banco mundial - seeds of corruption - do market institutions matter?

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  • S E E D S O F C O R R U P T I O ND o M a r k e t I n s t i t u t i o n s M a t t e r ?

    Harry G. Broadman and Francesca Recanatini

    The World BankEurope and Central Asia Regional OperationsPoverty Reduction and Economic Management Department

  • Summary findings

    Ten years into the transition process, corruption is now recognized to be a pervasive phenomenon that canseriously jeopardize the best intentioned reform efforts. Because of the complex and deep political economydynamics surrounding the process transition economies are undergoing it is essential for policy-makers tounderstand the causes of corruption. This paper develops an analytical framework for examining the rolebasic market institutions play as determinants of rent-seeking and illicit behavior in transition economies.Using data only recently available on the incidence of corruption and institutional development in sucheconomies, we provide some preliminary evidence on the linkage between the development of marketinstitutions and incentives for corruption. In addition, we explore the relative roles of different marketinstitutions on corruption.

    Utilizing various indicators for different dimensions of market institutions in transition economies based onour analytical framework, and after controlling for other factors that may affect corruption suggested in theliterature, we find empirically that these institutional indicators are systemically associated with the incidenceof corruption in a broad set of transition economies. While virtually all of the indicators we examine appearto be important, three emerge as especially statistically significant: the intensity of barriers to new businessentry, the effectiveness of the legal system and the efficacy and competitiveness of services provided byinfrastructure monopolies.

    The main lesson from our analysis is that a well-established system of market institutionsone characterizedby clear and transparent rules, fully functioning checks and balances, including strong enforcementmechanisms, and a robust competitive environmentreduces rent-seeking opportunities and, in turn, theincentives for corruption. Our empirical investigation points to the importance of both the design and effectiveimplementation of such measures to promote the establishment of an effective market system; in other words, itis not enough, for example, to simply enact first class laws if they are not enforced. In this regard, thedynamics engendered by the tensions in a countrys political economy regime play a crucial role indetermining the extent to which implementation of a given policy reform will be successful in curtailingcorruption. Indeed, throughout our analysis we emphasize the importance of political economy factorsthecredibility and commitment of government to carry out announced reforms, the degree to which governmentofficials are captured by the entities they regulate/oversee, the stability of the government itself, and thepolitical power of entrenched vested interests. These factors have long been recognized as potentdeterminants of opportunistic behavior and corruption by economists in the field of industrial organization,antitrust and regulation; only now are they becoming conventional wisdom among specialists in economies intransition.

    This papera product of Europe and Central Asia Regional Operations, Poverty Reduction and EconomicManagement Departmentis a part of the Departments continuing assessment of institutional reforms inEurope and Central Asia. Copies of the paper are available free from the World Bank, 1818 H Street, NW,Washington, DC 20433; papers are also posted on the Worldwide Web atwww.worldbank.org/research/workingpapers or please contact Ms. Sandra Craig on 202 473 3160 or atscraig@worldbank.org.

  • S E E D S O F C O R R U P T I O ND o M a r k e t I n s t i t u t i o n s M a t t e r ?

    Harry G. Broadman* and Francesca Recanatini**

    * Lead Economist, Europe and Central Asia Operations, The World Bank

    ** Young Professional, Europe and Central Asia Operations, The World Bank

    The World Bank, 1818 H Street, NW Washington, DC, 20433; email: hbroadman@worldbank.org;frecanatini@worldbank.org

    We would like to thank Roberta Gatti, Aart Kray, Vikram Nehru, Guy Pfefferman, James Roaf and RandiRyterman for their comments. We are also thankful to Dani Kaufmann, Aart Kray and Pablo Zoito-Lobatonfor sharing their data. Any remaining errors are our own. The views expressed here are those of the authorsand not of the World Bank or its member governments.

  • INTRODUCTION

    In recent years the fight against corruption has become a key element in the policy agenda ofmany governments and international development agencies. As emphasized by a growing literature,corruption affects growth and investment, making its eradication a fundamental challenge for thelong-term development of many countries (among others, see Mauro, 1995; Bardhan, 1997;Kaufmann et al., 1999a; Wei, 1999).

    The causes and origins of corruption, however, are less clear and less systematicallyinvestigated, with few empirical studies on the nature and extent of the determinants of corruptionavailable.1 Despite the limited evidence on the causes of corruption, researchers and policy-makersagree that corruption thrives in environments plagued by institutional deficiencies and non-transparent regulations (World Bank, 1997a).2 Thus, it is to be expected that incentives forcorruption would emerge especially during periods of systemic regime change, such as for thecountries making the transition from a planned to a market economy.

    Ten years into the transition process, corruption is now recognized to be a pervasivephenomenon that can seriously jeopardize the best intentioned reform efforts. Because of thecomplex and deep political economy dynamics surrounding the process transition economies areundergoingfundamentally replacing entrenched policy frameworks and vested interests regulatedby a regime of command and control with new policy structures and institutions governed by marketincentivesit is essential for policy-makers to understand the causes of corruption.

    This paper develops an analytical framework for examining the role basic market institutionsplay as determinants of rent-seeking and illicit behavior in transition economies. Using data onlyrecently available on the incidence of corruption and institutional development in such economies,we provide some preliminary evidence on the linkage between the development of marketinstitutions and incentives for corruption. In addition, we explore the relative roles of differentmarket institutions on corruption.

    Although the complexity of the issues and the limited data available call for caution, ourcross-country exploration provides important indicative results. Utilizing various indicators fordifferent dimensions of market institutions in transition economies based on our analyticalframework, and after controlling for other factors that may affect corruption suggested in theliterature, we find empirically that these institutional indicators are systemically associated with theincidence of corruption in a broad set of transition economies. While virtually all of the indicatorswe examine appear to be important, three emerge as especially statistically significant: the intensity ofbarriers to new business entry, the effectiveness of the legal system and the efficacy andcompetitiveness of services provided by infrastructure monopolies.

    The main lesson from our analysis is that a well-established system of market institutionsone characterized by clear and transparent rules, fully functioning checks and balances, includingstrong enforcement mechanisms, and a robust competitive environmentreduces rent-seeking

    1 Exceptions are Ades and Di Tella (1999), which explores the link between corruption and degree of foreign competition;and Treisman (1999), which analyzes the effect of historical and cultural traditions, economic development and politicalinstitutions on corruption..

    2 Klitgaard (1996) has attempted to formalize this intuition introducing an interesting, yet simple model to explaincorruption: C(corruption) = M(monopoly power) + D (discretion) A(accountability)i.e corruption depends on the amount of monopoly power and discretionary power that officials exercise and the degree towhich they are held accountable for their actions.

  • 2opportunities and, in turn, the incentives for corruption. Our empirical investigation points to theimportance of both the design and effective implementation of such measures to promote theestablishment of an effective market system; in other words, it is not enough, for example, to simplyenact first class laws if they are not enforced. In this regard, the dynamics engendered by thetensions in a countrys political economy regime play a crucial role in determining the extent to whichimplementation of a given policy reform will be successful in curtailing corruption. Indeed,throughout our analysis we emphasize the importance of political economy factorsthe credibilityand commitment of government to carry out announced reforms, the degree to which governmentofficials are captured by the entities they regulate/oversee, the stability of the government itself, andthe political power of entrenched vested interests. These factors have long been recognized aspotent determinants of opportunistic behavior and corruption by economists in the field of industrialorganization, antitrust and regulation; only now are they becoming conventional wisdom amongspecialists in economies in transition.3

    The structure of the paper is as follows. In the next five sections we outline thecharacteristics of a particular set of economic reforms to establish basic market ins

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