Why is corruption so costly?

The news is currently filled with stories of corruption.  A global group of media outlets just broke the story of secret offshore bank accounts in Panama, which suggests widespread corruption in the Russian government and elsewhere. For months, stories of the Brazilian government’s bribery scandal have filled the news. Other headline-grabbing events include Malaysia’s prime minister allegedly siphoning almost a billion dollars from a state development fund.

Many stories focus on the politics of corruption. The Economist magazine even has an entire section devoted to political corruption. Some stories focus on the exact details of how corrupt money flows around the world, such as a recent Wall Street Journal story on how Malysia’s missing funds actually paid for the movie “The Wolf of Wall Street.”

Corruption is ethically wrong and is illegal in most countries. For example, the U.S. has laws such as the Foreign Corrupt Practices Act that clearly states people in business should not bribe, cheat or steal when doing business.

Few of the news stories, however, explain in simple economic terms why corruption is so bad.

Corruption is another tax

In economic terms, bribery is simply another government tax.

Imagine a store owner who pays a set tax each year. Now imagine each year the store owner also needs to bribe local officials for an operating permit. The tax plus the bribe affects the store’s bottom line the same as simply being taxed once by the government at a higher amount.

In general, taxes discourage business. When costs go up without a change in revenue, profits fall. If profits fall so low as to disappear, the reason for being in business goes away.

In simple terms corruption and bribery reduce the economic incentive to produce. This lowers a country’s output and drags down the entire nation’s standard of living. Bribes result in a smaller economic pie because businesses don’t expand resulting in fewer jobs, smaller legitimate tax revenue and lower output for everyone.

Corruption and bribery, however, have a more damaging impact than most regular government taxes. First, having to pay bribes reduces people’s trust in government. Second, bribes are more damaging than a tax because the amount paid in bribes is often both unknown and highly variable.

The global cost of corruption is estimated at more than US$2.26 trillion a year, or 5 percent of global GDP, according to the World Economic Forum. More than $1 trillion of that is paid in bribes. Another study found that every percentage point increase in corruption – according to an index that measures it – reduces GDP growth by 0.13 percent and GDP per capita by $425 a year. Corruption has also been linked to higher levels of poverty and inequality.

But beyond the direct costs, even the threat of a bribe disrupts economic activity and leaves everyone worse off. While a tax is usually known in advance, allowing businesses and individuals to plan, it is exceedingly difficult to plan and adjust for bribes since the amount is not fixed but instead is “negotiated.”

A tale from Tanzania

Corruption exists in forms small and large across the globe, from poor country to rich. I saw the direct impact of low-level corruption and bribery and this “negotiation” a few months ago during a holiday stay in Tanzania. The incident occurred in Africa but it could have happened on any other continent.

Tanzania, a large country in East Africa, is home to many friendly and welcoming people as well as awe-inspiring scenery and wildlife. Unfortunately, the police in Tanzania can be less so. They are woefully underpaid and boost their pay by demanding bribes. Transparency International rates Tanzania 117th out of 168 countries on the scale of corruption. Denmark, at number one, is ranked least corrupt, while the U.S. comes in at 16.

On my way to climb Mount Kilimanjaro, Africa’s highest mountain, I hired a car and driver for the typically six-hour trip. On the way there, we were in a shiny new Toyota Land Cruiser, in perfect working order. As we passed police checkpoints, we saw cars being pulled over. We made the drive without incident.

On the return trip, however, the shiny Land Cruiser wasn’t available. Instead, the company’s owner and one of his drivers beckoned us into an old but serviceable minivan. Why did the owner have to tag along? I wondered. It soon became clear.

Police pulled us over at almost every other checkpoint, where we waited as they examined papers and inspected the horn, the lights, even the directional signal to ensure they worked. The company owner explained that the police were looking for any kind of a problem as an excuse to take a bribe (the brand new Land Rover didn’t offer such opportunities). If even the tiniest problem was found, he told me, they would offer a choice: accept the official fine or pay a lower bribe on the spot in cash. That’s why the owner came along, to negotiate how much to pay, which can depend on anything from how rich the passengers look to whether the police had already made a good haul that day.

Fortunately, everything worked, and the police didn’t have an excuse to extort us. But the economic cost of corruption isn’t only cash forked over in bribes. As my anecdote illustrates, a culture of corruption is extremely inefficient, costs a lot of time (in our case a couple of hours) and leads to wasted wages, among many other ill effects.

Corruption’s results

One of the most pernicious impacts is that this kind of low-level corruption and arbitrary demands stymie the kind of entrepreneurial activity that drives an economy.

The car company owner, for example, said it made him less eager to expand his business, hire more workers and buy more vehicles. This has resulted in Tanzania having a smaller economic pie because bribery made this owner reluctant to expand his business.

Corruption is highlighted by the media because the amounts being exchanged are often huge. The real reason corruption should be headline news is that it steals a bit of economic prosperity from every person each time it occurs.