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Corruption and the Institutional Environment for Growth

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Abstract

Several cross-country studies have found that corruption is detrimental to economic growth, but the findings are not universally robust. We utilize the economic freedom index to examine if corruption can facilitate growth by allowing entrepreneurs to avoid inefficient policies and regulations when economic freedom is limited. Using regression analysis, we find that corruption is growth enhancing when economic freedom is most limited but the beneficial impact of corruption decreases as economic freedom increases. Not all areas of economic freedom affect the corruption–growth relationship equally. In particular, we find the beneficial effect of corruption disappears most quickly when the size of government and the extent of regulation decrease.

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Notes

  1. Full website address: http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/EXTPUBLICSECTORANDGOVERNANCE/EXTANTICORRUPTION/0,contentMDK:21205078~menuPK:384461~pagePK:64020865~piPK:149114~theSitePK:384455,00.html, accessed May 2007.

  2. Full website address given in note 1 above.

  3. Full website address: www.usaid.gov/our_work/democracy_and_governance/technical_areas/anti-corruption/, accessed May 2007.

  4. In the quote above, USAID acknowledged that corruption may be able to reduce costs associated with bureaucratic red tape.

  5. For earlier surveys of the literature on corruption see Bardhan (1997), Rose-Ackerman (1999), Jain (2001), and Aidt (2003).

  6. We recognize that inefficient institutional environments that do not allow much economic freedom may in some cases be intentionally created to allow officials to extract bribes. Furthermore, the underlying cultural capital could jointly cause both corruption and low levels of economic freedom.

  7. Paldam (2002), Graeff and Mehlkop (2003), and Goel and Nelson (2005) have used the indexes of economic freedom to examine how economic freedom impacts corruption. They have generally found that the more economic freedom a country has the lower the level of corruption present; however, their studies did not examine how this relationship affects growth. As we show below, the inverse relationship between corruption and economic freedom is important for predicting the impact corruption will have on growth.

  8. For a general comparison between alternative measures of democracy, see Munck and Verkuilen (2002).

  9. Scores for each of the separate components of the political rights and civil liberties indexes are not publicly available, therefore the Freedom House democracy index cannot be purged of these particular elements.

  10. The Freedom House scores are based on rank, therefore lower values represent more freedom. The indexes were inverted in order to match the Polity method of higher values representing greater democracy, and thus result in positive correlations.

  11. Because each area contains a different number of components, this aggregation method (which weights each area equally) does not weight all the individual components equally.

  12. We thank Robert Lawson for rescaling the Area 5 scores and the overall EFW index without component C.v. when he sent us the EFW data.

  13. Area 4 (freedom to exchange with foreigners) component C of the EFW index includes a measure of the actual size of the international trade sector compared to the expected size. This measure may suffer from similar problems, but it does take account of structural and geographic characteristics of the country when calculating the expected size. Furthermore, it only accounts for 4% of the overall EFW score (20% of a country's Area 4 score).

  14. The regions include: Latin America, Asia, Europe, Africa, and Middle East. North America (comprised of Canada and United States; Mexico is included as part of Latin America) is the default region not included.

  15. The same is true for some of the components of economic freedom, described above.

  16. Alternative education measures from Barro and Lee (2000), such as primary and secondary completion rates, were also utilized but did not appreciably affect our results.

  17. See Ayal and Karras (1999) and Heckelman and Stroup (2000), who show differing marginal impacts of the economic freedom components on growth using earlier versions of the EFW that contained fewer total components.

  18. The test statistic of 2.36 is distributed as F(13, 68) with p-value of 0.01. An alternative test statistic of N × R2=25.52 is distributed as χ2(13) with p-value of 0.02.

  19. Our results do not substantially differ if we applied a two-step WLS, using the residuals from OLS as the weighting proportion.

  20. WLS contains no constant term, as the intercept is now the inverse of population (relative to the mean). As such, we do not report R2 measures because they do not retain their normal interpretation without a constant term. We also do not report specific estimates for the various regional dummies (Latin America, Asia, Europe, Africa, Middle East).

  21. The five highest-rated countries for EFW over the period 1995–2000 are United States (8.28), New Zealand (8.27), United Kingdom (8.06), Ireland (8.05), and Switzerland (8.00).

  22. As noted earlier, the CPI is not consistently measured over time due to the changing inclusion of varying surveys. As a check on our results, we ran another regression matching specification IV, but using only the 2000 values for all independent variables. This reduced our sample to 71 nations but our conclusions are similar. The coefficient on corruption is positive and significant, and the coefficient for the interaction with the EFW index is negative and significant. The estimated turning point for when additional corruption becomes harmful occurs at a slightly lower, but still quite high, rating for EFW at 8.26, roughly in accordance with US levels. The democracy index remains statistically insignificant.

  23. Neither country from the default region (Canada and US) is in the low EFW sample. To avoid perfect multicollinearity, one of the regional dummies used in previous regressions (see note 14) was dropped for that regression.

  24. The weighted standard deviation of growth in the low EFW sample is 96.9 with a mean of 25.5.

  25. The highest-rated countries for Area 5 are New Zealand (6.63), United States (6.60), Namibia (6.59), and United Kingdom (6.57).

  26. Another reason we are less certain about Area 1 than Area 5 is that the finding of significance of Area 5 was more robust across specifications in Table 3.

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Acknowledgements

We thank participants at the 2007 Southern Economics Association, and the 2007 Association of Private Enterprise conferences, the editor, and two anonymous referees, for valuable comments, Robert Lawson for providing a recalculated index of economic freedom with its corruption component removed, Lisa Verdon for providing data, and Kyle Jackson for excellent research assistance. The usual caveat applies.

Author information

Authors and Affiliations

  1. Department of Economics, Wake Forest University, Carswell Hall, Winston-Salem, 27109, NC, USA

    Jac C Heckelman

  2. Department of Economics, Suffolk University, 8 Ashburton PL, Boston, 02108, MA, USA

    Benjamin Powell

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Appendices

Appendix A

Components of economic freedom of the world

Area 1: Size of government: Expenditures, taxes, and enterprises

  1. a)

    General government consumption spending as a percentage of total consumption

  2. b)

    Transfers and subsidies as a percentage of GDP

  3. c)

    Government enterprises and investment as a percentage of total investment

  4. d)

    Top marginal tax rate and threshold at which it applies

    1. i)

      top marginal income tax rate (and threshold)

    2. ii)

      top marginal income and payroll tax rate (and threshold)

Area 2: Legal structure and property rights

  1. a)

    Judicial independence

  2. b)

    Impartial courts

  3. c)

    Protection of intellectual property

  4. d)

    Military interference in rule of law and the political process

  5. e)

    Integrity of the legal system

Area 3: Access to sound money

  1. a)

    Average annual growth of the money supply in the last 5 years minus average annual growth of real GDP in the last 10 years

  2. b)

    Standard inflation variability during the last 5 years

  3. c)

    Recent inflation rate

  4. d)

    Freedom to own foreign currency bank accounts domestically and abroad

Area 4: Freedom to trade internationally

  1. a)

    Taxes on international trade

    1. i)

      Revenue from taxes on international trade as a percentage of exports plus imports

    2. ii)

      Mean tariff rate

    3. iii)

      Standard deviation in tariff rate

  2. b)

    Regulatory barriers to trade

    1. i)

      Non-tariff barriers

    2. ii)

      Compliance cost of importing and exporting

  3. c)

    Actual size of trade sector compared to expected size

  4. d)

    Difference between official exchange rate and black-market rate

  5. e)

    International capital market controls

    1. i)

      Foreign ownership/investment restrictions

    2. ii)

      Restrictions on the freedom of citizens to engage in capital market exchange with foreigners

Area 5: Regulation of credit, labor, and business

  1. a)

    Credit market restrictions

    1. i)

      Ownership of banks – percentage of deposits held in privately owned banks

    2. ii)

      Competition – domestic banks face competition from foreign banks

    3. iii)

      Extension of credit – percentage of credit extended to private sector

    4. iv)

      Avoidance of interest rate controls and regulations that lead to negative real interest rates

    5. v)

      Interest rate controls

  2. b)

    Labor market regulations

    1. i)

      Impact of minimum wage

    2. ii)

      Hiring and firing practices (determined by private contract)

    3. iii)

      Share of labor force whose wages are set by centralized collective bargaining

    4. iv)

      Unemployment benefits

    5. v)

      Use of conscripts to obtain military personnel

  3. c)

    Business regulations

    1. i)

      Price controls

    2. ii)

      Burden of regulation

    3. iii)

      Time with government bureaucracy

    4. iv)

      Ease of starting a new business

    5. v)

      Irregular payments (omitted from this study because it is a measure of corruption)

Appendix B

See Table B1.

Table b1 Sample of countries
Full size table

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Heckelman, J., Powell, B. Corruption and the Institutional Environment for Growth. Comp Econ Stud 52, 351–378 (2010). https://doi.org/10.1057/ces.2010.14

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