Economic freedom, corruption, and growth.

• Author: us Swaleheen, Mushfiq
• Position: Critical essay

This article adds to the empirical literature on the relationship between corruption and economic growth by incorporating the impact of economic freedom. We utilize an econometric model with two improvements on the previous literature: (1) our model acconnts for the fact that economic growth, corruption, and investment are jointly determined, and (2) we include economic freedom explicitly as an explanatory variable. Using a panel of 60 countries, we find that for countries with low economic freedom (where individuals have limited economic choices), corruption reduces economic growth. However, in countries with high economic freedom, corruption is found to increase economic growth. Our results contradict the generally accepted view that corruption lowers the rate of growth. We use Osterfeld's (1992) distinction between expansive and restrictive corruption to explain our results. According to Osterfeld, corruption expands output if more bribes help the economy move toward greater free exchange. Thus, in economies where economic freedom is high, if bribing makes public officials less diligent in enforcing restrictions on firms' activities, output will increase. However, corruption will restrict output when bribes reduce competition and increase market rigidities. This outcome is more likely in countries where economic freedom is low due to widespread state ownership of assets (e.g., in China), monopolies and high tariff barriers granted to businesses owned by ruling elites and their cronies (e.g., the Philippines under Marcos and Indonesia under Suharto), and state-run marketing boards that are often the sole purchasers of agricultural products (e.g., in several African countries). An increase in corruption in these low economic freedom countries means even less competition and free exchange and leads to a fall in output. The policy implication of our finding is straightforward: The surest way to mitigate corruption and its adverse effects is to increase economic freedom.

Private property rights need to be better protected if economic freedom is to increase. The protection of the right to one's person and property and the right to make choices about their disposition are the essence of economic freedom. When allocative decisions are made in a system where economic freedom is strong, markets lead to an efficient outcome. Societies obviously do not use such a one-dimensional system of allocation. The political system restricts or augments the economic power of individuals or groups on the basis of society's expressed preferences for goals other than efficiency.

We define corruption as the use of public office for private gain. It occurs at the fault line between the society's pursuit of the expressed non-efficiency preferences and the outcome that would occur when economic freedom is complete. This fault line, however, is amorphous because individuals' desire for economic freedom and the benefits that flow from it leads them to circumvent government regulations that limit the scope of legal market transactions. Thus, corruption, as well as its economic effects, is conditioned by the degree of economic freedom that market participants enjoy.

Previous Studies

There is an extensive literature on the economic effects of corruption. In modeling the effect of corruption on economic growth, previous studies have used a neoclassical growth specification. The rationale is that physical capital, labor (population growth), human capital (education), and institutional variables (of which corruption is one) contribute to the steady-state per capita income level. Given the initial per capita income, the rates of growth of these variables determine the speed at which an economy converges to its steady state, which affects the growth rate of GDP.

There are two serious problems in examining the relationship between economic growth, economic freedom, and corruption. First, differences among countries (known as "time invariant heterogeneity" or "country fixed effects") in terms of religion, culture, and institutions have an important role in explaining cross-country differences in corruption (Triesman 2000) and the rate of growth (Islam 1995). We believe these country fixed effects are correlated with economic freedom. Second, corruption, investment, and the rate of economic growth are simultaneously determined: The random shocks that affect the rate of economic growth may also simultaneously affect corruption, economic freedom, and other explanatory variables such as investment. Dawson (2003) shows that economic freedom is the result of growth rather than a cause of growth. Our review of the literature reveals that (a) the current body of empirical evidence on the effect of corruption on growth is based largely on cross-sectional models that cannot account for unobserved country-specific heterogeneity; (b) the degree of economic freedom in an economy is not considered explicitly; and (c) the simultaneity between corruption, investment, and economic growth is ignored.

Mauro (1995) is the seminal empirical work on the interaction between corruption and growth. He finds that much of the effects of corruption on growth take place indirectly, through the effect on investment. He also finds that when investment is controlled for, the direct effect of corruption on growth is weak. Mo (2001) presents evidence that corruption affects economic growth by lowering human capital accumulation and by undermining political stability. Pelligrini and Gerlagh (2004) add trade openness as an additional channel through which the effect of corruption on growth is transmitted.

Meon and Sekkat (2005) investigate the direct effect of corruption on economic growth while controlling for the quality of governance. Kaufmann, Kraay, and Zoido-Lobaton (1999) measure the quality of governance using an index based on the openness of the political system, the degree of political risk, the burden of regulatory controls, and the rule of law, and perceptions of the quality of public service provisions, the competence of the bureaucracy, and their independence. They address the following question: How does a distortion in the form of corruption (or an increase in the degree of corruption), on top of an existing distortion in the form of poor governance, affect growth? They find that corruption has a negative effect on economic growth and that the negative effect is stronger if governance is of poor quality. The policy implication is that reducing corruption would be more profitable in countries with poor governance.

In contrast to Meon and Sekkat, Houston (2007: 15) finds that in countries with poor governance, corruption helps to expand output and concludes, "Corruption should not be indiscriminately attacked in poorly goverued countries." The econometric models used in these two articles are very different: Meon and Sekkat use a neoclassical growth specification while Houston neglects to include some fairly standard explanatory variables based on the previous literature (e.g., investment and population growth).

Mauro (1995), Mo (2001), Meon and Sekkat (2005), and Houston (2007) all use cross-sectional models and ignore the endogeneity of corruption and investment. In contrast, Ehrlich and Lui (1999) and Mendez and Sepulveda (2006) use panel data to address the problem of the endogeneity of corruption through country fixed effects. However, neither work addresses the problem of simultaneity between corruption, investment, and the rate of growth. Ehrlich and Lui report that for a sample of 68 countries corruption affects the level of GDP but not economic growth. They treat corruption as exogenous. Using the categories "free"...