Can corruption ever improve an economy?

• Author: Houston, Douglas A.
• Position: Critical essay

Many in the world of developmental economics believe that corruption, the circumvention of the rule of law for private gain, leads to nothing but woe for any nation's economy, under any circumstances. Transparency International makes the elimination of corruption their mission, and many large multinational firms today echo that goal by building ethical codes that prohibit employees from engaging in practices deemed corrupt, regardless of local attitudes and customs toward the practices. The World Bank makes curbing corruption a linchpin in their campaign to improve governance. Reasons given for blanket condemnation of corrupt behavior are often utilitarian: Corruption is expected to increase the economic costs of doing business by undermining the laws of the land; this, in turn, reduces productive activities and investments, with negative consequences unfolding for human development and economic growth.

When legal protection of personal and property rights is strong, this argument is reasonable, but does it hold for nations that have failed to establish and consistently enforce a sound rule of law? Left (1964) and Huntington (1968) speculated that corruption may be considered a useful substitute for a weak rule of law. In other words, the value of behaving corruptly--the value of additional productive transactions that occur--can exceed the costs of engaging in corruption. This is most likely when the legal options for doing business are quite limited. Osterfeld (1992) makes a useful distinction in sorting out corrupt behaviors that is followed in this article. He divides corrupt actions into two categories: economically restrictive and economically expansionary. Corruption may often be restrictive, rent-seeking actions, such as firms' seeking government protection from competitors. But corruption also can expand economic activity, for example, by private citizens bribing officials to evade bad law. An underground ("informal") economy is built precisely upon effective evasions.

There can be both indirect costs and benefits related to corrupt behaviors that are not captured directly in individual acts of corruption, such as the support given to inefficient producers and forced allocation of resources away from their most productive uses (Murphy, Shleifer, and Vishny 1993). Such costs might exceed micro-level expansionary gains from particular corruption acts, and therefore it could be that all corrupt acts are economically restrictive, even those that are seemingly expansionary. But there is a lack of compelling empirical evidence that this is so, and the counter proposition--that sometimes corruption assists a nation's economy--is feasible and testable. The primary purpose of this article is to examine a broad spectrum of country-level data to understand better whether corruption might under some circumstances be expansionary for a nation.

The primary results from this study are that corruption has significant restrictive as well as expansionary economic effects. The relative magnitude of the two forces depends on the degree to which laws protecting property are enforced in a nation. When protections are weak, corruption can play a significant expansionary role for a nation. When they are strong, the primary economic effects from corruption are restrictive. This article suggests that in most stable nations the negative effects of corruption outweigh the positive by 50- to 100-fold; most corrupt behaviors seem to be consistent with a rent-seeking model. In such cases, broad direct campaigns to eradicate corruption are more likely to be useful.

On the other hand, nations with weak governance show much larger positive effects from corruption: For about 20 percent of the nations analyzed, the expansionary economic effects from corruption were above 20 percent of the restrictive effects, and for 12 nations the expansionary effects from corruption exceed the restrictive. This evidence supports the proposition that many corrupt activities substitute for missing or misguided law. These results suggest that direct attacks on corruption can be costly battles that will be resisted when corruption plays an expansionary role in a nation. Improving fundamental governance structures is a more appropriate target in these circumstances.

Corruption and Economic Welfare: Arguments and Findings

Corruption's effects on economic outcomes have been extensively studied. Many studies have been at the micro level, detailing the outcomes from acts of corruption. Most of these studies are anecdotal or case-based and generally argue that systemic effects of corruption on economic well-being are adverse (De Soto 1989). These findings support the intuition that corruption's impacts are quite damaging to economic efficiency.

Choi and Thum (1998) argue that firms may be prompted to organize themselves in inefficient ways in order to diminish the risks due to future demands of corrupt officials (e.g., building fly-by-night production that can be shut down with ease). Svensson (2005) argues that firms might expend considerable effort in building organizations that are particularly accomplished at dealing with corrupt officials. Additionally, corrupt acts can damage prevailing legal institutions so that generalized public trust falls, further weakening frail institutions and pushing more production into the underground economy.

A smaller set of studies has examined economic outcomes from corruption at the nation-state (macro) level, which is the approach used in this article. Mauro's (1995) large cross-sectional study demonstrates that corruption reduces investment, and this, in turn, reduces national economic growth. However, the corruption index he uses only affects GDP growth at the 10 percent significance level, while a broader measure of bureaucratic efficiency (presumed to be inversely related to corruption) has a more statistically significant impact on investment than on GDP. Svensson (2005) updates Mauro with more recent data but is unable to find any statistically significant relationship between economic growth and corruption. Although his regression model points to corruption's negative relationship to economic growth, the variable is not statistically different from zero, a result that does not change as he inserts a number of explanatory variables suggested in the growth literature.

Three IMF working papers (Abed and Davoodi 2000, Leite and Weideman 1999, and Tanzi and Davoodi 1997) all argue for corruption's negative impact on GDP per capita growth. Akcay (2006) finds that a country-level dependent variable measuring human development (which contains a one-third weighting on GDP per capita in terms of purchasing power parity) is negatively affected by corruption. Akcay (2006: 46) concludes that his study "extends the list of negative consequences of corruption and argues that corruption in all its aspects retards human development." Such a broad conclusion does not appear to be warranted by either theory or evidence to date.

Modeling Corruption's Influence on Economic Activity

The economically expansive view of corruption cannot be ruled out, and under some conditions can be compelling. Corruption could lubricate the flow of commerce when few legal (noncorrupt) options are viable for economic actors. Corruption would have value when it permits productive investments and trades that otherwise would not occur. For example, marketing boards in many African nations force farmers to sell produce at far below cost of production and external market prices; government officials can then resell crops for a sizeable profit. To survive under these conditions, farmers often bribe public officials to permit private sales or to smuggle product out of country. Such corruption permits the continuation of valuable economic activity that otherwise would decline precipitously (Osterfeld 1992).

As another example, licensing restrictions on many businesses are so draconian in many central and Latin American countries that many businesses operate illegally to avoid the endless restrictions and delays placed in front of a formally legal enterprise. Bribery is essential to sustain such businesses operating in the informal economy (De Soto 1989). The bribes paid by private parties generally are volitional (not forced extortions of funds), and presumably decisions to pay...