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An economic approach to understanding and addressing corruption

October 5, 2021
Editor(s): Ben Griffiths
Writer(s): Chamindu Athauda, Jade Chen, Morgan McDonagh, Stephen Kanavoutsos

Corruption is a universal issue that exists in developing and developed economies, defined by UNESCAP as the use of public office for private gain. Although corruption is a somewhat nebulous term, it can be quantified and understood through a microeconomic lens, with research leading to the creation of a microeconomic model of corruption. This model is formed with four key elements: disposable income from corruption, determinants of demand for corruption, determinants of the offer of corruption, and a corruption income model. Rent for corruption is modelled as:

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A graphical illustration of this corruption income model from the research paper is represented below:

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There is a clear linear relationship between regulation, control, punishment, and the level of corruption. As regulations, control, and punishment increase, the price of corruption rises, which in turn leads to higher quantities of overall corruption. While relatively intuitive, by framing corruption as a rent-seeking activity, an objective analysis of how to reduce and discourage corruption can be undertaken.

Economic rent from corruption reflects the incentive to seek out opportunities for private gain. This rent is necessarily compared to the potential costs associated with punishment and the risk of being caught. This cost-benefit analysis is primarily analysed through the role of ethical considerations and psychological factors which lead to corrupt behaviours. Other than rent-seeking, corruption can be caused by the political and economic environment, morality, professional ethics, and cultural customs. Studies have also shown that when corruption is rampant in an economy, the psychic cost of tax evasion is reduced. Additionally, compliance rates are seen to decrease in states with more corruption because it impacts the perceived unfairness in the exchange between taxpayers and the state. Drawing from broken window theory, wherein the perception of disorder and crime fuels further criminal activity by reducing the perception of control within the community, prevalent corruption can skew moral judgement in other areas of the economy. This occurs through widespread beliefs in the unfairness of the governmental system and which resultantly leads to further corruption.

Determinants of corruption, which are explored in the research for the microeconomic model of corruption are varied. Anti-corruption regulation and policy therefore play a crucial role in the behavioural economics framework for understanding corrupt actions by government officials. This extends to how methodologies for whistleblowing legislation can be constructed.

A behavioural ethics approach to whistleblowing regulation reveals key insights into the inherently intertwined nature of morality, ethics, and psychology in corruption. Despite standard economic theory assuming behaviour is motivated by incentives such as a monetary reward, empirical studies show that the reverse is true for whistle-blowers. Financial rewards for reporting corrupt behaviour dilute the moral dimension and discourage reporting as it undermines the sense of civic duty which motivates whistle-blowers. In order to increase reporting and whistleblowing of corrupt behaviour, requirements for anonymity protection are vital. Anonymity increases reporting due to its reduction in the costs of whistleblowing, namely wellbeing concerns, while maintaining the benefits of catalysing investigation into unethical and corrupt behaviour.

Behavioural economics investigates human action and behaviour through an understanding of economic costs and benefits. This has wide-ranging applications for corruption by facilitating the study of the motivations for corruption, the role of prevalent corrupt behaviour in breeding more corruption, and the structuring of regulation that can encourage whistleblowing.


The effects of corruption


The effects of corruption in politics, business and the broader society often loom large over public debate in almost every nation. A key part of this discussion is the economic implications of corruption, stemming from the inefficiencies it creates. The IMF estimates that the direct cost of bribery alone amounts to 2% of global GDP, which is equivalent to trillions of dollars.  Beyond that, corruption also results in distortion of incentives and market forces, leading to a misallocation of resources. For instance, unfair and illegal tenders (such as those involving kickbacks) lead to unsuitable contractors being awarded projects. This results in excessive expenditure in substandard or failed projects that waste taxpayer funds. Additionally, the creation of monopolies and oligopolies through bribery and corrupt deals lowers competition, which results in higher costs for lower quality outputs. 

Furthermore, uncertainty, reputational implications, and vulnerability to extortion in environments where corruption is pervasive discourages business investment and capital accumulation. Bribery and extortion, in practice, serve as an inefficient tax on business, with research into African firms estimating it at 2.5-4.5% of business sales. This adds to production costs and reduces the profitability of potential investments. Therefore, multiple studies also find corruption to be a significant factor in reducing FDI into the host country.  For example, a one-point increase on a corruption index from 0 to 10 depresses productivity by 4% of GDP and cuts net annual capital inflows by 0.5% of GDP. Additionally, the potential to evade intellectual property laws through corrupt dealings dampens the incentive for innovation, thus limiting technological growth within a country.

Moreover, countries with higher levels of corruption tend to have larger shadow economies, as many businesses avoid registering with tax authorities. Consequently, profits earned by many firms are outside the official economy and thus are not subject to taxation. Further, these secretive operations ignore official labor regulations by underpaying workers and denying them acceptable working conditions. Businesses may avoid liability for labor exploitation, including child labor, through bribery and connections to those in power.

Corruption also exacerbates poverty and inequality due to a positive correlation between corruption and income inequality, with a point increase in the corruption index associated with a seven-point increase in the Gini coefficient. Corruption in public policymaking often leads to lower levels of effective social spending due to the diversion of resources away from public welfare to infrastructure and defence projects with more room for extortion. Further, whatever funds that are allocated to areas such as healthcare and education are misused by corrupt public officials in those spheres, therefore limiting the effectiveness of social programs. 

Finally, the influence of corruption in policy formulation is linked to tax structures that favor the well connected, the facilitation of tax evasion, and irregular tax enforcement.  This undermines a nation’s tax base and the state’s ability to equitably redistribute economic gains.

Moreover, there are other social impacts of corruption such as personal loss and intimidation suffered by members of the public at the hands of the powerful, who enjoy impunity due to their influence over law enforcement and the judicial system. This deepens public cynicism and mistrust, undermining trust in democratic institutions and potentially sparking social unrest. Corruption therefore creates a hospitable environment for populist politicians with illiberal tendencies which further intensify public divisions.

Furthermore, due to the influence corrupt politicians can have over anti-corruption bodies the onus of removing them from office falls to the voters. This is especially true in countries lacking robust institutions and separation of powers. However, empirical findings on the effect of corruption on incumbency advantages and election outcomes are mixed. For example, while there is some evidence of incumbency disadvantages in Brazilian mayoral elections for corrupt officials, re-election chances of corrupt officials and non-corrupt officials were not significantly different in Italian legislative elections. Despite these conflicting findings, there is no doubt that the re-election of corrupt politicians is common in many countries. This coupled with the use of voter intimidation and election interference as a campaign tactic in many poorer nations facilitates the perpetuation of corruption.


Identifying corruption


Although achieving “zero corruption” is fundamentally unrealistic, countries must minimise the severe damage to a country’s infrastructure, economy, and drainage of public resources for citizens’ well being resulting from corruption. Consequently, practical methods for corruption identification are crucial, with four primary ways to scrutinize in subsequent paragraphs.

Auditing

Auditing is a standard method utilised by various institutions, which entails both internal and external forms. Internal audits assist in reviewing the organisation’s safeguards and core control systems against fraud and corruption, with forensic auditing being prioritised since standard financial auditing excludes discovering corruption. On the other hand, external audits emphasise an institution’s financial reports, thus being more compliance-focused. Audits can be effective in identifying and consequently reducing corruption. Specifically, a case study in Indonesia that involved increasing external government audits in projects from 4% to 100% has decreased “missing expenditures”, thus proving the necessity for audits as a functional corruption detection tool.

Citizen reporting

Citizen reporting involves reporting potentially corrupt or suspicious incidents to authorities. Particularly, standard crime-reporting channels at the national and municipal levels enable individuals to report corruption to relevant authorities. Citizens should also take this opportunity to support training programs and campaigns which promote integrity with essentially zero tolerance for corruption. Countries that utilise this strategy include Papua New Guinea, with a system known as “Phones Against Corruption” introduced in 2014, where citizens can report corruption incidents anonymously via text messages. This ensures that citizens may feel encouraged to report corruption while safeguarding their identities. Furthermore, the Vietnamese Mobile Scorecard program (The M-Score) allows all citizens to rate public administration services and report whether they have been asked to pay a bribe.

Journalism and media reporting

Additionally, journalism and media reporting also constitute standard mechanisms to prompt organisations in conducting further investigation in light of fraud potential. Overall, due to institutions’ needs to preserve their reputation, investigations have demonstrated a prominent inverse correlation between press freedom and corruption. Correspondingly, the widespread use of social media can drive public opinion, which has led to “uprisings” and alterations in governments such as in Tunisia, Egypt, and Armenia.

Whistleblowing

Furthermore, another valid mechanism to detect and reveal corruption includes whistleblowing. This concept is based on the argument that certain forms of corruption can only be discovered if internal personnel within projects or institutions report on it. For this reason, entities should create protocols for corruption reporting, which already exist in countries such as Australia. Studies have depicted whistle-blowing as an extremely effective method in exposing corruption within the public sector, which is imperative for corruption investigations in many countries.

Besides the four common ways to identify corruption, active investigations by law enforcement institutions are also crucial and pertinent for the “detection, investigation and prosecution” of fraud and corruption. It is also essential to recognise that corruption identification necessitates public and private sector efforts, including both governments and corporations. Legal and regulatory incentives to encourage self-reporting and self-help within companies – such as providing official channels where employees can report without fear should also be readily available.

Moreover, besides ascertaining corruption, preventing corruption is also vital in each country where institutional systems and incentives should be in place to avoid corruption. Notable examples include the World Bank’s set of initiatives in 2020 to help countries address corruption. Countries to receive the aid included Afghanistan, Brazil, Serbia, Mongolia, Kenya, Somalia, and Ukraine. Additional examples involve corruption prevention systems, including frameworks such as corruption risk mapping utilised by the Australian Commission for Law Enforcement for corruption prevention at the national level.


Disincentivising corruption


When considering how corruption can be reduced, it is important to establish the link between corruption and integrity. Corruption flourishes in the absence of a strong and independent public service, and as such, the public sector is the primary bulwark against corruption. The public sector in turn supports and regulates other institutions such as the private sector. Integrity within the public sector is essential to maintain the rule of law and overall quality of life for a country’s citizens. This relationship is referred to by the UN as the Pillars of Integrity, emphasising the role of integrity in reducing corruption, as well as changing societal attitudes to corruption. While corruption may be rife in both the public and private sectors, accountability, and a sense of public duty within officials is imperative to address societal issues. Hence, it is the public sector that is primarily targeted by policies to reduce corruption.

Corruption, by nature, often permeates numerous levels of governance and society. Hence, to effectively target corruption, it is necessary to establish agencies and institutions whose role is to specifically target corruption. When the separation of powers has already been weakened, the separation of anti-corruption agencies from existing agencies ensures that malfeasance does not infect the effort against corruption. The overarching goal of any policy is to reduce corruption by reducing the opportunities of gains through corruption while maximising the likelihood and magnitude of punishments. By doing so, not only will corruption be reduced, but also the attitudes towards corruption will shift, with lower levels of acceptance amongst officials and the public.

Domestic policies can also be created to effectively target corruption through legislation and advocacy. Legislation can act to subsidise conscionable behaviour, while taxing and punishing undesirable, corrupt behaviour. This can exist in practice through legislation that assigns penalties such as fines or imprisonment for corrupt acts. Domestically, it is also pertinent to address public attitudes towards corruption, particularly where it has been accepted as a tool to advance in life by many citizens. Combining the legislation with anti-corruption messages can work to shift public attitudes. Appealing to a sense of patriotism and culture within citizenry can aid in reemphasising the immorality of corruption.  

Foreign aid is another method of targeting corruption. In most instances, foreign aid occurs as funds donated by foreign organisations or governments. The goal of such aid is to provide the necessary funds with which to improve the quality of life in a disadvantaged country, where corruption has likely hampered development and equality. However, large inflows of foreign aid can encourage further corrupt acts such as embezzlement by officials. In cases where the donated funds are not then monitored by the donor, as much as 30% are misdirected from their original purpose to support corrupt motivations. Therefore, there is a need for oversight from donors, establishing performance-based lending and aid to ensure that donated funds are used correctly. Setting commitments and targets for the use of funds and making further aid or lending conditional on meeting such targets can reduce corruption.

As with domestic tools, where policies can both subsidise and punish, foreign actors can also use sanctions in addition to aid. The adoption of a Magnitsky Act allows governments to impose economic sanctions on foreign individuals or entities who have committed corrupt acts or breached human rights. Using such a tool can allow a country to enforce penalties on individuals and groups around the world without employing economy-wide sanctions that devastate innocent populations. These sanctions can be particularly useful in allowing foreign nations to punish corrupt actors within the private sector, especially when a country’s public sector is still hampered by corruption, and unable to target the private sector until it re-establishes its integrity.

It is ultimately through behavioural and society-wide lenses that corruption can be addressed holistically through prevention, detection, and justice.

The CAINZ Digest is published by CAINZ, a student society affiliated with the Faculty of Business at the University of Melbourne. Opinions published are not necessarily those of the publishers, printers or editors. CAINZ and the University of Melbourne do not accept any responsibility for the accuracy of information contained in the publication.

Meet our authors:

Ben Griffiths
Editor

My name is Ben Griffiths and I’m currently a 4th year Bachelor of Commerce (Economics) and Diploma in Languages (French) student at the University of Melbourne. I’m passionate about policy, public health, climate change, international collaboration, and finding ways to combine these interests to make a tangible impact. In my spare time I like to play guitar, learn more about the world, hang out with friends, and write articles. You can find more of my current and previous writing at Cainz, ESSA Unimelb, Melbourne Microfinance Initiative, Strive Student Health Initiative, and LSE International Development Review.

Chamindu Athauda
Writer

I am a Bachelor of Commerce student who is interested in Macroeconomics, Finance and Policy. I enjoy working with like-minded peers to produce Economics related material that are both interesting and informative for readers.

Jade Chen
Writer
Morgan McDonagh
Writer

I'm a first year Bachelor of Commerce student majoring in Finance and Economics with a passion for writing and research. My key interests are primarily public policy and macroeconomics. Outside of university commitments, I enjoy playing guitar, chess and watching Formula One.

Stephen Kanavoutsos
Writer

Stephen is a first-year Bachelor of Commerce student, majoring in Accounting and Finance, with an interest in macroeconomic trends and government policy. In his spare time, you can find him swimming at the pool or beach.