Corruption: A Hidden Tax on Growth

By Vitor Gaspar and Sean Hagan

(Versions in Español عربي中文Français日本語, Русскийعربي)

In recent years, citizens’ concerns about allegations of corruption in the public sector have become more visible and widespread. From São Paulo to Johannesburg, citizens have taken to the streets against graft. In countries like Chile, Guatemala, India, Iraq, Malaysia and Ukraine, they are sending a clear and loud message to their leaders: Address corruption!

Policymakers are paying attention too. Discussing corruption has long been a sensitive topic at inter-governmental organizations like the International Monetary Fund. But earlier this month at its Annual Meetings in Lima, Peru, the IMF hosted a refreshingly frank discussion on the subject.  The panel session provided a stimulating debate on definitions of corruption, its direct and indirect consequences, and strategies for addressing it, including the role that individuals and institutions such as the IMF can play. This blog gives a flavor of the discussion.

What is corruption

Defining corruption may seem easy. Most people will have the sense that they know it when they see it. For example, a public official takes a bribe in exchange for providing a financial or political gain. However, experts increasingly consider corruption to be much broader. Rather than merely being a transaction between two parties, as one panelist put it, corruption can be viewed as “the privatization of public policy.” Powerful elites in business and politics collude to control public institutions, capture the policy-making process, and monopolize government contracting and procurement. Another panelist defined corruption even more broadly as “the lack of impartiality in government”, where public money and authority are used in ways that impact negatively on human well-being.

The costs of corruption

The direct economic costs are obvious to most people. Demand for bribes by providers of services affects achievement of social outcomes. The bribe to the taxman that reduces public revenues, and lowers government’s provision of public services. A school that is not built because the allocated funds have been misappropriated. Yet, the indirect costs are likely to be economically far-reaching. As investigated in Governance, Corruption, and Economic Performance by George T. Abed and Sanjeev Gupta (editors), corruption has a negative impact on economic growth through, for example, the over-investment in rent seeking, the underinvestment in productive activities,  and the perpetuation of inefficient policies, among other things. The economic costs of corruption, which by the way afflicts countries at all stages of development, are substantial. One 2005 study estimated that the global cost of bribery alone could be as high as 1.5 trillion dollars (in the order of 2 percent of the world’s current GDP). Other studies show a strong correlation between lower levels of corruption and long-term improvements in GDP per capita and in human development indices. In sum, corruption is a tax on growth and investment.

Moreover, some panelists emphasized that the costs are not only economic in nature. Corruption also contributes to the loss of public trust in government, higher levels of inequality in political influence, the deterioration of public values and, ultimately, to the diminution of citizens’ well-being or quality of life. These non-economic costs create a vicious cycle of under-performance of the public sector that is harmful to the economy in the long-term. 

Broad and multifaceted approach required 

Given how broadly corruption and its consequences are now viewed, all panelists agreed that addressing it also requires a broad and multifaceted approach. Such a holistic approach requires leadership, changing incentives and building values, which are all mutually-reinforcing.

  • First, leaders must be willing to bring to account powerful vested interests—the big fish rather than the small fish, the tigers rather than the flies. They must also set the example by being above reproach. Lee Kuan Yew of Singapore is a prime example of a leader who successfully fought corruption through his own personal example and the political will that he engendered.
  • Second, strong incentives. Leadership must be complemented by a strong system of carrots and sticks—positive reinforcement and accountability. There needs to be a clear framework to combat corruption that is enforced. At the same time, governments need to ensure that public officials earn a living wage. Openness of the economy through deregulation and liberalization will also help since overly-regulated economies create strong incentives to maintain corrupt practices. Poland is a good example of quick and effective liberalization measures. Transparency of government operations and transactions is also important as a disincentive.
  • Three, building values of integrity. Countries need to promote a culture that values clean government. Building such a culture requires education of citizens. Formal training can help, but ultimately values must be learned through the education system, peer pressure and the day-to-day work experiences and practices of institutions.

How the IMF can help 

Given that corruption has implications for the soundness of public finances and for the stability of financial markets—issues of direct interest to the IMF—panelists emphasized that the Fund has a clear interest in helping its members to tackle corruption.

The IMF assists countries to deter corruption through better design and transparency of public financial management systems (see, for example, IMF Fiscal Transparency Code) and by supporting stable and transparent economic and regulatory environments that limit the scope for arbitrary and preferential treatment. In crisis situations where dealing with corruption is deemed to be critical for macroeconomic stability, the Fund has been more active. In some instances, it has insisted on the reform of legislative frameworks for anti-corruption and of law enforcement functions. Kenya, Indonesia and Ukraine are examples.

In most cases, corruption starts long before it becomes critical to the economy. How early should the IMF become more directly involved in helping to address it? Given the long-term impact of corruption, should discussions be integrated in the IMF’s annual consultations with its members? Here, the IMF’s First Deputy Managing Director, David Lipton, acknowledged that this is not an easy question. While member countries are more open to discussing corruption, it is still a sensitive topic and the IMF role will require some further examination and discussion. In any case, Mr. Lipton emphasized, when a country shows real political will to tackle corruption, the IMF should help it to make the bold and comprehensive changes to economic policies and regulatory frameworks that are necessary to decisively limit the costs of this hidden tax.

One Response

  1. Dear Mr. Gaspar and Mr. Hagan:

    Thank you for writing this interesting blog on corruption which adversely impacts so many countries across the world.

    The main problem of addressing corruption is that the term is too generic and means different things to different people as its nature changes from one country to another. The issue has been discussed to death but economists and policymakers have little to show for it. In fact, according to World Bank Governance Indicators, corruption has perceptively worsened in many countries around the world. What then would be a preferable method to make tangible progress against corruption?

    We at Global Financial Integrity believe that it is far better to curtail illicit financial flows (IFFs) to and from developing countries. IFFs are strongly and positively linked to corruption. In fact, IFFs represent one of the few quantifiable indicators of corruption. Governance indicators, in contrast, are qualitative indicators based on surveys of economic agents. Empirical estimates of the underground economy is another quantifiable indicator of corruption–the larger the underground economy as a share of GDP, the weaker the state of overall governance in a country. Quantifiable indicators of corruption are necessary to complement qualitative indicators in order to allow policy makers and the public to measure progress and monitor the performance of anti-corruption policies in the medium to long run..

    The major conduit of IFFs is the deliberate misinvoicing of external trade. Only about 20 percent of IFFs exit these countries through the balance of payments. GFI studies estimate that slightly more than a trillion dollars leave developing countries in an unrecorded manner. Apart from the fact that IFFs reflect poor governance, they drain resources and pose a serious challenge to sustainable development. Even illicit inflows (such as through import under-invoicing) represent tax evasion and are not a benefit unlike inflows of recorded capital like FDI.

    The IMF should provide technical assistance to member countries to track and curtail illicit financial flows. A range of measures needs to be put in place. For instance, the IMF could provide more TA in the area of comprehensive Customs reform in order to curtail trade misinvoicing. Members could also benefit significantly from strengthening their AML/CFT laws so as to strengthen key regulatory institutions such as the Central Bank and the Financial Intelligence Units. The IMF could also help member countries develop various indicators of IFFs based on the data reported for publication in the DOTS, IFS, BOP, etc. It is time that the IMF take concrete steps to reign in the pernicious influence of IFFs on the social and economic stability of its members.

    Dev Kar
    Chief Economist
    Global Financial Integrity
    Washington DC 20036

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