This paper will demonstrate that corruption is a major cause of poverty. This paper will closely examine the effects of corruption on the poor and will show corruption discriminatorily diverts funds away from the poor. Finally, this paper will conclude that if corruption indices were lower, developing countries could have significantly lower rates of poverty.
Any attempt to examine the effects of corruption on poverty must first provide for a useful definition of corruption. All forms of corruption are harmful however it is important to distinguish between public corruption which includes corruption in the government and in the market, and private corruption such as money laundering done by private individuals involved engaged in illegal conduct. This paper will focus on the former type of corruption which has shown to be most devastating to poverty.
Corruption
A widely accepted definition of corruption as used by the World Bank and the International Monetary Fund is ‘the abuse of public roles or resources for private benefit.’ More narrowly construed, corruption is the bribery of government officials for any services rendered whether such services are directed towards achieving a business advantage or personal gain. Demanding bribes in exchange for tax incentives or to obtain government contracts are included in this definition of corruption.
Corruption and Economic Growth
Economic growth is the single most important facture in the reduction of poverty. Despite a considerable increase in economic growth in developing countries, presently 1.3 billion people live on less than $1 a day. Many reasons can account for the discrepancy in economic growth and the reduction of poverty. The effects of corruption, however, are uniquely devastating to the poor. This paper will demonstrate that corruption causes poverty by 1) showing that corruption impedes economic growth and 2) showing that corruption eliminates the benefits that the poor would otherwise receive from economic growth and other sources.
Corruption impedes economic growth by creating income inequality, perpetuating unfair asset distribution, deterring private investment and foreign direct investment , and by resulting in poor allocation of government expenditure.
Corruption and Income inequality
Research conducted by the IMF , provides the earliest evidence of the correlation between high rates of corruption and income inequality. The study reveals that an increase in the corruption index is tied to a substantial increase in income inequality. Specifically, the studied shows that a worsening in the corruption index in one country by the standard deviation of 2.25 points is associated with an increase in the Gini coefficient by 4.4 points. Furthermore, the study concludes that corruption causes income inequality and not the other way round. The graph located in Appendix 1 reflects these results.
Studies also reveal that high income inequality can cause poverty despite evidence of economic growth. Ravallion argues that high income inequality can cause poverty even if the country is experiencing economic growth. This might explain why in developing countries experiencing high rates of economic growth, poverty reduction remains dismal. China, for example, has experienced significant increases in overall economic growth. Nevertheless, individuals at the lower end of income distribution have experienced a decline in income levels while the top ten percent have enjoyed significant and disproportional increases. An article recently published by the Financial Times reported that amid substantial economic growth, the income levels of the bottom ten percent of the Chinese population have dropped by 2.4% in the last two years up till 2003. Simultaneously, over the same period of economic growth, the top ten percent of the population enjoyed increased income levels at 16%. This is an abnormally large discrepancy and can be the result high income inequality resulting from high rates of corruption.
Asset Distribution
Studies also reveal that unequal asset distribution perpetuates income inequality and exacerbates poverty by decreasing economic growth. Birdsall and Lonoño argue that unequal asset distribution is a significant cause of poverty. When assets are concentrated within a small group of well connected elite members, these wealthy asset owners lobby the government for preferential treatment with respect to favorable trade policies, tax breaks, exchange rates and government spending. These policies will yield high returns for wealthy owners and minimal returns for the less well connected thereby increasing income inequality.
Studies reveal that corruption increases unequal asset distribution. Furthermore, in a society where corruption is low, a multitude of other factors including the increased transparency of government action and market forces affect the direction government policies. Evidence also suggests that efforts to alleviate poverty will be significantly more effective in societies that have equal asset distribution patterns.
The unequal distribution of assets also perpetuates income inequality. Assets can readily be used as collateral in financing transactions through which money can be lent. Unequal asset distribution limits the poor in their ability to borrow money and increase their lifetime income.
Poor allocation of government expenditure (public investment)
Corruption also impedes economic growth by distorting government expenditure and the allocation of government resources. Tanzi and Davoodi explain that corruption leads to increased public investment in areas based on a preference for industries from which large bribes can be extracted. Corruption tends to diverts public funds to areas that are not related to social welfare. Ranking projects based on social values differ from ranking projects based on corrupt payments. Under the latter circumstances only the government officials and the recipient of the funds will benefit from these expenditures. Evidence also suggests that lower rates of corruption will lead to higher public investment in projects relating to social welfare.
Similarly, based on empirical studies, Mauro concludes that increases in corruption leads to increases in government spending in ‘useless’ projects that do not benefit society as a whole. Evidence also reveals that corruption leads to poor targeting of social programs. Tanzi concludes that in societies where corruption rates are high, government benefits are more likely received by the well connected high income individuals of society are unlikely extended to the poor through social programs. In this respect, in addition to impeding economic growth corruption directly diverts government funds away from the poor. Additionally, high corruption levels have been associated with significantly less government spending on health and educational programs.
Biased Tax System
Findings show that corruption leads to poor tax administration and biased tax systems. Tax exemptions are regularly extended to the well-connected and wealthy sector of the population who can pay bribes in exchange for tax benefits. Preferential tax exemptions are not based on any other factors and are arbitrarily provided to people based solely on the level of connection recipient has to the government and on the bribe the recipient is able to pay. This results in the loss of progressivity in the tax system which increases income inequality because the poor will pay a higher portion of their income in taxes then the wealthier individuals. In addition, studies show that high rates of corruption lead to a lower tax revenue and reduces available government funds to provide for public services including education and health services.
Unequal distribution of risk
Where regulations are unclear and bias towards the well connected, corruption can impose greater risks on the poor with respect to their investments in any of their resources such as human, land, capital or physical. Studies reveal that in societies where corruption is high, the poor alone experience a heightened risk associated with any investment. These risks discriminate against the poor and are not anticipated by the well-connected who can expect to enjoy high returns on their investments. This phenomenon perpetuates income inequality because the poor are discouraged from investing in any resource.
Corruption and private investment (domestic and foreign)
The effect that corruption has on private investment and on foreign direct investment is extremely important because of the significant impact that these forms of investment have on economic growth. Of all the different instrumentalities of economic growth, private investment is regarded as having most significant impact on economic growth.
Corruption and private investment (domestic)
Although critics argue that corruption leads to enhanced market efficiencies and increased private investments , empirical evidence reveals that corruption actually decreases private investments. As Mauro explains, entrepreneurs are aware that a portion of their payment will go to bribes. As a practical matter bribes are usually demanded up front before any permits are issued. He found that a one-standard deviation improvement in corruption indices drawn from Business International (BI) causes investment to rise by 5% of GDP and the annual per capita growth rate to rise by half a percentage point. Mauro concludes that the magnitude of the effect that corruption has on private investment is considerable.
Additional empirical studies conducted by Keefer and Knack reveal similar results. Using corruption indices from BI, Keefer and Knack concluded that institutional variables, including corruption, directly effect economic growth and indirectly effect economic growth through by negatively impacting private investment. This conclusion provides further supports for the argument that corruption decrease domestic private investment.
Corruption and Foreign Direct Investment
Perhaps the most important way that corruption obstructs economic growth is by deterring foreign direct investment. Although evidence suggests that corruption reduces foreign investment, critiques argue that corruption has very little effect on direct foreign investment. As a result, whether corruption decrease direct foreign investment has sparked a large debate and has attracted a lot of attention within the economic community.
Understanding the impact that corruption has on direct foreign investment has traditionally been regarded as a stepping stone in examining exactly how corruption affects economic growth. Whether corruption deters direct foreign investment has been largely debated over the years and will unlikely be settled in the near future. Nevertheless, some studies suggest that corruption significantly decreases foreign direct investment. Shang Jin Wei who has conducted extensive research on the impact of corruption on foreign direct investment within the East Asia region concludes that corruption significantly affects foreign direct investment. Wei argues that inward foreign direct investment is significantly lower for host countries that have high indices of corruption. Wei argues that foreign investment prefers less corrupt countries within the East Asian region. In conclusion, Wei suggests that China in particular would have experienced significantly higher rates of direct foreign investment during its recent high rates of growth if it had lower rates of corruption.
Alternatively but with equal fervor, scholars have argue that corruption does not deter or reduce foreign direct investments. While both sides of the argument have been heavily debated the research remains inconclusive. The more important question however is how does corruption affect the distribution of funds that are already within the country?
In addition to impeding economic growth this paper will now examine how corruption discriminates against the poor and causes poverty even in nations that experience high levels economic growth. As we shall see, the reason for this unequal distribution of funds is high rates of income inequality.
Corruption destroys elements necessary for economic growth
Economic growth and foreign investment can only be successful if the proper foundations that are necessary for economic growth are first in place. Moreover, economic growth will not be effective in alleviating poverty if certain factors are not present in a given society. The factors necessary for successful foreign investment are income equality, fair asset distribution and a fair and equal access to the market. Absent these factors, foreign investment and other instrumentalities of economic growth will have little effect on alleviating poverty. Corruption, as discussed above, directly increases income inequality and unfair asset distribution and therefore destroys the very elements that are necessary for the reduction of poverty. In this regard, corruption is a doubled edge sword. In addition to retarding economic growth, high corruption rates reduce the effect that economic growth has on poverty. It is necessary to recall at this point, that economic growth is the most effective tool in the reducing poverty.
A report administrated by United Nations Economic and Social Council to determine the level of poverty eradication for the years 1997-2006 also recognized that the higher the level of income inequality the less impact economic growth would have on poverty reduction. The report identified corruption as a major obstacle in poverty reduction because of its effects on income inequality. One of the most significant ways corruptions causes poverty is by creating and increasing income inequality which is regarded as a major obstacle in reducing poverty. Finally, evidence suggests that efforts that reduce corruption rates are likely to reduce poverty.
Corruption and Supply Side Economics
Empirical evidence suggests that corruption impedes economic growth which is the regarded as most effective tool in reducing poverty. Presently, no empirical studies have focused on the relationship of corruption and supply side economics. Nevertheless, the results of studies examining the effects of corruption on economic sheds light on how corruption could affect an economic system is modeled on supply side economics.
Supply side economics is rooted in the theory that increased capital in the private sector will trickle down to the rest of the population. An open market where transactions are determined by market forces such as supply and demand is necessary to sustain an economy based on supply side theory. Supply side theory also holds that increased marginal taxes and government regulation will discourage private investment.
Primarily, as a matter of pure logic, the more bribes that are paid and are unaccounted for in a society, the less funds are available to private sector for investment and expenditure. (In addition, as discussed above, the funds that are taken as bribes are unlikely returned into to society in the form of public services.).
Secondly, taken from the findings discussed above, higher rates of corruption lead to a decrease in private investment which is the heart of supply side economics. Mauro argues that bribes, which are usually demanded up front, can be interpreted as a tax. This increase cost of investment resulting from the bribe payments will lower the incentives of private parties to invest. In addition, domestic investors will look else where to invest their money if, after a cost-benefit analysis, paying the bribes does not justify the investment. Private investment triggers the trickle down effects of supply side economic. Therefore, if there is zero or little private investment then there will be no funds to trickle down to the rest of society. One can immediately see how corruption cannot coexist with supply side economics.
A third factor associated with corruption that can undermine the establishment of a system based on supply side economic theory is the heightened risk factor that is felt only by the lower income individuals who not well connected. Even if private investment exists, the uncertainty and bias for the well connected that results from corruption discourages the unconnected or poor individuals to engage in transactions that are necessary to reap the benefits of increased funds in the private sector. Based on empirical studies Gupta, Davoodi and Also-Terme discovered that corruption causes the poor and unconnected members of society to feel insecure in investing in resources such as human, capital, physical or land. Unlike the well connected, the poorer members of society are discouraged from investing in their resources. Therefore, even if private investment coexists with high rates of corruption, the poor and unconnected members of society will unlikely engage transactions that allow them to reap the benefits of the funds that flow from large scale private investments.
Corruption further undermines the theory of supply side economics because it distorts market forces. Where corruption is high, the market cannot possibly function in an open manner because projects awarded to those that are willing to pay the bribes as opposed to being superior in quality or more valuable to society. Projects are therefore not subject to the forces of supply and demand and are instead regulated by government preference. It should also be noted that supply side economics calls for government deregulation of the market.
The hidden tax aspect of the bribe diminishes the benefits of the trickle down effects of supply side economics. When corruption is high, substantial amount of funds that are generated from private investments do not necessarily flow down to the other members of society. These funds that would otherwise be directed to productive use in society are usurped by corrupt government officials for private gain.
In addition, the lack of transparency associated with illegal bribery creates a lack of accountability. The bribes that are unaccounted for distort equilibrium in an open market.
Criticisms
The first criticism to examine is the argument that corruption is a victimless crime. All empirical studies suggest the poor suffer greatly from the effects of corruption. According to World Bank studies, $1 trillion a year go as bribes unaccounted for. That is twice the GDP of Africa. Furthermore, increased transparency and accountability that is eliminated by corruption would encourage more government expenditure in projects directed to service the whole population. Empirical studies also indicate that when corruption is high, poverty reduction programs have little effect. Corruption also directs income away from the poor by perpetuating unequal asset distribution and by discouraging investment of poor in resources by imposing heighten risks that the elite members of society to not share. Corruption creates an unequal playing field where the allocation of government funds is influenced by bribes and not by social value.
A close examination of the relationship of income levels and corruption conducted under the supervision of the International Monetary Fund reveals that corruption does in fact affect the income growth rates of the poor. The study shows that an increase in the corruption index is associated with a decrease in income growth rates of the bottom twenty percent of a nation. More specifically, an increase in the corruption index of .78 points resulted in a decrease in a 7.8% decrease in the income growth rate of the bottom twenty percent. The study found that this is valid for countries experiencing different rates of growth. These results are depicted in the graph located in Appendix 2.
One major concern of developing nations is that corruption reduces the effectiveness of aid money by diverting funds away from the poor. Presently, there is debate on whether corrupt governments use aid money to fund unproductive projects however such studies remain inconclusive. That is, it is difficult to trace the flow of aid money. Nevertheless, evidence suggests that only a fraction of aid money reaches the poor. Although a majority of donor countries continue to provide aid to nations who have high corruption indices, donors continue to pressure recipients on good governance. In cases where governance is considered very poor, donor nations have refused to provide assistance.
Critiques also argue that corruption can lead to increased private investment by allowing individuals to circumvent strict bureaucratic regulations. These arguments however fail to account for the dire distributional consequences that corruption has income equality and fair asset distribution. In their analysis, the critiques do not consider the permanent consequences of corruption which includes the creation of vicious circle in which certain members of society benefit from corrupt practices while the majority of those at the bottom end of the income distribution do not. These critiques do not consider the gross impact that corruption has on income inequality and hence economic growth. Complex studies are not necessary to show that theses consequences of corruption clearly outweigh any benefits resulting from private investment that can be associated with bribery. Furthermore, as discussed above, any increases in private investment, foreign direct investment or economic growth have no affect on reducing poverty in a society where income inequality is high. Although bribery can help individuals further their own interests in a corrupt society it is ultimately at the expense of economic growth and poverty that such objectives are met.
Secondly, this argument is flawed because it assumes that corruption increases private investment. It is the act of bribery and not corruption that allows individuals to circumvent strict government regulations to obtain contracts or permits that would otherwise be inaccessible. Bribery in and of itself does not increase private investment. Rather, bribery should be regarded as the tool employed by corrupt government officials for private gain. In a corrupt society bribery is usually the only means to participate in private transaction and increase income. However, this can hardly justify the consequences of corruption discussed throughout this paper. Furthermore, it is ridiculous to assume that bribery, the only channel through which people can invest in the private sector, increases private investment. This reasoning is flawed because it is circular.
Finally, empirical studies reveal that corruption actually decreases private investment. As a corollary, an improvement in the corruption index leads to higher rates of private investment. In a corrupt society, bribery may be the only way to survive but this can hardly justify corruption itself or its consequences. The economic significance of bribery is strictly related to corrupt practices for it is immediately apparent that bribery does not confer any benefit on an open market economy. People do not bribe because they want to or because it is in their best interest; people bribe because they have to. Bribing in return for the opportunity to invest in the private sector is only indicative of the people’s desire to invest and nothing more. Evidence suggests that lower rates of corruption will increase private investment. The allowance of private investment through bribery hardly compensates for the decrease of private investment resulting from corrupt practices.
Critiques also argue that corruption can result in enhanced efficiencies in the market as it is the much needed “grease for the squeaking wheels of the a rigid administration.” In this manner bribes are seen as a reflection of an individual’s willingness to pay and therefore clear the market. These critiques regard bribes as part of the ‘purchase price’ of a service or of a contract however this is hardly the case.
Again, the argument fails to consider the distributional impact that corruption has on income inequality including creating a system in which only a few can benefit. This argument also fails to consider that those people who are willing to pay the bribes are not necessarily the intended beneficiaries of government programs. The problem here is that corruption creates an unequal playing field for certain members of society. If bribes are to be considered as additional payments or taxes the function of secrecy of these payments must be included in the analysis.
To begin with, the administration of taxes whether imposed on services, commodities or income is usually consistent with some form of progressivity. With respect to income, taxes are usually higher for high income levels and lower for low income levels. Along the same lines, for commodities, luxury goods tend to have greater added value while necessities are either not taxed or have very little added value. This system ensures some form of consistency in the portion of income that each individual pays in the form taxes. On the other hand, the calculation of bribes is arbitrary and no consideration is given to the income level of the briber. This creates an unequally playing field because individuals at the lower end of income bracket will pay a higher portion of their income in bribes than will those who have high incomes. It is significantly easier for the wealthy individuals to acquiesce to bribe payments than it is for those who are not wealthy. In this respect, corruption creates an unequal playing field where it is easier for the wealthy to accumulate more wealth than it is for the poorer members of society.
Furthermore, the requirement of bribe payments for services rendered or on commodities distorts the efficiencies of an open market. In an open market the purchase price is established by the equilibrium of demand and supply. Supply and demand are driven, among other things, by product quality and consumer desirability. The artificial addition of bribes in the purchase price distorts this equilibrium. The purchase price no longer reflects what consumers are willing to pay for the service or the commodity. Rather, the purchase price incorporates the bribe that is demanded in exchange for the service. A depiction of the effect that bribe payments have on the supply and demand can best illustrate the market inefficiencies created by bribe payments. With market forces in play, the equilibrium price is P1 which represents what the consumer is willing to pay for the commodity or service. Q1 represents the quantity that the consumer is willing to purchase at the equilibrium price. The addition of the bribe payment will raise the price of the service or commodity to P2. At this price, the demand for the product or service will drop Q2. This is an example of how bribery can reduce efficiency in the market. The addition of the bribe payment increases the price to a level that artificially decreases consumer demand. This is market inefficiency because although the supply is able to meet demand at P1, demand for the product or service will drop when the price increases to P2. The inefficiency in this example is the creation of a surplus of the goods or services.
Therefore, contrary to what the critiques suggests, bribery does not result in efficiencies in the market and actually distort market forces because demand has been artificially reduced resulting in a surplus.
Conclusion
In conclusion corruption causes poverty because it significantly impedes the most effective tool in reducing poverty: economic growth. Corruption interferes with many channels of economic growth including the allocation of government resources, perpetuating unfair asset distribution and lowering private investment. Furthermore, corruption reduces the impact that economic growth has on alleviating poverty because it directly increase income inequalities and creates an unequal playing field which are both requisites for successful economic growth. Furthermore, bribes are not proportional to the income of the briber and it is immediately apparent that the poorer members of society will pay a higher proportion of their income in bribes than will the wealthy individuals. Finally, evidence suggests efforts to reduce corruption rates will likely reduce poverty.
Contrary to the arguments postulated by the critiques there, are no efficiencies associated with corruption. Even if there were such efficiencies they are completely outweighed by the devastating effect that corruption has on income inequality, economic growth and on poverty.
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