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Corruption & Fiscal Stability

The adverse budgetary consequences of corruption are especially devastating for developing countries. It reduces the amount of public money in state coffers by decreasing state revenue (through losses in tax and customs income) while promoting wasteful spending.


Corruption Reduces Government Revenue

One of the main ways in which corruption reduces state funds is through its negative effect on tax income by opening up loopholes in tax collection.  Tax policies in corrupt countries often favor the rich, well-connected and powerful to begin with. Tax evasion through corruption as well as poor tax administration where some of the revenue “disappears” before it reaches government coffers reduces the tax base and adds to the progressivity of the tax system.

Corruption also thrives in the unofficial economy and vice versa.  Data analysis of registered firms in Poland, Slovakia and Romania show that higher levels of bureaucratic corruption is associated with underreporting of revenue which results in forgone tax revenue for the state.  In transition economies and in many developing countries corruption may reduce revenue collection by driving firms (or their most profitable activities) out of the formal sector and by providing a moral justification for widespread tax evasion (World Bank. 1997).  Likewise, businesses in the informal sector do not report revenue and therefore do not pay taxes.  [Johnson, Kaufmann, and Shleifer. 1997Johnson, Kaufmann, and Zoido-Lobaton. 1998a and 1998bSchneider and Enste. 1998]. Tax evasion offers a competitive advantage while simultaneously disadvantaging companies in the official economy, driving some out of the market, which further reduces the tax base. [Johnson, Kaufmann, and Shleifer. 1997  Johnson, Kaufmann, and Zoido-Lobaton. 1998a and  1998b].

This has two effects: first, it reduces the distributive function of tax collection and hence contributes to increasing income inequality; second, it reduces the amount of public funds and therefore the amount of public spending [Gupta et al, 1998].

One entry point for curbing corruption in revenue administration is to reduce the opportunities for corruption in tax administration and to change the incentive structures for tax officers while keeping tax policies simple.  Transparency and arm’s length relationships between taxpayers and officials are key in reducing vulnerability to corruption. 

A successful example is Korea where  reform of tax administration led to a drop of reported corruption cases from 45 to 9 over a one year period while the tax revenue increased.

Equally harmful to fiscal stability is forgone state revenue through corruption in customs, involving senior public officials as well as low-level customs officials.

Not surprisingly, participants in corruption surveys rank tax and customs administrations among the most corrupt government agencies in developing countries.

Corruption Promotes Excessive Spending 

A major challenge not only in the developing world is corrupt procurement where contracts are awarded to high-cost bidders without competitive tendering.  Corruption in procurement decreases state funds since it leads to higher spending on projects of often inferior quality.

There are various ways in which corruption in procurement can be curbed.  Transparency International’s “Integrity Pact” is based on a voluntary agreement between the government and all bidders to abstain from corrupt practices, thereby overcoming a collective action problem.  The Integrity Pact specifies sanctions in case of transgression [Transparency International. 2001].

The internet also offers great opportunities for clean procurement, capitalizing on the power of total transparency to deter corrupt practices.

Furthermore, a lack of transparency and accountability allows for cases of theft, where politicians take advantage of their powers to channel money into their own pockets. In Uganda an empirical investigation revealed that only 13% of public funds allocated for education actually reached schools. The rest was either pocketed by public officials or used for purposes other than education.

Wasteful spending is also encouraged by a general erosion of public expenditure control. (To learn more about public expenditure management go to their website.)

For instance, when the scrutiny of finance ministries and central banks is bypassed excessive debt may be incurred through “white elephant” investment projects that in many cases are the results of bribes.  To the extent to which bribes are used in the political process to “buy” political support from the electorate or Members of Parliament they deplete public revenue and may lead to an increase in public deficits, affecting the country’s financial situation (Pani. 1996).

Macroeconomic stability may also be threatened by debt guarantees and otheroff-budget contingent liabilities agreed to in corrupt transactions without public scrutiny. It may further be undermined by fraud in financial institutions, leading to loss of confidence by savers, investors, and foreign exchange markets. Other examples include the misuse of official foreign exchange reserves, and bank supervisors abusing their power or failing to take action. Mauro hypothesizes that multiple exchange rate systems and foreign exchange allocation schemes might also lead to corruption since they might prompt entrepreneurs to bribe managers of state-owned commercial banks to increase their share in order to buy much needed imports for their business (Mauro 1997).

Price controls also pose a potential incentive for rent-seeking behavior as businesses have an interest in keeping prices for their inputs low (Mauro 1997).

Interesting are also the findings on the degree of openness of an economy and corruption, where greater openness is associated with lower levels of corruption (Ades and Di Tella. 1994).

Overall, corruption affects macroeconomic stability through its effects on institutions necessary for sound macroeconomic policy-making and implementation.

The quality of institutions matters for macroeconomic performance.  Empirical analysis of data in transition economies shows that the effectiveness of institutions for macroeconomic governance is inversely correlated with levels of corruption (World Bank. 2000), where macroeconomic governance is defined as the extent to which policy instability, exchange rate instability and inflation impede business. 

This page was developed by  Stefanie Teggemann.