Privatesector P U B L I C P O L I C Y F O R T H E The World Bank April 1996 Note No. 74 The Political Economy of Corruption— Causes and Consequences Susan Corruption occurs at the interface of the public Paying for benefits Rose-Ackerman and private sectors. Sometimes officials simply steal state assets. But the more interesting and Governments buy and sell goods and services complex cases occur when a private individual and distribute subsidies. More recently, many or organization bribes a state official with power governments have sold state firms and provided over the distribution of public benefits or costs. infrastructure service concessions to private op- erators. All these activities can create corrupt What determines the level of corruption? The incentives. When the government is a buyer question is a vexing one, especially since no or a contractor, for example, there are several comprehensive empirical research exists on the reasons why a corrupt firm may pay off offi- incidence of corruption or its impact on resource cials. A corrupt firm may pay to be included in use and the distribution of income. Many offi- the list of qualified bidders, to have officials cials remain honest in the face of considerable structure the bidding specifications so that it is temptation, and others accept payoffs that seem the only qualified supplier, or to be selected small relative to the benefits under their con- as the winning contractor. And once selected, trol. Others, however, amass fortunes. The level it may pay for the opportunity to charge in- of malfeasance depends not only on the vol- flated prices or to skimp on quality. ume of potential benefits, but also on the riski- ness of corrupt deals and on the participants’ Similarly, when governments sell goods or ser- moral scruples and bargaining power. The over- vices at below-market prices, firms will often pay all impact of corruption, however, depends not off officials for access to state supplies. In China, just on the size of payoffs, but also on their for example, where many raw materials are sold distortionary effects on the economy. But even both at state subsidized prices and on the free when the impact is significant, the efficient level market, payoffs reportedly are common.1 When of bribery will not be zero. Bribery is costly to the state controls the supply of credit and the control, and reforms must consider the costs as rate of interest, bribes may be paid for access. well as the benefits of fighting it. Businesspeople in Eastern Europe and Russia report that payoffs are often necessary to obtain This Note examines the opportunities for illicit credit.2 And, when the state maintains multiple gain that exist in all countries. It asks what exchange rates at artificially low levels, firms of- factors determine the size and incidence of ten pay bribes to get scarce foreign exchange. bribe payments, and assesses the political, eco- nomic, and distributive consequences of cor- Corruption can also occur when spending on ruption. A companion Note reviews strategies subsidies and benefits is too low to satisfy all that can reduce corruption. who qualify, or when officials must use discre- tion in allocating services. People may pay to Economic opportunities for corruption be judged qualified for a public benefit or to be selected to receive a scarce benefit. In the United Bribes are paid for two reasons—to obtain States, for example, corruption has periodically government benefits and to avoid costs. surfaced in public housing programs. And in Private Sector Development Department ▪ Vice Presidency for Finance and Private Sector Development The Political Economy of Corruption—Causes and Consequences India, observers report that even the very poor- trol access to the outside world, something that est must pay to obtain old age assistance. firms value highly. Recent customs reforms in Indonesia and Mexico were prompted, in part, Although privatizing state-owned enterprises by widespread evidence of this kind of reduces opportunities for corruption, the priva- corruption. tization process itself can create corrupt incen- tives. A firm may pay to be included in the list Firms and individuals everywhere will pay to of qualified bidders or to restrict their number. avoid the costs of delay. For example, if the It may pay to obtain a low assessment of the government or a parastatal does not pay its public property to be leased or sold off, or to bills on time, contractors may pay to get speedy be favored in the selection process. Before re- settlement. In many countries, informal pay- forms to the process in Argentina, for example, offs are required to obtain even ordinary ser- privatizations allegedly favored those with in- vices such as a telephone, a passport, or a side information and connections, as have some driver’s license. In India, for example, a news- privatizations in the former Eastern bloc.3 paper recently published the “fees” for a range of routine public services such as access to gas, In all these types of government programs of- telephone, power, and education services.4 ficials are likely to amass valuable information. Private individuals and firms may be willing to Businesses selling outlawed goods and services pay for information such as bidding specifica- are especially prone to extortion. Law enforce- tions, the actual condition of soon-to-be-priva- ment authorities can demand payments to over- tized firms, and the location of future capital look criminal law violations or limit penalties. If projects. the evidence of criminal behavior is clear, such firms are unable to credibly threaten to report Paying to avoid costs corrupt authorities. Of course, illegal business- people are hardly innocent victims. They may Governments also impose regulations, levy purposely corrupt the police, seeking not only taxes, and enforce criminal laws. As they carry immunity from prosecution, but also monopoly out these functions, officials can delay and ha- power in the illegal market. In the United States, rass those they deal with, and they can impose for example, gamblers and drug dealers have costs selectively in a way that affects firms’ paid officials to raid their competitors.5 competitive position. Under public regulatory programs, firms may pay for a favorable inter- The size and incidence of bribes pretation of the rules or a discretionary judg- ment in their favor. The incentives to do so are The level of corruption is a function of the hon- especially high when the regulatory require- esty and integrity of both public officials and ments are unclear, giving much discretion to private individuals. With these factors held con- officials, or when regulatory agencies are new stant, the size and incidence of bribe payments and unproven. are determined by the overall level of benefits available, the riskiness of corrupt deals, and To reduce their tax payments, businesses and the relative bargaining power of briber and individuals may collude with tax collectors, di- bribee. The level of benefits is determined by viding the savings with them. In some parts of the nature of government programs, but cor- Eastern Europe and the former Soviet Union, rupt public officials themselves often influence where nominal tax rates are very high, business- the supply of benefits up for negotiation. For people report steep payoffs. In Italy, many al- example, they may be able to extract some of legations of corruption involve payoffs to tax a contractor’s profits by delaying payments or inspectors. Customs officials are particularly inventing ex post regulatory hurdles. They can likely to engage in corruption since they con- threaten to enforce criminal and regulatory laws more vigorously than is the norm. They can The costs of corruption also propose “white elephant” projects, or struc- ture privatization projects or natural resource How often do officials, private firms, and indi- concessions to include high monopoly profits. viduals take advantage of corrupt opportuni- ties, and how much money is paid in bribes? If the likelihood of detection and punishment is Not surprisingly, there is little solid evidence high, bribes may not be worthwhile. As the riski- on the incidence and magnitude of corruption. ness of corruption rises, the division of gains Surveys of businesspeople indicate that the from corruption will depend in part on the briber problem varies widely across countries. And and bribees’ relative tolerance for risk. It may within countries, some public agencies—for also depend on whether the probability of de- example, customs and tax collection—are more tection and punishment is a function of the size of a problem than others. Surveys also suggest of bribes. One possible result of stepped-up en- that where corruption is endemic, it imposes a forcement is a lower incidence of corruption, disproportionately high burden on the small- but an increase in the size of bribes paid. est firms. But, importantly, the most severe costs are often not the bribes themselves, but the Generally, the division of gains between the underlying distortions they reveal. payer and the recipient of the bribe depends on their relative bargaining power. One aspect Inefficiency and unfairness of this is their relative vulnerability to prosecu- tion. For example, if firms are punished less When payoffs are commonplace, government severely than public officials, their threat to contracts, privatized firms, and concessions may reveal a corrupt arrangement is more credible, not be allocated to the most efficient bidders. and they ought to be able to garner a larger One might argue that the most efficient firm share of the monopoly gains of bribery. In such would be willing to pay the highest bribe, but cases the size of the bribes is a poor guide to this would not be the case if this firm happens their distortionary effect. to be scrupulous. Corruption favors those with no scruples and those with connections over The relative position of a potential briber also those that are the most efficient. It produces depends on whether there are other ways of inefficiency because the need to pay bribes is obtaining the desired benefit. The potential an entry barrier, and firms that make payoffs briber might be able to obtain the same ben- may expect not only to win the contract or the efit by relocating to another jurisdiction or privatization auction, but also to obtain ineffi- country, by following legal processes at some cient subsidies, monopoly benefits, and regu- additional cost, or by using threats and intimi- latory laxness in the future. dation rather than payoffs. Or it might be able to obtain a comparable benefit by applying to Corruption introduces other kinds inefficien- another official in the same government. This cies into government contracting. Projects may is a real possibility when many officials can be too large and too numerous if bribe rev- provide a benefit, such as a license, a pass- enues increase with the dollar volume of pro- port, or help in smuggling goods. Similarly, in curement. They may also be too technically a democratic legislature, where a majority complex, since corrupt payments are easier to would have to be bribed, no one legislator has hide in one-of-a-kind projects. Quality may much bargaining power. Individual payoffs will suffer if contractors make payoffs to be allowed be low, but the overall incidence of corrup- to cut corners. In privatizations there is a more tion may be high. In general it seems that when subtle reason why the most corrupt firm will firms have other options, they can more easily not necessarily be the most efficient. A corrupt avoid making high payoffs and may be able to bidder with inside access may persuade offi- avoid corruption entirely. cials to badly manage a parastatal in order to The Political Economy of Corruption—Causes and Consequences lower its value. The insider then emerges as countries, corruption is both unfair and ineffi- the high bidder. Such behavior is difficult to cient. Corrupt countries can still grow, however, detect since, ex post, the privatization will ap- as long as corruption has not gone so far as to pear to be a smashing success. undermine economic fundamentals totally. For example, countries with mineral wealth can Officials may raise firms’ costs by introducing maintain living standards while officials siphon delays and unnecessary requirements as a way off a high level of payoffs. But recent econo- of inducing payoffs. This can happen in con- metric research suggests a negative association tracting and auctioning, for example, or in the between growth and high levels of corruption.6 administration of regulatory and tax laws. Fur- Case study material from around the world in- thermore, the process of paying bribes is itself dicates that illegal payoffs can increase the cost costly. For example, a firm might need to es- and lower the quality of public works projects tablish a web of offshore bank accounts to hide by as much as 30 percent to 50 percent.7 its illegal gains. Despite the costs of widespread corruption, they Corruption in contracting and privatizations also are a symptom of disease, not the disease itself. has distributive consequences. The gains of Eliminating corruption makes no sense if the re- bribery accrue to winning bidders and public sult is a rigid, unresponsive, autocratic govern- officials rather than to the state and ordinary ment. Instead, anticorruption strategies should citizens. To make up for high contract prices seek to improve the efficiency and fairness of and the disappointing revenue generated by government and to enhance the efficiency of the privatizations, the state must raise taxes or cut private sector. The companion to this Note ex- spending. Third parties may suffer in other ways plores reforms that respond to these concerns. The Note series is an open forum intended to too. Consumers may end up with low-quality encourage dissemina- products if bribes are paid to induce regula- 1 Michael Johnston and Yufan Hao, “China’s Surge of Corruption,” tion of and debate on tory officials to overlook dangerous conditions Journal of Democracy 6:80–94 (1995). ideas, innovations, and 2 best practices for or permit firms to reduce quality. Enforcement Martha de Melo, Gur Ofer, and Olga Sandler, “Pioneers for Profit: St. Petersburg Entrepreneurs in Services,” World Bank Economic expanding the private of workplace safety rules and environmental Review 9:425–50 (1995); Leila M. Webster, The Emergence of Private sector. The views regulations can be compromised by payoffs. Sector Manufacturing in Hungary, World Bank Technical Paper published are those of 229 (1993). the authors and should 3 For examples from around the world, see Michelle Celarier, “Steal- not be attributed to the Undermining political legitimacy ing the Family Silver,” Euromoney (February): 62–66 (1996). World Bank or any of its 4 “Bribe Index,” Sunday Times of India, December 17, 1995. affiliated organizations. 5 Nor do any of the con- Systemic corruption undermines the legitimacy Allan Kornblum, The Moral Hazards, Lexington, Mass.: D.C. Heath (1976). clusions represent of governments, especially in democracies, 6 Paolo Mauro, “Corruption and Growth,” Quarterly Journal of Eco- official policy of the where it can even lead to coups by undemo- nomics 109: 681–712 (1995). World Bank or of its 7 Executive Directors cratic leaders. By contrast, nondemocratic gov- Robert Wade, “The System of Administrative and Political Corrup- tion: Canal Irrigation in South India,” Journal of Development Stud- or the countries they ernments can use corruption to maintain power ies 18: 287–327 (1982), and Luigi Manzetti and Charles Blake, “Mar- represent. by spreading its benefits. If most wealthy and ket Reforms and Corruption in Latin America: New Means for Old Comments are welcome. powerful individuals are part of a web of cor- Ways,” Review of International Political Economy , forthcoming. Please call the FPD rupt payoffs and favors, the threat of exposure Note line to leave a can help current rulers to maintain power. Thus, Susan Rose-Ackerman is Henry R. Luce Profes- message (202-458-1111) or contact Suzanne corruption need not be destabilizing, but it al- sor of Law and Political Science at Yale Univer- Smith, editor, Room ways runs against norms of open and fair sity and a Visiting Research Fellow at the World G8105, The World Bank, dealing. Bank in the Private Sector Development Depart- 1818 H Street, NW, Washington, D.C. 20433, ment (email: sroseackerman@worldbank.org). or Internet address Conclusions She is the author of Corruption: A Study in ssmith7@worldbank.org. Political Economy and is currently working on 9 Printed on recycled Although no definitive evidence exists, there are a book on corruption in developing and transi- paper. good reasons to suspect that even in high-growth tion economies.