Effects of corruption on economic growth through transmission channels in developing coutries

Indirect effects of corruption on economic growth will be examined by five transmission channels such as government size, capital investment, trade openness, human capital, and political

VIETNAM-NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

EFFECTS OF CORRUPTION ON ECONOMIC GROWTH THROUGH TRANSMISSION CHANNELS

IN DEVELOPING COUNTRIES

By

NGUYEN NINH QUOC TRAN

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, JULY 2013

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM-NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

EFFECTS OF CORRUPTION ON ECONOMIC GROWTH THROUGH

TRANSMISSION CHANNELS IN DEVELOPING COUNTRIES

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

This paper examines direct and indirect effects of corruption on economics growth in developing countries Indirect effects of corruption on economic growth will be examined by five transmission channels such as government size, capital investment, trade openness, human capital, and political instability With 35 developing countries

in data set and OLS, 2SLS method, the result is that corruption has positive relationship with government expenditure, trade openness, human capital, and political instability That means more corruption will make more government expenditure, trade openness, human capital, and political instability However corruption only relates negatively with capital investment And through the effects of these transmission channels on economic growth, we can infer that totally corruption has positive relationship with economic growth The result in this paper is also an evidence of

“grease the wheel” hypothesis in developing countries This is like a careful remind on the policy of fighting against corruption because in developing countries a characteristic of corruption is positively related with economic growth

Keywords: Corruption, economic growth, government expenditure, capital investment,

openness, human capital, political instability

ABSTRACT

ABSTRACT i

CHAPTER 1: INTRODUCTION 1

1.1- Research context 1

1.2- Research objective 5

1.3- Thesis structure 7

CHAPTER 2: LITERATURE REVIEWS 8

2.1- CONCEPT OF corruption 8

2.2- Practical researches 9

2.2.1- Corruption greases the wheels of growth 10

2.2.2- Corruption is sand of the wheels of growth 10

CHAPTER 3: CONCEPTUAL FRAMEWORK 16

3.1- DIRECT EFFECT 16

3.2- INDIRECT EFFECTS 17

3.2.1- Government size 17

3.2.2- Capital investment 18

3.2.3- Trade openness 18

3.2.4- Human capital 19

3.2.5- Political instability 20

CHAPTER 4: METHODOLOGY AND DATA SOURCE 23

4.1- DIRECT EFFECT OF CORRUPTION AND TRANSMISSION CHANNELS ON GROWTH 23

4.2- INDIRECT EFFECTS OF CORRUPTION ON GROWTH THROUGH TRANSMISSION CHANNELS 24

TABLE OF CONTENTS

4.3- TOTAL EFFECT OF CORRUPTION ON GROWTH 25

4.4- DATA 25

CHAPTER 5: RESEARCH FINDINGS IN DESCRIPTIVE STATISTIC ANALYSIS 27

5.1- RELATIONSHIP BETWEEN TRANSMISSION CHANNELS AND GROWTH 27

5.2 RELATIONSHIP BETWEEN CORRUPTION AND TRANSMISSION CHANNELS AND EFFECT OF CORRUPTION ON GROWTH 32

CHAPTER 6: REGRESSION ANALYSIS 40

6.1- DIRECT EFFECT OF CORRUPTION ON GROWTH AND EFFECTS OF TRANSMISSION CHANNELS ON GROWTH 40

6.2- EFFECTS OF CORRUPTION ON TRANSMISSION CHANNELS AND GROWTH 45

6.2.1- Effect of corruption on government expenditure 45

6.2.2- Effect of corruption on capital investment 46

6.2.3- Effect of corruption on openness 48

6.2.4- Effect of corruption on human capital 49

6.2.5- Effect of corruption on political instability 50

6.3- TOTAL EFFECT OF CORRUPTION ON GROWTH 52

CHAPTER 7: CONCLUSION REMARKS 54

7.1- RESEARCH FINDINGS 54

7.2- THE DRAWBACK 55

7.3- POLICY IMPLICATION 56

REFERENCES 58

APPENDIX 61

OLS: Ordinary Least Square

2SLS: Two Stages Least Square

CI: Corruption Perceptions Index

EEPC: Engineering Enrolment Per Capita

ABBREVIATION

Table 2.1: Summary of literature reviews……… 15

Table 6.1: OLS of transmission channels and corruption on growth……… 41

Table 6.2: 2SLS of gGX-CI……… ……….45

Table 6.3: 2SLS of gFC-CI……… ………… ………47

Table 6.4: OLS of gFC-CI……….………47

Table 6.5: 2SLS of gTT-CI……… ……… 48

Table 6.6: 2SLS of EEPC-CI……….………49

Table 6.7: 2SLS of PI-CI………….……… 51

LIST OF TABLE

Figure 3.1: Effect of corruption on transmission channels and economic growth … 21

Figure 5.1: Scatter graph between g and gFC………… ……….…….28

Figure 5.2: Scatter graph between g and gGX……… ………….29

Figure 5.3: Scatter graph between g and gTT……… ……….….30

Figure 5.4: Scatter graph between g and PI………… ……….31

Figure 5.5: Scatter graph between g and EEPC……….31

Figure 5.6: Scatter graph between CI and gGX……….32

Figure 5.7: Scatter graph between CI and gFC…….……….34

Figure 5.8: Scatter graph between CI and gTT….……….35

Figure 5.9: Scatter graph between CI and gTT (dropping out two outliner points) …35

Figure 5.10: Scatter graph between CI and PI….……… 36

Figure 5.11: Scatter graph between CI and EEPC… ……… 37

Figure 5.12: Scatter graph between CI and g………39

LIST OF FIGURES

1.1- RESEARCH CONTEXT

Till now there is not the answer about the exact effects of corruption on economic growth The literatures have not come to one final agreement about the corruption on economic growth yet In early time, some authors argued that with an appropriate level

of corruption, it can make benefit for economic growth In the case of rigid government administration, corruption can act as the “grease” to make smooth for economic operation Without corruption, people or enterprises may have to “queue in line” and waste a lot of time to have the final ideas from the government And the government also spends more labor force to deal with this situation Or like another argument on benefit of corruption, Acemoglu and Verdier (1998) showed that the cost for ensuring the government officials absolutely clean from corruption can be higher than the price

of corruption Lui (1985) established “equilibrium queuing model of bribery” to examine the effect of bribery With this model, bribes can reduce the cost related with queuing Through that it improves the efficiency of public administration Moreover Beck and Maher (1986) also showed that bribery model would be “isomorphic” with bidding model in supplying goods and services to the government That means “in the absence of penalties for bribery, supplier firms would be indifferent between bribery and bidding institutions.”

On the side of against the corruption, many empirical researches have come to the results that corruption was the “sand” for the wheels of economic operation In contrast

of the idea of corruption is the “grease” for economic operation in rigid government administration, the corruption can make much more delays in administration to attract

CHAPTER 1: INTRODUCTION

more bribes The government officials do not want to act quickly because they want to have more time and force the people or enterprises spend more bribes to them With this behavior the officials have tendency to give out their decisions basing on the price

of corruption The enterprises with better quality but without corruption will have the disadvantaged decision from the authorized officials So a good project may come to

an inability enterprise The benefit from this project can be destroyed by this enterprise So by corruption, effective allocation in economic has been made distortion This will have the negative effects on economic growth

Moreover on the side of against the corruption, there are the ideas that corruption reduces the investment With corruption, the cost of project can become higher So this can drop out the good projects and reduce the investment Reduced investment will affect negatively to economic growth

So until now we really look corruption like the impediment to the economic growth The report from World Bank in 1998 has seen corruption like the great obstacle to economic and social development However we does not still have enough the exactly theoretical framework to definitely confirm the impacts of corruption on economic growth We have the empirical researches to find out the effects of corruption in the specific cases with different methodologies Mauro (1995) showed that corruption reduced investment However investment is a main source of economic growth So corruption lowered economic growth through reducing investment As in Mauro (1995) corruption and growth (also investment) had negative relationship and significant in aspect of statistic and “in an economic sense” Tanzi and Davoodi (1997) conducted the research about “corruption, public investment and growth” With cross-section data of countries and regression method they found that more corruption made more public investment and lower government revenues Also higher corruption made

“lower operation and maintenance expenditures” and “lower quality of public

infrastructure” Also in this paper the authors showed that corruption lowered productivity of public investment (however increased public investment) So that led to negative impact of public investment on economic growth Finally corruption had negative impact on economic growth Kaufmann and Wei (1999) had a research on

“grease money” With data at firm level from worldwide, the authors found conclusion against “efficient grease” hypothesis They found that paying more bribes does not lead

to reduce “management time wasted with bureaucrats” and cost of capital However paying more bribes would create more “management time wasted with bureaucrats” and more cost of capital This would affect investment projects and economic growth

in general

Beside the direct impact of corruption on economic growth, recent researches have shown out the indirect impacts of corruption on growth In summary, we can list out five popular channels such as human capital, capital investment, government size, trade openness, and political instability through which corruption affect economic growth About human capital channel, Murphy, Shleifer, and Vishny (1991) found that corruption affected how people invest in human capital If rent seeking rewards more than producing operation, people will devote most ability to become rent seeker and choose occupation that bring them more rent seeking, not for production Investment in human capital in this case will be reduced; production of nation will be lowered Finally it will reduce growth

About capital investment, Mauro (1995) showed the negative relationship between corruption and private investment Corruption adds more cost for investment So it reduces private investment However investment is the main source of growth Lower investment will lower economic growth Mo (2000) also found corruption had negative

impact on private investment channel And through impact on this channel it reduced economic growth

Tanzi and Davoodi (1997) examined the impact of corruption on public investment Public expenditure had tendency to become bigger under corruption Corruption made public investment increase but its productivity decrease On net effect, it reduced economic growth However according to Hodge, Shankar, Rao, and Duhs (2009) corruption reduced government spending On total effect, corruption fosters growth through this channel by lowering government spending So we have mixed impact of corruption on government size Corruption can decrease or increase government spending

About trade openness, one of the ways that the corruption affects trade is quota of exporting and importing By that way corruption can restrict trade openness Pellegrini and Gerlagh (2004) found negative relationship between corruption and trade openness And final impact of corruption on growth through this channel was negative Finally corruption affects growth through political instability channel Corruption can create the ideas about inequality and impropriety among citizens This is the root of political instability And political instability makes bad environment for investment and economy It will impede economic growth Mo (2000) examined the indirect impact of corruption on growth through political instability He found that corruption had positive relationship with political instability More corruption will be more instability And this will lead to lower growth Pellegrini and Gerlagh (2004) also came

to the same result as Mo (2000) about the impact of corruption on political instability and economic growth

Looking closer on impact of corruption in developing countries, till now we have very few researches about it Almost researches here have used data of cross countries all

over the world to find out the impact of corruption on economic growth (indirect and direct impact) According to these researches, corruption has mostly had negative relationship with growth That means the countries with higher corruption will suffer lower growth However this is still right if we look into group of developing countries? Corruption makes more cost for the economy and impedes economic growth If this is still right for developing countries, corruption will become the great obstacle for development in developing countries However we may have the argument when we look separately in some developing countries For example, Indonesia and Thailand have had fast pace of growth in spite of high corruption in these countries South East Asia has also experienced fast growth although corruption in most countries of this area is very popular So in this case corruption has promoted economic growth This is the reason why this paper would like to focus on developing countries We would like

to examine more detail about the impact of corruption on this group of countries

Obviously, corruption has the impact on economic growth In scope of this research we would like to examine the effects of corruption on economic growth in developing countries and to find out that corruption has negative or positive effect on economic growth

1.2- RESEARCH OBJECTIVE

This paper tries to examine the impact of corruption on economic growth by the model

of transmission channels such as human capital, investment, government size, openness, and political instability Firstly the corruption will affect these channels In this paper, corruption is supposed to affect human capital, investment, government size, openness, and political instability After that these channels will affect economic growth By that way we will have the total effect of corruption on economic growth

By using system of equations this paper establishes the links between corruption and

economic growth across countries This method will break down the ways by which the corruption affects growth Because of that we will have the better view on the link between corruption and growth

General speaking, this paper firstly establishes the transmission channels model between the corruption and the economic growth And by that way we will come to answer the question “how does the corruption affect the economic growth in developing countries? “

This paper uses cross section data in developing countries at 2008 and bases on the methodology in the paper of Lorenzo Pellegrini and Reyer Gerlagh (2004) to deal with our problem However in this paper we replace the variable “human capital” used in Lorenzo Pellegrini and ReyerGerlagh (2004) and other papers by variable investment type of human capital The investment type of human capital means that you choose how to investment in human capital such as you can choose your study and occupation

in engineering to promote the productivity or you can choose your study and occupation in other fields to have more opportunities to corrupt Moreover this paper also puts the government size into examining And with the sample data collected from developing countries at 2008, we hope to have better view about how the corruption affects the economic growth in developing countries through the transmission channels

In summary, by focusing on developing countries, this paper has the following main objectives:

‐ Systematizing indirect transmission channels of corruption on growth and examine the impacts of corruption on these channels such as human capital (focusing on investment type of human capital), capital investment, government size, trade openness, and political instability

‐ Examining the impacts of transmission channels on economic growth, then finding out indirect impact of corruption on economic growth through theses channels and comparing indirect and direct impact of corruption on growth

‐ Combine the direct and indirect effects of corruption on growth and find out the total effect of corruption on growth This final result can be considered as the reference for policies issued to deal with the corruption problem

1.3- THESIS STRUCTURE

This paper includes total seven main chapters Chapter 1 Introduction is to represent generally the context of research and some main objectives of this research Chapter 2 Literature Review is to review some studies in past that related to the topic of this paper Chapter 3 is Conceptual Framework This chapter will outline the paths that corruption relates with economic growth And through it we will set up the framework

to research the effect of corruption on economic growth And the purpose of chapter 4 Methodology and Data is to build up the methodology and to look for the data source

to solve the issue and find out the answer for research objectives Chapter 5 Research Findings in Descriptive Statistics will show out the results of relationship between corruption and growth in the context of descriptive statistics And chapter 6 Regression Analysis will find out the results of relationship among corruption, transmission channels, and economic growth in the approach of regression Finally chapter 7 Conclusion Remarks will summarize the main findings of this paper and give out some comments around these findings

In this section we will review necessary researches and papers that were conducted to examine the relationship among corruption, transmission channels of corruption and economic growth

However at the beginning we are going to present a few things about corruption and sources of growth Then we are going to review some papers to see how the relationship between corruption and growth has been examined

2.1- CONCEPT OF CORRUPTION

According to the definition from Transparency International (on its website)

“Corruption is operationally defined as the misuse of entrusted power for private gain” Also according to this organization, corruption can be separated into two types:

"according to rule" and “against the rule” The first type is defined as “facilitation payments, where a bribe is paid to receive preferential treatment for something that the

bribe receiver is required to do by law” And the second one is “a bribe paid to obtain services that the bribe receiver is prohibited from providing” And also according to Transparency International, corruption can cost in four aspects: economic, political, social, and environmental costs With more focusing on economic aspect, the corruption can “lead to the depletion of national wealth” Corruption leads to allocate the national resources inefficiently Corruption can cause uneconomic projects to take place meanwhile economic projects are rejected Corruption also breaks up the “fair market structure” and “distort competition” As a result corruption makes negative economy Moreover corruption makes political system become weaker It destroys

CHAPTER 2: LITERATURE REVIEWS

people’s trust in the political system It makes instability in society And with the existence of corruption, projects damaging environment can be licensed This will lead

to destroy living environment and natural resources

In this paper we consider the impact of corruption on economic growth by direct and indirect way So corruption is also called the factor of growth Basically on the neoclassical growth theory, following the growth model of Solow, growth is a function

of capital and labor Capital formation and labor force are the main factors of economic growth Moreover on researches about the determinants of growth, other factors have been found out Human capital is also the important factor of growth Mankiw, Romer, and Weil (1992), by cross-country data, found out human capital was the significant factor of economic growth beside labor and physical capital And Baro (1996) also showed that initial level of GDP, human capital, government consumption, term of trade, investment ratio were among the factors affecting growth Moreover Alesina, Ozler, Roubini, and Swagel (1992) found that political instability had negative effect

on economic growth Generally economic growth is a complicated function of many independent variables In this paper we add one more determinant of growth This is corruption However beside the direct impact of corruption on growth, we also examine the indirect impact of corruption Corruption makes links with growth by just source factors of economic growth such as human capital, capital investment, government size, trade openness, and political instability Indirectly corruption affects growth through these channels In the following part we are going to represent some researches about how corruption affects growth and its transmission channels

2.2- PRACTICAL RESEARCHES

Like in Introduction part, we have stated that corruption can be good or bad for economic growth So we will break down this section into two parts The first part is to

review some papers that support for the positive effect of corruption on growth And the second part is of negative effect of corruption

2.2.1- Corruption greases the wheels of growth

As in Meon and Weill (2008), the authors tested whether corruption is “grease” or

“sand” of economic growth They examined the relationship among corruption, aggregate efficiency, and the dimensions of governance across 54 countries (including developed and developing countries) in period 1994-1997 With OLS method, the result showed that in the countries with effective institution, corruption would have negative effect; however in case of ineffective institution, corruption would have positive effect So, this paper came to conclusion of supporting for “grease the wheels” hypothesis According to this paper, with inefficient institutional countries, let corruption being free would bring back benefit However the authors also warned that

“country that would allow unfettered corruption may eventually find itself with an even worse global institutional framework, and thus be caught in a bad governance/low efficiency trap”

Or in Kaouthar Gazdar (2012), the author also would like to test the hypothesis “grease the wheels” of corruption This paper examined the relationship among the corruption, growth, and the quality of governance 19 MENA countries in period of 1984-2010 were used in this paper as the data for analyzing With the method of GMM, the author found that in case of weak institutional framework, the corruption is less detrimental for economic growth The corruption is positive effect on economic growth in case of low governance The hypothesis was again supported by this paper

2.2.2- Corruption is sand of the wheels of growth

Firstly Pak Hung Mo (2000) did a research about the relationship between corruption and economic growth He used data of 52 countries in period 1960-1985 He found that

“1% increase in the corruption level reduces the growth rate by about 0.72% or, expressed differently, a one-unit increase in the corruption index reduces the growth rate by 0.545 percentage points” And political instability is one of the top important channels beside human capital, and investment channels Political instability took 53%

of total effect on economic growth

With the research “Does corruption grease or sand the wheels of growth?”, Pierre and Khalid (2003) assessed the corruption’s effect on growth and investment Panel data from 71 countries in period time 1970-1998 was used in this research The corruption would have more and more negative impact on investment in case of inefficient government and political instability Same as investment, corruption also affected negatively on economic growth This result supported for the hypothesis of “corruption sands the wheels of growth”

Beside the impact of corruption on growth, Lorenzo Pellegrini and Reyer Gerlagh (2004) also did the research about the transmission channels of corruption They examined four channels such as schooling, political instability, openness of trading, and investment Corruption had all negative effects on schooling, trade openness, and investment However corruption and political instability had positive relationship The final result confirmed that corruption had negative impact on economic growth

Moreover Mina Baliamoune-Lutz and Léonce Ndikumana (2008) also examined the impact of corruption on investment in African countries Firstly they analyzed the effect of investment on economic growth After that they would research the impact of corruption on investment By that way they could have a better view about the effect of corruption on growth through investment The paper used the GMM method to examine 33 African countries from 1982 to 2001 The result once again concluded that investment had significant effect on economic growth More important thing was that

corruption also had negative impact on domestic investment However corruption had different effects on private investment and public investment In aspect of private investment, corruption had negative effect on it But in view of public investment, corruption had positive relationship with it

And Aliyu and Elijah (2008) also did the research in Nigeria about the relationship between corruption and economic growth The authors used ECM method along with time series data in period 1986-2007 to conduct research The study showed that corruption had negative impact on economic growth Moreover it also explored that corruption had negative relationship with human capital development However corruption went the same way with government capital expenditure

Sriram Shankar (2009) conducted the paper to “model the transmission channels through which corruption indirectly affects growth” Five main transmission channels

he used in this research were investment, human capital, government size, openness, and political instability Data of 81 countries from 1984 to 2005 was chosen to examine in this paper Using system of equations methods he found that corruption had negative effects on investment, human capital, and political instability Through these channels corruption hindered economic growth However “corruption is found to foster growth by reducing government consumption and, less robustly, increasing trade openness” In total, corruption had negative effect on economic growth

And Ugur and Dasgupta (2011) have conducted the research about the impact of corruption on economic growth in low income countries The author has used meta-analysis method to analyze the findings of 72 empirical researches The authors also have examined the transmission channels of corruption to economic growth The result

of this research showed that corruption put the significant effect on economic growth And another important thing was that corruption had negative impact on growth This

result also extended to non-low income countries The corruption also had negative and

significant effect on growth in non-low income countries Without transmission

channels, the paper found out that the direct effect of corruption on non-low income

countries was higher than low income countries So the authors concluded that

“corruption should be considered as an international problem with negative economic

consequences rather than as a problem specific to LICs only”

All the above studies can be summarized like the following:

time 1970-1998 political instability corruption also

affected negatively on economic growth

Lorenzo

Pellegrini and

Reyer Gerlagh

(2004)

OLS, 2SLS Cross countries Corruption had all negative effects

on schooling, trade openness, and investment But corruption and political instability had positive relationship The final result confirmed that corruption had negative impact on economic growth Mina

corruption also had negative impact

on domestic investment and growth

Aliyu and Elijah

Sriram Shankar

(2009)

System of equations

Data of 81 countries from

1984 to 2005

Corruption had negative effects on investment, human capital, and political instability "corruption is found to foster growth by reducing

government consumption and, less robustly, increasing trade openness" Ugur and

Dasgupta (2011)

analysis

Meta-Corruption had negative and significant impact on growth And without transmission channels, the paper found out that the direct effect

of corruption on non-low income countries was higher than low income countries

Table 2.1: Summary of literature reviews

Most of these practical researches used data of all countries on the world (except Mina

Baliamoune-Lutz and Léonce Ndikumana (2008) using African countries) And

popular method of examining is OLS Some studies used 2SLS, GMM, ECM, system

of equations As a result, most findings showed that corruption had total negative effect

on economic growth However there are still some papers supporting for the hypothesis

“grease the wheels of growth” of corruption such as Meon and Weill (2008) and

Kaouthar Gazdar (2012) It means that in reality there are some cases where corruption

has positive relationship with economic growth

The effect of corruption on economic growth will be divided into two parts Firstly that

is direct effect of corruption on growth Secondly that is indirect effect through transmission of corruption on economic growth This chapter will help us figure out generally how corruption affects economic growth through direct and indirect ways

3.1- DIRECT EFFECT

In this paper we consider effect of corruption on growth through two ways The first way is direct and the second way is indirect There are not many papers finding out direct effect of corruption on growth is significant As in Lorenzo Pellegrini and Reyer Gerlagh (2004), the direct effect of corruption on growth is not significant Effect of corruption on growth mainly goes through indirect effects and transmission channels Insignificant direct effect of corruption does not mean that there is not existing of direct effect of corruption As in Dzhumashev (2009), the author proved the significant direct effect of corruption In this paper corruption affects directly growth by

“distorting the publicly provided productive externality and by deteriorating the overall business climate and perpetuating bad expectations about economic opportunities” So corruption affects negatively growth by direct way

So according to the paper of Dzhumashev (2009), we expect that in this paper direct effect of corruption on economic growth will be negative (corruption will inhibit growth directly)

CHAPTER 3: CONCEPTUAL FRAMEWORK

3.2- INDIRECT EFFECTS

In this section we would like to find out how corruption affects economic growth by the transmission channels So first in this section we will list out and describe these channels

According to Sriram Shankar and co-authors (2009), corruption will affect growth by five transmission channels such as government size, capital investment, openness, human capital, and political instability

3.2.1- Government size

As in Sriram Shankar and co-authors (2009), there are two different ideas about the impact of corruption on government size On one way, corruption makes government size increase On the other way, corruption reduces government size

To some officials, they can corruption by the way of extending the government expenditure By that way they have more opportunities to make the corruption They also allocate the budget inefficiently because of their corruption For these officials expending more and more governmental budget is an opportunity to take more corruption

However for some other officials, narrowing public expenditure is the way to take more corruption They report lower budget that is available for consumption in order to using more part of this budget or take corruption under various forms Under this way, limiting government size creates opportunities for take corruption

So here it is up to every specific case to have a negative or positive effect of corruption

on government expenditure This effect will result from empirical examination

3.2.2- Capital investment

There are some ideas to explain the impact of corruption on investment As in Sriram Shankar and co-authors (2009), Lorenzo Pellegrini and Reyer Gerlagh (2004), and Pak Hung Mo (2000) corruption adds more cost to projects when the corruption exists Corruption can make feasible projects become infeasible projects And when corruption exists, enterprises can be uncertainty about the return on investment activities Enterprises must pay bribes in corrupting officials to go ahead the business operation So corruption is another cost of business operation of enterprises As a result corruption will make less incentive to proceeds to investment activity As in growth theory, investment is a very important factor of economic growth Less investment may lead to less growth

However according to idea of “grease the wheels” of corruption, it may go positively with investment In case of complicated administration existing in some countries, without corruption, administrative procedure of business operation can be more time, more money, and more labor So in this case corruption can make support for business and investment operation

However in reality, until now more practical studies found that corruption has negative impact on capital investment More corruption will lead to less investment So we can expect that in this paper we also come to the result that corruption also has negative impact on capital investment However we aware that corruption can still have positive impact on capital investment in the hypothesis of “grease the wheels”

3.2.3- Trade openness

Lorenzo Pellegrini and Reyer Gerlagh (2004) showed that corruption have a negative effect on trade openness The corruption activities happen on the process of quota of export and import With the incentive to free trade, rent-seeking activities through

quota will stop down So the intervention into the trade to have more opportunities to corrupt will remain This will limit the openness of trading According to this, corruption is expected to have negative relationship with openness of trade

3.2.4- Human capital

In some recent empirical research such as Pak Hung Mo (2000) and Sriram Shankar (2009), corruption showed a negative effect on human capital This impact can be explained by some ideas Firstly, corruption is the cause for reducing government revenue Because of corruption, tax evasion activity and wrong tax exemption cases can happen This will lead to reduce government tax revenue Education and health are usually in the categories of budget spending of government So when government revenue is reduced, the government expenditure to develop human capital will be reduced too As a result corruption has made negative impact on human capital Another idea to examine the effect of corruption on human capital is in budget of enterprises to develop human capital Existing of corruption can acts as another cost for enterprises When the cost increases, the budget for investment may be reduced It also means that budget for developing human capital may be reduced as well So through some these ideas about the relationship between corruption and human capital, this give us the thinking about negative impact of corruption on human capital investment Moreover on the paper of Murphy, Shleifer, and Vishny (1991) about “The allocation

of talent: Implications for growth” showed that people choose occupation due to the return of that occupation When people see that rent seeking rewarding more, they will become rent seeker However rent seeker does not support growth They just

“redistribute wealth and reduce growth” This behavior affects the different types of investment in human capital People can devote all in how to have power and become a rent seeker Or they can devote to the occupation such as engineering, science, manufacturing to promote productivity and support for growth In the paper of

Murphy, the authors used two proxy variables to represent for two cases of occupational choices They used the variable college enrollment in law to stand out for the talent towards rent seeking And enrollment in engineering to represent for talent allocated to productivity And the result showed that the country with more engineering grow faster Through that we can think about whether corruption can affect investment in types of human capital So beside the effect of reducing the investment in human capital, corruption can affect types of investment in human capital

In this paper we intend to examine the effect of corruption on types of human capital More detail we will see how corruption affects engineering type of human capital Because of having more benefit from corruption, people have tendency to become rent seeker This choice will make people go away from devoting to the occupation such as engineering, science, manufacturing Because of that, we expect corruption will have negative effect on human capital (in aspect of investment in engineering area of human capital)

3.2.5- Political instability

Also in the paper of Lorenzo Pellegrini and Reyer Gerlagh (2004) showed that corruption had a significant and positive effect on political instability The idea is that corruption makes political discontent among citizens and bureaucratic officials and even among bureaucratic officials This is the root of political instability

According to Pak Hung Mo (2000) the corruption can cause the inequality in income This can cause the people in poor bottom group to make violent reaction to protest this corruption behavior Violence and political instability is dangerous for material and property rights This will affect negatively to investment operation and growth So this political instability will be expected to have positive with corruption

To synthesize the above analysis about the transmission channels, we have a diagram like this:

Figure 3.1: Effect of corruption on transmission channels and economic growth

According to this diagram, corruption has direct and indirect effect on economic growth Indirect effects will be created by five transmission channels such as human capital, investment, government size, openness, and political instability

In this paper we are going to examine total effect of corruption on growth through indirect and direct effects Five transmission channels of indirect effects are included in examining And this research is conducted on the background of the practical research

in history And the paper of Lorenzo Pellegrini and Reyer Gerlagh (2004) will serve as the reference background for this paper The framework to conduct this research is

similar to the framework used in Lorenzo Pellegrini and Reyer Gerlagh (2004) So with reference to Lorenzo Pellegrini and Reyer Gerlagh (2004) will be good guide for this research Compare with the paper of Lorenzo Pellegrini and Reyer Gerlagh (2004), this paper has some differences Firstly in this paper we examine five transmission channels compared with four channels in that paper We include government expenditure channel in this paper (this channel examined in Sriram Shankar (2009)) Secondly human capital in this paper is to focus in investment type of human capital Thirdly we examine the effects of corruption on growth just in developing countries compared with all over the world of Lorenzo Pellegrini and Reyer Gerlagh (2004)

4.1- DIRECT EFFECT OF CORRUPTION AND TRANSMISSION CHANNELS

Comparing with those in Lorenzo Pellegrini and Reyer Gerlagh (2004), here we add one more channel that is government expenditure And because we would like to examine the effect of corruption on type of human capital, so we choose the ratio of tertiary enrolment in engineering as a channel We also include one more explanatory variable gLF in this model

Because in this paper we would like to examine the impacts of corruption and transmission channels on growth rate, so the presentations of these variable in this model 4.1 are noticed We do not intend to establish a perfect growth rate model So It

is possible that in the model 4.1 there are not enough variables that are the factors of economic growth because economic growth is a complicated function of many factors

CHAPTER 4: METHODOLOGY AND DATA SOURCE

However if we just notice about the impacts of corruption and transmission channels in this model, we can accept the shortcoming of a perfect growth model like this

Model (4.1) will be examined by OLS method to see how the relationship among corruption, transmission channels and growth And from this we can estimate direct effect of corruption on growth by using coefficient a2

4.2- INDIRECT EFFECTS OF CORRUPTION ON GROWTH THROUGH TRANSMISSION CHANNELS

Second, we will examine the effect of corruption on each channel Like in Lorenzo Pellegrini and Reyer Gerlagh (2004) we have:

Ti= b0 +b1.LY0i + b2.CIi +ui(4.2) Where T is the vector of transmission channel variables such as gFC, gGX, gTT, PI, EEPC And b0, b1, b2 are five-dimensional coefficients vector, CI is corruption perception index, LY0 is the log of GDP per capital in the base year 1990

Through model (4.2) we can see the effect of corruption on each channel And by the model (4.1) we can estimate the indirect effect of corruption on growth by each channel The indirect effect of corruption on growth through each channel will be achieved by b2 x a (a3 to a7) For example the indirect effect of corruption on growth through capital investment channel will be the product of corresponding coefficient b2and a3

Because the capability of having endogenous problem transmission channels in model (4.2), so 2SLS method with instrument variable LO (legal origin) also intends to use to solve this problem

According to Conceptual Framework part, we expect that corruption will have negative relationship with human capital in type of engineering, investment, and openness And corruption will have positive relationship with government size, and political instability Finally, total effect of corruption on economic growth will be negative

4.3- TOTAL EFFECT OF CORRUPTION ON GROWTH

With 4.1 we have direct effect of corruption on growth And with 4.2 the indirect effects of corruption on growth through each channel has been achieved Total indirect effect of corruption on growth will be the sum of all indirect effects of corruption on growth through each transmission channel And finally total effect of corruption on growth will be the sum of direct effect and total indirect effect of corruption on growth

4.4- DATA

This paper intends to use cross section data in developing countries in 2008 However for enough data of each variable, we just have around 35 observations cross developing countries in 2008 to do the research

The economic crisis has happened from the end of 2008 up to now If we choose time point at 2009, 2010 or 2011 to collect data, the abnormal changes rooted in crisis can effect negatively to our estimation So the reason of choosing year 2008 is to avoid the turbulence of economic crisis in the recent years

Most of data are taken from World Bank except Corruption Perceptions Index (CI) is taken from Transparency International CI ranges from 1 to 10 The country with higher score will be cleaner from corruption

Moreover, We will express the definition of some main independent variables like following:

- Fixed capital formation growth rate (gFC): According to definition from World Bank,

“Gross fixed capital formation (formerly gross domestic fixed investment) includes land improvements (fences, ditches, drains, and so on); plant, machinery, and equipment purchases; and the construction of roads, railways, and the like, including schools, offices, hospitals, private residential dwellings, and commercial and industrial buildings According to the 1993 SNA, net acquisitions of valuables are also considered capital formation” And the growth rate of fixed capital formation is the increasement in percentage compared with the previous year

- Government expenditure growth rate (gGX): This is the increasement in percentage year to year of general government final consumption expenditure According to World Bank, it is defined as “all government current expenditures for purchases of goods and services (including compensation of employees) It also includes most expenditures on national defense and security, but excludes government military expenditures that are part of government capital formation”

- Political stability index (PI): This index is taken from the project “Worldwide Governance Indicators” from World Bank This index “reflects perceptions of the likelihood that the government will be destabilized or overthrown by unconstitutional

or violent means, including politically-motivated violence and terrorism” It ranges from -2.5 to 2.5 Higher score reflects stronger in political stability

- Enrolment in engineering per capita: This data is taken from database from World Bank It represents the human capital in engineering area

- Total trade growth rate (gTT): it is the increasement in percentage of total trade year

to year And the total trade is the sum of total export of goods and services and total

import of goods and services This variable represents the openness of economy

In this section we will consider the relationship between each pair of variables under descriptive statistic situation such as between corruption and every transmission channel and between every transmission channel and growth

5.1- RELATIONSHIP BETWEEN TRANSMISSION CHANNELS AND GROWTH

Firstly we are going to consider the relationship between every main transmission channel and growth As be stated in previous section there are five transmission channel examined in this paper such as investment, government size, openness, political instability, human capital Here we use growth rate of gross fix capital formation (gFC) to represent for investment variable, growth rate of general government final consumption expenditure (gGX) to stand for government size, growth rate of total trade (gTT) for openness variable, percent of number of enrolment

in engineering over total population (EEPC) for human capital variable, and political instability index (PI) for political instability And growth rate of GDP (g) is chosen to stand for economic growth All these data are collected in 2008

In descriptive statistic approach we are going to use graph and correlation coefficient

to show the relationship between every pair of variables, beginning with the relationship between economic growth and investment

CHAPTER 5: RESEARCH FINDINGS IN DESCRIPTIVE STATISTIC

ANALYSIS

Figure 5.1: Scatter graph between g and gFC

Looking at figure 5.1 we can recognize this is nearly a linear relationship between investment and growth Slope of this linear relationship is visually upward So we can infer that growth and investment have positive relationship This is absolutely suitable for growth theory More investment will create more economic growth The correlation coefficient between investment and growth is 0.534 This also shows a strong relationship in this pair of variables

Now we come to pair of government expenditure and growth