability 8

Innovation 9

Competition & Efficiency 11

Government Policy 12

Methodology 15

The Asian Miracle and Corruption 16

The Paradox of Corruption and Growth 16

Tangible Costs of Corruption 18

Intangible Costs of Corruption 20

Uneven Impact of Corruption and Development 21

The Asian Financial Crisis 23

Crony Capitalism 23

Unveiling the Impact of Corruption 25

Conclusions 27

Bibliography 29

Books 29

Journals 29

Online Sources 30

Other 31

Appendices 32

Introduction

The post Cold War, globalized era of the 1990’s saw a renewed interest in corruption and its impact. Corruption, a previously neglected issue, became one of the greatest preoccupations of Western powers trying to bring stability and prosperity to global markets. But is the pursuit of an anti-corruption agenda really conducive to development? Corruption has always existed, in all societies and at all stages of development. The dominant discourse suggests that systemic corruption is a major impediment to sustainable economic development yet despite extensive normative discussion on the merits of the absence of corruption, little academic discussion based on empirical evidence demonstrates the validity of this argument.

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This paper seeks to establish the relationship between corruption and development. The focus of this discussion will be the South East Asian newly industrialised countries (NICs). NICs are countries exhibiting considerable industrialisation having switched from agriculture to industrial production. South East Asian economies, including South Korea, Taiwan, Hong Kong and Singapore, achieved exponential growth from the 1960’s to the late 1990’s when the Asian financial crisis took effect. The transformation from poverty to affluence was widely heralded as the success of capitalism over communism and a demonstration of the success of liberal, free market principles. However, while the governments were ostensibly laissez-faire, in practice they were quite active in their economies. It is within this context that the study of corruption in NICs is so fascinating. Despite bureaucracy within the market and widespread corruption, remarkable economic development prevailed. What remains unclear is to whether this was because of or in spite of corruption. Can some corrupt activities actually be beneficial to rapid development?

In only focussing on economic development, just one facet of the multi-faceted issue of development, is addressed. The reason for this focus is for reasons of brevity and that unlike aspects such as political or social development for which improvements or otherwise is harder to prove, economic development is more quantifiable. A holistic approach to development may yield different results and whilst recognising the importance of political and social aspects, economic development yields the clearest indicators for development. Hereafter economic development is shortened to, ‘development’ although this is not meant as an all encompassing term to describe all aspects of development.

Beginning with an analysis of the academic perspectives on corruption, this paper investigates South East Asian NICs to establish the impact of corruption on economic development. These countries have been chosen as they have to a great extent completed the industrialisation process and thus the impact of corruption is more readily and clearly identifiable. Extensive reports of corruption in these countries make them well suited to investigation. I argue that corruption acts as a brake to development and that in the absence of corruption, even greater and sustained levels of development can occur. Additionally, I argue that all corruption is inimical to the process of sustainable development and suggest the Asian Financial Crisis is proof of this.

Perspectives on Corruption

It is prudent to establish what we understand by the term ‘corruption’. There are various definitions and understandings as to what exactly constitutes corruption. The definition most frequently used by social scientists is Nye’s, that corruption is: “…behaviour which deviates from the normal duties of a public role because of private-regarding (family, close private clique), pecuniary or status gains; or violates rules against the exercise of certain types of private-regarding influence. This includes such behaviour as bribery (use of rewards to pervert the judgment of a person in a position of trust); nepotism (bestowal of patronage by reason of ascriptive relationship rather than merit); and misappropriation (illegal appropriation of public resources for private-regarding uses)” [1] This can be simplified to a general definition that will be used for the purposes of this paper: the abuse of public office for private gain.

Although defining corruption in this way is convenient, it should not be considered a rigid framework for ruling what should or should not be considered corrupt. Different nations and cultures have differing conceptions of corruption; legally, in terms of public interest, and in public opinion. Furthermore, certain ‘corrupt’ exchanges such as clientelism and gift giving may be engrained within the culture of the society and so are not considered by those involved, to be corrupt. As Gardiner notes, “There are nations where official corruption has been widespread for many years with no visible signs of public outrage.” [2] The reason for this may be, as the analysis on the benefits of corruption reveals, there are instances when ‘corrupt’ activities seem to be beneficial to development.

Perspectives on the costs and benefits of corruption can divided into those that perceive the benefits of corruption to be positive for development, and those that regard it as inimical to the development. Although among recent literature there is consensus that Leff’s arguments lauding the benefits are flawed, an understanding of his rationale in asserting that corruption can be beneficial to development is valuable if only to juxtapose against opposing arguments.

Corruption and Development

Influencing Government

Leff argues that corruption is an extralegal institution used by interest groups to gain influence over the actions of the bureaucracy to an extent that would not otherwise be possible. This he suggests can be beneficial to development if business groups that would otherwise be at a disadvantage in articulating their interests to the government get an opportunity to do so. If these groups are more likely to promote growth than the government, an enhanced position in policy making could, he suggests, be beneficial to development. He outlines instances where this may be the case; “…the government and bureaucracy may simply be indifferent to the desires of entrepreneurs wanting to initiate or carry on economic activities.” [3] The reasons for this may be the government’s dislike for a competing centre of power or that they do not attribute much value to economic activity. Leff also suggests that governments may have other priorities rather than the pursuit of economic development such as the consolidation of armed forces. These are priorities which can impede development. He suggests bribery can activate the bureaucracy to get things done which otherwise would not take place; “…it can induce the government to take a more favourable view of activities that would further economic growth… [and] provide the direct incentive to mobilize bureaucracy for more energetic action on behalf of entrepreneurs.” [4] If this were true, and operated under a perfect competition model then there may be benefits to development.

Mauro disputes these claims, noting how in this corrupt system, the sale of government contracts or policy through bribery means that the highest bidder always wins: “The allocation of public procurement contracts through a corrupt system may lead to a lower quality of public infrastructure and services.” [5] Rather than choosing contractors by merit and the best potential outcome, corrupt bureaucrats could harm development by awarding contracts which result in substandard outcomes. In this instance the impact of corruption is a clear failure to achieve government objectives; instead producing inefficiency and waste. With bureaucrats being ‘buyable’, they are most likely to seek out the highest rent-seeking opportunities; “Corrupt government officials may be more likely to choose to undertake types of government expenditure that allow them to collect bribes and to maintain them a secret.” [6] Rather than seeking projects which would genuinely contribute to development, bureaucrats will look to find large projects where money can easily be siphoned off.

If corruption takes the form of a kickback, the total amount available for public purposes is reduced. Corruption is sometimes compared in this way to a tax on investments and business. However, Shleifer and Vishny note that because of the need to maintain secrecy, corruption causes a greater distortion in economic activity than taxation. For example, dishonest government officials may favour promoting government activities, where bribery is most easily concealed. They suggest; “…the demands of secrecy can shift a country’s investments away from the highest value projects, such as health and education into potentially useless projects such as defence and infrastructure, if the latter offer better opportunities for secret corruption.” [7] Not only are total funds available for public use diminished but they are spent on projects which are not necessarily best for development.

Predictability

Investments in developing countries can be particularly risky due to the unpredictability of the political and economic conditions. The extensive role of the government in the economy means arbitrary decision making can be problematic for business for which maintaining consistency and judging long term economic trends is important. In this situation, securing predictability for their investment, Leff suggests, creates a more attractive environment for investment; “Corruption can help economic development by making possible a higher rate of investment than would otherwise be the case.” By bribing officials to maintain certain political conditions, the success of an otherwise risky investment can be secured as there is a much more assured return on investment.

However, Mauro has demonstrated through empirical evidence that high levels of corruption are associated with lower levels of investment and GDP. In a corrupt environment, entrepreneurs are aware that bribes are required to ensure the release of required documentation needed to begin business and are consequently discouraged from investing. Additionally, a percentage of returns on the new enterprise may be claimed. It is for this reason that Mauro suggests “…corruption may be interpreted to act as a tax…which correspondingly reduces incentives to invest.” [8] Empirical evidence shows low levels of corruption correspond to greater levels of investment; “…a one standard deviation improvement in corruption indices drawn from the Business International causes investment to rise by five percent of GDP and the annual per capita GDP growth rate to rise by half a percentage point.” [9] Although establishing what constitutes ‘higher’ and ‘lower’ levels of corruption is problematic, this link, supported by the work of Keefer and Knack indicates that there is an unambiguous link between corruption and levels of investment, GDP and thus development. [10] Businesses want secure investments but adding corrupt rent-seeking bureaucracy may not be effective in securing the political conditions; investors would simply prefer a non-corrupt environment in which to invest.

Innovation

In an undeveloped society, potential entrepreneurs may be discouraged from investing and innovating due to the barriers of entry created by existing products and processes. In this situation, Leff suggests, “…graft may enable an economic innovator to introduce his innovations before he has had time to establish himself politically.” Leff suggests that because of bureaucrats’ existing economic interests, innovators may be regarded with indifference or even hostility. In this environment, bribery could provide innovators an opportunity to obtain elusive government licenses and permits. Furthermore, ‘facilitation payments’ may allow businesses to bypass unnecessarily cumbersome delays. Leff also suggests that corruption may increase investment by reducing the risk that a fickle government may, in the future, intervene harmfully in an innovator’s project.

Whilst entrepreneurship is generally regarded as being innovative and beneficial to development, in the case of, ‘innovative rent-seeking’ this is not the case. Baumol argues it is not always productive; it may even have a destructive impact on economies where parasitical activities damage the economy. [11] Corruption misallocates potentially beneficial talent to corrupt activities and distorts investment priorities. Where the informal, black market and corruption is more financially rewarding than the formal economy, a brain drain effect could occur. Rather than highly talented and educated individuals aiding development they will prevent potential development from taking place.

Corruption invariably increases transaction costs and uncertainty in an economy while lowering efficiency by forcing entrepreneurs to divert their scarce time and money to bribery rather than production. As has been previously discussed, those paying the highest bribes may be those with the best insider information and funding rather than those who would most productive and reap the best rewards for development. Furthermore, bribery increases business risk because of the uncertainty as to whether government officials will actually provide the services for which they have been bribed.

Contrary to economists who argue the benefits of entrepreneurial corruption, Murphy suggests that, “…rent seeking activities, particularly public rent-seeking by government officials, is likely to hurt innovative activities…” [12] He notes that in order to start a new enterprise, innovators often require government documentation and licenses. Without an inside contact to expedite this process, they may be forced to pay bribes to secure the paperwork required. This in turn increases the vulnerability to long term bribery. Because innovators are outside the established system of bribery, it is often not in the bureaucrat’s interest to enter into new corrupt transactions because in doing so they increase their chances of being caught. Instead they may prefer to charge their existing ‘clients’ to bar innovators from entering the market. It is in this way that oligarchies can maintain their power in the developing world and prevent innovation which could aid development.

Competition & Efficiency

Some political scientists view corruption as being a, ‘second best, or ‘grease the wheels’ solution, particularly in the inefficient, inept, and mismanaged bureaucracies in developing countries. Huntington suggests, “…in terms of economic growth, the only thing worse than a society with a rigid, over-centralized dishonest bureaucracy is one with a rigid, over centralized honest bureaucracy.” [13] Those willing and able to pay the highest bribes are likely to be those able to use it most productively.

Similarly, Leff contends that introducing competition into an otherwise uncompetitive economy can be beneficial to development; “…corruption brings an element of competition with its attendant pressure for efficiency to an underdeveloped economy.” [14] By allocating contracts to the highest bidder, it ensures only those able to pay the highest bribes, and thus the most efficient (because they have to muster capital required) survive. Riley makes similar conclusions in a study of the impact of corruption in developing countries – that corruption simply reflects misadministration of government in general; a way to get around inefficient and cumbersome government bureaucracies. [15] It is suggested that bribery can be an efficient way of negotiating otherwise over regulated, cumbersome and ineffective legal systems.

However, there is little evidence to support these arguments. In response to the argument for corruption being a ‘grease’ which lubricates the ‘squeaky wheels’ of a bureaucratic and rigid administration, Gray and Kaufmann suggest inventing bureaucracy to facilitate rent-seeking opportunities; “…fuels the growth of excessive and discretionary regulations.” [16] Corruption leads to economic inefficiency and waste, because of its effect on the allocation of funds, on production, and on consumption. Gains obtained through corruption are unlikely to be reinvested within the country but transferred to foreign bank accounts. These transfers represent a capital leakage from the domestic economy. Furthermore, corruption generates inefficiency in allocation, by permitting the least efficient contractor with the highest ability to bribe to be the recipient of government contracts. In addition, since the cost of bribes is included in the price of the goods produced, demand tends to be reduced, the structure of production becomes biased, and consumption falls below efficiency levels.

Corruption encourages competition in bribery, rather than in quality and in the price of goods and services. It inhibits the development of a healthy marketplace and distorts economic and social development (see Appendix I). Moreover, evidence shows that if corruption is not contained, it will grow exponentially. [17] Studies show that: once a person is identified as willing to pay bribes, other ‘gatekeepers’ appear to be alerted, so that the person is delayed and subjected to additional forms of extortion as he or she proceeds. Conversely, those who refuse to pay at the first ‘gate’ are earmarked as non-payers and therefore not worth the time and energy for others to try to exploit. [18] 

Government Policy

Leff suggests that corruption can alleviate problems of bad government policy and planning; “Corruption performs the valuable function of a ‘hedge’ and a safeguard against the full loses of bad economic policy.” [19] Through corrupt activities it is possible to implement the opposite policy to the government. For example in the case of export promotion versus import substitution – whilst the government is pursuing one avenue of policy, entrepreneurs can activate a parallel yet opposite policy to ensure that all is not lost if the government are wrong in their policy decision.

If however, the government is in fact pursuing policy most conducive to development, this is clearly problematic; a corrupt black market undermining government policy is counter productive to the broader processes of development. Corruption reduces opportunities for the government to control the economy and limits potential spending -a strong informal economy can have a crippling effect. A Mauro notes: “Corruption may also bring about loss of tax revenue when it takes the form of tax evasion….” [20] Corruption reduces the transparency of economic transactions by both public and private sector firms while undercutting the government’s ability to raise capital. Corruption can create fiscal weakness which in order to compensate for decreasing tax revenue, may force an increase in rates of taxation on a diminishing number of taxpayers thus reducing its ability to provide essential public goods and services (see Appendix II).

Corruption weakens the State and its ability to promote development and social justice. It is regressive in the sense that its costs and negative economic impact tend to fall more heavily on small enterprises and an on individuals in a weak economic position. The World Bank suggests: “Corruption is a double jeopardy for the poor and unprotected. They pay a high share of monopoly rents and bribes, while they are often deprived of essential government services.” [21] It pushes firms into the black market, which effectively reduces the state’s ability to raise capital and thus leads to ever-higher taxation on fewer and fewer taxpayers. This in turn reduces the state’s ability to provide essential public goods, including the rule of law. [22] 

Corruption undermines development by distorting the rule of law and weakening the institutional foundation on which economic growth depends. The harmful effects of corruption are especially severe on the poor, who are hardest hit by economic decline, are most reliant on the provision of public services, and are least capable of paying the extra costs associated with bribery, fraud, and the misappropriation of economic privileges. Thus corruption can be seen to be’ “…one of the greatest enemies of development.” [23] 

Methodology

I hypothesise that all corruption, no matter what its form is inimical to long term and sustainable development. Measuring specific impacts from corruption is difficult due to the vary nature of corruption – unless the corruption is brought into the public domain, the exact impact of corruption cannot be known. In order to prove the validity of my hypothesis I intend to investigate the economic development of South East Asia to ascertain whether or not an explanation can be given for concurrent high levels of corruption and development.

Rather than examining specific cases of development and corruption in countries, I seek to explain the broader phenomena of the coexistence of development and corruption in the region. The investigation will rely on secondary evidence from journal articles and evidence from the internet. I will understand economic development to be “…increases in a country’s real per capita income that affect broad segments of the population and in which the productivity of resources is enhanced as new stocks of resources are generated.” [24] Although Transparency International now offers the Corruption Perceptions Indicator (CPI) to measure the extent of perceptions of corruption, in the period of phenomenal growth, there is no such data available. Consequently, it will be assumed that the allegations of widespread and systemic corruption are in fact true.

The Asian Miracle and Corruption

The Asian Miracle raises questions for the modern view that corruption is inimical to development. Evidence clearly shows that phenomenal rates of growth have occurred in an in environment of high, even astronomical rates of corruption. The academic response has been divided. Some believe it vindicates Leff’s proposal that corruption can be good – business with an emphasis on connections works as well, if not better for development than a system based on openness, accountability and competitive bidding. Others suggest that the Asian Miracle can be explained because systemic corruption was not actually as bad as it is made out to be. The logic for this fits modern analysis of corruption; systemic corruption is harmful to development and so development within this environment is impossible. By examining the causes and costs of corruption it will become apparent to what extent these perspectives on the impact of corruption are true.

The Paradox of Corruption and Growth

The prevalence of informal networks, weak indigenous business, and a strong state can explain the high levels of corruption that have co-existed with economic growth. After the Second World War, the extensive role of the state in creating, and augmenting markets, as well as controlling investment and the role of exports was invaluable to their initial growth and success. The legitimacy of these managed and fragile democracies was dependent on securing economic growth. Pei suggests that the, “…emphasis on growth in East Asia had a political origin: authoritarian regimes ruled in all high-performance East Asian economies …maintaining high growth rates was and is regarded as essential for building not just industrial economies, but the political legitimacy of the ruling elites.” [25] Poor performance was typically concealed by large government loans so that what appeared to be growth was often simply recycled state capital.

Most of the governments owned and ran banking businesses and so corrupt finance markets provided a way for many businesses to generate capital; “Through the operation of the black market mechanism, relevant officials obtain ill gotten gains from the enterprises, while the enterprises themselves are provided special privileges to make money.” [26] Businesses borrowed substantial sums of capital from the state owned banks with low interest rates. Due to the ease and availability of these loans, businesses tended to expand simply because they could and in so doing became increasingly inefficient and vulnerable to problems in the face financial challenges. Companies would reward officials who provided privileges (this could take various forms but includes procurement of government finance, expediting paperwork and overlooking anomalies) by providing a job for them within the company upon their retirement from government. Due to the very nature of this bad finance, debtors were simply unable to pay off their loans, increasing their vulnerability to financial crisis.

Xu suggests that corruption was an integral part of the way in which the economies and markets functioned; “Corruption is viewed as a kind of transaction cost, through which enterprises can enjoy special privileges offered by the government.” [27] The corrupt finance enabled businesses to grow at a much faster rate than would otherwise be possible. As Segal notes, “Companies cut in a member or a friend of the elite, so that business still got done, but at a vastly inflated cost.” [28] These inflated costs reduced the rate at which development could have progressed as well as creating an underlying weakness in many businesses. Rather than expansion and success based on results, it was through an unsustainable system of corruption.

The states’ role in controlling business, and largely suppressing labour and civil society groups led to their strength and independence from outside interests. A weak civil society compounded the corruption issue. Moran suggests that, “Corruption… stemmed from interconnecting historical and structural factors. The strong state was vital here but so also were weak social forces (particularly nascent entrepreneurial groups) and traditions of patron-client networks of family, school, regional and other ties.” [29] Government regulation, restrictions on foreign capital and competition, a concentration of power in family-owned business groups with close ties to government, and closed financial systems contributed to growth but paradoxically, also contributed to a steady weakening of the South East Asian economies.

Finally, in contrast to the ‘rule based capitalism’ prevalent in developed Western countries, Sing suggests the most suitable label for East Asian economies is ‘relation-based capitalism,’ a system characterised by personal and implicit agreements and governed by second-party enforcement – based on a mutual trust between the transaction parties. [30] Where the market is small, or the number of transa