Fiscal policy, corruption, and institutional quality

Why are many countries stuck in a vicious circle of widespread corruption even if the governments change through elections or violent public upheavals? A possible explanation is that when corruption is widespread, people become used to it and feel helpless, and stop complaining. The media stops publishing comments and columns on corruption because no one reads them. Of course, 'corrupticians' (corrupt politicians) do not read because it is about them.

Bangladesh's corruption perception index (CPI) between 2012 and 2023 shows no perceptible and meaningful changes -- the CPI score has been trapped between 24 and 28 and the global ranking trapped between 139 and 149. It is hard to say if CPI reflects perception stickiness or actual experiences of corruption.

There are countries where people elect the same political party to power because the alternative could be worse with "worser" history. The political party governing the country may change but the corrupt bureaucracy stays, and the new government becomes dependent on the existing bureaucracy to govern. In physics terms, this may be characterised as a merry-go-round game that has its own perpetual inertia of motion unless divine intervention comes down on earth to put it to inertia of rest or disappear.

In a research-based article titled "The impact of fiscal policies on corruption: A panel analysis" published on the Internet, Monica Achim, Sorin Borlea, and Andrei Anghelina using panel data from 185 countries (2005-2014) found that for "developed countries, with high-quality institutions, low fiscal pressure leads to a lower level of corruption, which is in line with expectations. Conversely, in developing countries, with low-level institutional quality, low fiscal pressure increases corruption, because of low governance efficiency under which people may easily circumvent the law."

The authors' analysis and findings recommend that governments and policymakers willing to combat corruption need to recognise that the crusade against "corruption requires not only the right fiscal policies but also the right way of implementing these policies, recognising the role of quality institutions, which need to prevail in any country".

To me among all the evils that engulf a society, income inequality and the spread of poverty are the most obvious ones. Corruption has two opposing effects - it has some positive trickle-down effects on the poor through the "corrupticians" induced elevated lifestyles - living beyond their means and the adverse negative effects on the low-income people through causing inflationary pressure on consumer goods and services. Because of income inequality, corrupticians' children go to better schools and colleges with pompous lifestyles and amenities.

The other detrimental effects of corruption such as undermining democratic governance, abuse of rule of law, adverse effects on and impediments to investment and growth, capital flight and so on are well known to all and sundry.

A good question to ask: why fiscal policy implementation is linked to corruption but not monetary policymakers. In developing countries, where central banks are constitutionally subservient to the political government or autocratic rulers, the CB officials are not monetary policymakers like any constitutionally independent central bank like the U.S. Federal Reserve, they are monetary policy implementers (MPI). Therefore, they have no direct contact with the public on a day today basis - not responsible for enforcing rule of law and general governance of the country.

The MPIs are watchdogs and enforcers of banking regulations. Any corruption that infects the banking sectors comes from fiscal policy makers. For example, pleading with commercial banks to approve loans to fewer loans worthy borrowers, not enforcing recoveries of funds from loan defaulters, and bank looters while letting political cohorts own bank ownership. Therefore, you will rarely hear any corruption disrepute involving Bangladesh bank officials.

Fiscal policy is often linked with corruption in which the bribing of officials is done by business people for personal aggrandisement, such as dodging taxes and regulations, or securing public projects. The researchers conducted a panel analysis on a large sample of 185 countries over the period 2005-2014. Their analysis indicated that the influence of fiscal activism on the level of corruption is influenced by income and institutional quality. The results between developed and developing countries are contrasting as one would expect. They found that in developed countries with high-quality institutions, lower fiscal activities lead to a lower level of corruption, while in developing countries with low-level institutional quality, low fiscal pressure increases corruption because in the latter case under low governance efficiency people may easily circumvent the laws and regulations. They found that certain fiscal policies may work in some countries, but not in others. They recommended that "governments and policymakers need to acknowledge that the anti-corruption fight requires not only the right fiscal policies but also the right way of implementing these policies, whilst recognizing the role of quality institutions prevailing in any country.

In economic literature on corruption, numerous studies have highlighted the importance of a high level of confidence in governance institutions, to ensure the proper functioning of the state. Corruption and trust in the governance are two important precursors to establishing institutional quality in public sectors. Obviously, the better the institutional quality, the more is the trust in the people who conduct the business of the state. Since allocation of resources for public projects are vested with the government, opportunity seekers will always try to bribe officials to gain favours, avoid paying taxes and violate regulations.  

Trust in public servants reflects citizens' subjective judgement on governance as being competent, reliable, and honest, whilst also meeting their needs. In this respect, for delivering political goods and services there is no alternative to advancing institutional quality. There are empirical studies which found that an improvement in institutional quality decreased the influence of shadow economy and the level of corruption in 18 OECD countries. It may be underscored that institutional quality is measured using the good government effectiveness as provided through the Worldwide Governance Indicators by the World Bank. 

Various studies reported that high-income countries face a low-level of corruption. Some of the studies argued that 'since the level of development is related to the overall level of resource munificence, one would expect that corruption would be more common in the less developed economies. Some researchers have found that corruption is poverty-driven which fades away when the country becomes richer. They documented that transition economies have more corruption than developed countries. Others provide evidence indicating that the cross-country pattern of corruption can be explained with a high degree of confidence by the cross-country pattern of income-with strong correlation of 0.81 between GDP and the level of corruption.

It is a well-researched fact that corruption in developing economies lead to capital flight and non-policy induced undesirable increase in currency circulation, domestic currency depreciation, and hence cost push inflation through higher foreign import costs. This threatens the economy with stagflation (aggregate Supply Curve shifting leftward).

In a 2016 study, entitled, "Corruption, fiscal policy, and growth: a unified approach," published in the B.E. Journal of Macroeconomics, Sugata Ghosh and Kyriakos Neanidis have found that the effects of bureaucratic corruption on fiscal policy and economic growth reduces the tax revenue raised from households, inflates the volume of government spending, and reduces the productivity of "effective" government expenditure. The study distinguished between the policies pursued by a non-optimising, and an optimising government. For both cases, they found that corruption leads to higher income tax and drives up inflation rates and lowers the level of government spending, thus hindering growth. In these cases, the activist governments should identify what types of corruption hinders the growth most and accordingly should allocate more resources to sectors that are least harmed by corruption and inefficiency.

Dr. Abdullah A. Dewan, formerly a physicist and a nuclear engineer at BAEC, is professor of economics at Eastern Michigan University.
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