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

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

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

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 indeveloping countries Indirect effects of corruption on economic growth will beexamined 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 positiverelationship with government expenditure, trade openness, human capital, and politicalinstability That means more corruption will make more government expenditure, tradeopenness, human capital, and political instability However corruption only relatesnegatively with capital investment And through the effects of these transmissionchannels on economic growth, we can infer that totally corruption has positiverelationship 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 onthe policy of fighting against corruption because in developing countries acharacteristic of corruption is positively related with economic growth

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

openness, human capital, political instability

TABLE OF CONTENTS

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

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

LIST OF TABLE

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 FIGURES

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

CHAPTER 1: INTRODUCTION

1.1- RESEARCH CONTEXT

Till now there is not the answer about the exact effects of corruption on economicgrowth The literatures have not come to one final agreement about the corruption oneconomic 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 governmentadministration, corruption can act as the “grease” to make smooth for economicoperation Without corruption, people or enterprises may have to “queue in line” andwaste a lot of time to have the final ideas from the government And the governmentalso spends more labor force to deal with this situation Or like another argument onbenefit of corruption, Acemoglu and Verdier (1998) showed that the cost for ensuringthe government officials absolutely clean from corruption can be higher than the price

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

On the side of against the corruption, many empirical researches have come to theresults 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 governmentadministration, the corruption can make much more delays in administration to attract

more bribes The government officials do not want to act quickly because they want tohave more time and force the people or enterprises spend more bribes to them Withthis 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 thedisadvantaged 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 willhave the negative effects on economic growth

Moreover on the side of against the corruption, there are the ideas that corruptionreduces the investment With corruption, the cost of project can become higher So thiscan drop out the good projects and reduce the investment Reduced investment willaffect 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 toeconomic and social development However we does not still have enough the exactlytheoretical framework to definitely confirm the impacts of corruption on economicgrowth We have the empirical researches to find out the effects of corruption in thespecific cases with different methodologies Mauro (1995) showed that corruptionreduced investment However investment is a main source of economic growth Socorruption lowered economic growth through reducing investment As in Mauro (1995)corruption and growth (also investment) had negative relationship and significant inaspect of statistic and “in an economic sense” Tanzi and Davoodi (1997) conductedthe research about “corruption, public investment and growth” With cross-section data

of countries and regression method they found that more corruption made more publicinvestment and lower government revenues Also higher corruption made “loweroperation and maintenance expenditures” and “lower quality of public

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

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

to reduce “management time wasted with bureaucrats” and cost of capital Howeverpaying 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 haveshown out the indirect impacts of corruption on growth In summary, we can list outfive popular channels such as human capital, capital investment, government size, tradeopenness, and political instability through which corruption affect economic growth.About human capital channel, Murphy, Shleifer, and Vishny (1991) found thatcorruption affected how people invest in human capital If rent seeking rewards morethan producing operation, people will devote most ability to become rent seeker andchoose occupation that bring them more rent seeking, not for production Investment inhuman 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 betweencorruption and private investment Corruption adds more cost for investment So itreduces private investment However investment is the main source of growth Lowerinvestment will lower economic growth Mo (2000) also found corruption had negative

impact on private investment channel And through impact on this channel it reducedeconomic growth.

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

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

Looking closer on impact of corruption in developing countries, till now we have veryfew 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 anddirect impact) According to these researches, corruption has mostly had negativerelationship with growth That means the countries with higher corruption will sufferlower 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 isstill right for developing countries, corruption will become the great obstacle fordevelopment in developing countries However we may have the argument when welook separately in some developing countries For example, Indonesia and Thailandhave had fast pace of growth in spite of high corruption in these countries South EastAsia has also experienced fast growth although corruption in most countries of thisarea is very popular So in this case corruption has promoted economic growth This isthe 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 wewould like to examine the effects of corruption on economic growth in developingcountries and to find out that corruption has negative or positive effect on economicgrowth

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 Inthis paper, corruption is supposed to affect human capital, investment, governmentsize, openness, and political instability After that these channels will affect economicgrowth 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 whichthe corruption affects growth Because of that we will have the better view on the linkbetween corruption and growth.

General speaking, this paper firstly establishes the transmission channels modelbetween the corruption and the economic growth And by that way we will come toanswer the question “how does the corruption affect the economic growth indeveloping countries? “

This paper uses cross section data in developing countries at 2008 and bases on themethodology in the paper of Lorenzo Pellegrini and Reyer Gerlagh (2004) to deal withour problem However in this paper we replace the variable “human capital” used inLorenzo Pellegrini and ReyerGerlagh (2004) and other papers by variable investmenttype of human capital The investment type of human capital means that you choosehow 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 andoccupation in other fields to have more opportunities to corrupt Moreover this paperalso puts the government size into examining And with the sample data collected fromdeveloping countries at 2008, we hope to have better view about how the corruptionaffects the economic growth in developing countries through the transmissionchannels

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

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

‐ Examining the impacts of transmission channels on economic growth, thenfinding out indirect impact of corruption on economic growth through theses channels andcomparing indirect and direct impact of corruption on growth.

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

1.3- THESIS STRUCTURE

This paper includes total seven main chapters Chapter 1 Introduction is to representgenerally the context of research and some main objectives of this research Chapter 2Literature Review is to review some studies in past that related to the topic of thispaper Chapter 3 is Conceptual Framework This chapter will outline the paths thatcorruption 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 4Methodology 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 ResearchFindings in Descriptive Statistics will show out the results of relationship betweencorruption and growth in the context of descriptive statistics And chapter 6 RegressionAnalysis will find out the results of relationship among corruption, transmissionchannels, and economic growth in the approach of regression Finally chapter 7Conclusion Remarks will summarize the main findings of this paper and give out somecomments around these findings

CHAPTER 2: LITERATURE REVIEWS

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

However at the beginning we are going to present a few things about corruption andsources of growth Then we are going to review some papers to see how therelationship 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 definedas themisuse 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 “facilitationpayments, 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 obtainservices 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, thecorruption can “lead to the depletion of national wealth” Corruption leads to allocatethe national resources inefficiently Corruption can cause uneconomic projects to takeplace meanwhile economic projects are rejected Corruption also breaks up the “fairmarket structure” and “distort competition” As a result corruption makes negativeeconomy Moreover corruption makes political system become weaker It destroys

people’s trust in the political system It makes instability in society And with theexistence 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 andindirect way So corruption is also called the factor of growth Basically on theneoclassical 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 economicgrowth Moreover on researches about the determinants of growth, other factors havebeen 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 significantfactor of economic growth beside labor and physical capital And Baro (1996) alsoshowed that initial level of GDP, human capital, government consumption, term oftrade, 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 manyindependent variables In this paper we add one more determinant of growth This iscorruption However beside the direct impact of corruption on growth, we alsoexamine the indirect impact of corruption Corruption makes links with growth by justsource factors of economic growth such as human capital, capital investment,government size, trade openness, and political instability Indirectly corruption affectsgrowth through these channels In the following part we are going to represent someresearches 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 foreconomic 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 Andthe 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 (includingdeveloped and developing countries) in period 1994-1997 With OLS method, theresult showed that in the countries with effective institution, corruption would havenegative effect; however in case of ineffective institution, corruption would havepositive effect So, this paper came to conclusion of supporting for “grease the wheels”hypothesis According to this paper, with inefficient institutional countries, letcorruption being free would bring back benefit However the authors also warned that

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

Or in Kaouthar Gazdar (2012), the author also would like to test the hypothesis “greasethe wheels” of corruption This paper examined the relationship among the corruption,growth, and the quality of governance 19 MENA countries in period of 1984-2010were used in this paper as the data for analyzing With the method of GMM, the authorfound that in case of weak institutional framework, the corruption is less detrimentalfor economic growth The corruption is positive effect on economic growth in case oflow 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 corruptionand 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 growthrate by 0.545 percentage points” And political instability is one of the top importantchannels 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 andKhalid (2003) assessed the corruption’s effect on growth and investment Panel datafrom 71 countries in period time 1970-1998 was used in this research The corruptionwould have more and more negative impact on investment in case of inefficientgovernment and political instability Same as investment, corruption also affectednegatively on economic growth This result supported for the hypothesis of “corruptionsands 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 Theyexamined four channels such as schooling, political instability, openness of trading,and investment Corruption had all negative effects on schooling, trade openness, andinvestment However corruption and political instability had positive relationship Thefinal result confirmed that corruption had negative impact on economic growth

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

corruption also had negative impact on domestic investment However corruption haddifferent effects on private investment and public investment In aspect of privateinvestment, 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 relationshipbetween corruption and economic growth The authors used ECM method along withtime series data in period 1986-2007 to conduct research The study showed thatcorruption had negative impact on economic growth Moreover it also explored thatcorruption had negative relationship with human capital development Howevercorruption went the same way with government capital expenditure

Sriram Shankar (2009) conducted the paper to “model the transmission channelsthrough 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 negativeeffects on investment, human capital, and political instability Through these channelscorruption hindered economic growth However “corruption is found to foster growth

by reducing government consumption and, less robustly, increasing trade openness” Intotal, corruption had negative effect on economic growth

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

Kaouthar Gazdar GMM Panel, 19 MENA This paper supports for "grease the

2010

1985 the top important channels beside

human capital, and investmentchannels

Pierre and OLS Panel data from 71 The corruption would have more andKhalid (2003) countries in period more negative impact on investment

in case of inefficient government and

time 1970-1998 political instability corruption also

affected negatively on economicgrowth

Lorenzo OLS, 2SLS Cross countries Corruption had all negative effects

relationship The final resultconfirmed that corruption hadnegative impact on economic growth

Ndikumana

(2008)

Aliyu and Elijah ECM Time series data in Corruption had negative relationship

in Nigeria However corruption went the same

expenditure and growth

Sriram Shankar System of Data of 81 Corruption had negative effects on

1984 to 2005 political instability "corruption is

found to foster growth by reducing

government consumption and, lessrobustly, increasing trade openness"

without transmission channels, thepaper found out that the direct effect

of corruption on non-low incomecountries was higher than lowincome 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

CHAPTER 3: CONCEPTUAL FRAMEWORK

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 throughtransmission of corruption on economic growth This chapter will help us figure outgenerally 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 firstway is direct and the second way is indirect There are not many papers finding outdirect effect of corruption on growth is significant As in Lorenzo Pellegrini and ReyerGerlagh (2004), the direct effect of corruption on growth is not significant Effect ofcorruption on growth mainly goes through indirect effects and transmission channels.Insignificant direct effect of corruption does not mean that there is not existing ofdirect effect of corruption As in Dzhumashev (2009), the author proved the significantdirect effect of corruption In this paper corruption affects directly growth by

“distorting the publicly provided productive externality and by deteriorating the overallbusiness climate and perpetuating bad expectations about economic opportunities” Socorruption affects negatively growth by direct way

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

3.2- INDIRECT EFFECTS

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

According to Sriram Shankar and co-authors (2009), corruption will affect growth byfive 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 theimpact of corruption on government size On one way, corruption makes governmentsize increase On the other way, corruption reduces government size

To some officials, they can corruption by the way of extending the governmentexpenditure By that way they have more opportunities to make the corruption Theyalso allocate the budget inefficiently because of their corruption For these officialsexpending more and more governmental budget is an opportunity to take morecorruption

However for some other officials, narrowing public expenditure is the way to takemore corruption They report lower budget that is available for consumption in order tousing 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 SriramShankar and co-authors (2009), Lorenzo Pellegrini and Reyer Gerlagh (2004), and PakHung Mo (2000) corruption adds more cost to projects when the corruption exists.Corruption can make feasible projects become infeasible projects And whencorruption exists, enterprises can be uncertainty about the return on investmentactivities Enterprises must pay bribes in corrupting officials to go ahead the businessoperation So corruption is another cost of business operation of enterprises As a resultcorruption will make less incentive to proceeds to investment activity As in growththeory, investment is a very important factor of economic growth Less investment maylead to less growth

However according to idea of “grease the wheels” of corruption, it may go positivelywith 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 businessand investment operation

However in reality, until now more practical studies found that corruption has negativeimpact on capital investment More corruption will lead to less investment So we canexpect that in this paper we also come to the result that corruption also has negativeimpact on capital investment However we aware that corruption can still have positiveimpact 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 negativeeffect on trade openness The corruption activities happen on the process of quota ofexport 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 tocorrupt 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 beexplained by some ideas Firstly, corruption is the cause for reducing governmentrevenue Because of corruption, tax evasion activity and wrong tax exemption casescan happen This will lead to reduce government tax revenue Education and health areusually in the categories of budget spending of government So when governmentrevenue is reduced, the government expenditure to develop human capital will bereduced 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 ofenterprises to develop human capital Existing of corruption can acts as another cost forenterprises When the cost increases, the budget for investment may be reduced It alsomeans that budget for developing human capital may be reduced as well So throughsome these ideas about the relationship between corruption and human capital, thisgive 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 thereturn of that occupation When people see that rent seeking rewarding more, they willbecome rent seeker However rent seeker does not support growth They just

“redistribute wealth and reduce growth” This behavior affects the different types ofinvestment in human capital People can devote all in how to have power and become arent 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 ofoccupational choices They used the variable college enrollment in law to stand out forthe talent towards rent seeking And enrollment in engineering to represent for talentallocated to productivity And the result showed that the country with more engineeringgrow 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 humancapital, 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 rentseeker This choice will make people go away from devoting to the occupation such asengineering, science, manufacturing Because of that, we expect corruption will havenegative effect on human capital (in aspect of investment in engineering area of humancapital)

3.2.5- Political instability

Also in the paper of Lorenzo Pellegrini and Reyer Gerlagh (2004) showed thatcorruption had a significant and positive effect on political instability The idea is thatcorruption makes political discontent among citizens and bureaucratic officials andeven 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 thiscorruption behavior Violence and political instability is dangerous for material andproperty rights This will affect negatively to investment operation and growth So thispolitical instability will be expected to have positive with corruption

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

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

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

In this paper we are going to examine total effect of corruption on growth throughindirect and direct effects Five transmission channels of indirect effects are included inexamining 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 asthe 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 withreference to Lorenzo Pellegrini and Reyer Gerlagh (2004) will be good guide for thisresearch Compare with the paper of Lorenzo Pellegrini and Reyer Gerlagh (2004), thispaper has some differences Firstly in this paper we examine five transmission channelscompared with four channels in that paper We include government expenditurechannel in this paper (this channel examined in Sriram Shankar (2009)) Secondlyhuman capital in this paper is to focus in investment type of human capital Thirdly weexamine the effects of corruption on growth just in developing countries comparedwith all over the world of Lorenzo Pellegrini and Reyer Gerlagh (2004).

CHAPTER 4: METHODOLOGY AND DATA SOURCE

4.1- DIRECT EFFECT OF CORRUPTION AND TRANSMISSION CHANNELS

ON GROWTH

This paper intends to use methodology in paper of Lorenzo Pellegrini and ReyerGerlagh (2004) First we have the basic growth model like following:

gi= a0 + a1.LY0i + a2.CIi + a3.gFCi + a4.gGXi + a5.gTTi + a6.EEPCi + a7.PIi + a8.gLFi+ ei (4.1)

Where g is the GDP growth rate, CI is corruption perception index, gFC is fixed capitalformation growth rate, gGX is government expenditure growth rate, PI is politicalstability index, EEPC is enrolment number in engineering per capita, gTT is the totaltrade growth rate, gLF is labor force growth rate, and LY0 is the log of GDP per capital

in the base year 1990

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

Because in this paper we would like to examine the impacts of corruption andtransmission channels on growth rate, so the presentations of these variable in thismodel 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 ofeconomic growth because economic growth is a complicated function of many factors

However if we just notice about the impacts of corruption and transmission channels inthis 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 amongcorruption, transmission channels and growth And from this we can estimate directeffect 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 LorenzoPellegrini 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 corruptionperception 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 themodel (4.1) we can estimate the indirect effect of corruption on growth by eachchannel The indirect effect of corruption on growth through each channel will beachieved by b2 x a (a3 to a7) For example the indirect effect of corruption on growththrough 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 tosolve this problem

According to Conceptual Framework part, we expect that corruption will have negativerelationship with human capital in type of engineering, investment, and openness Andcorruption will have positive relationship with government size, and politicalinstability 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 indirecteffects of corruption on growth through each channel has been achieved Total indirecteffect of corruption on growth will be the sum of all indirect effects of corruption ongrowth through each transmission channel And finally total effect of corruption ongrowth 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 Howeverfor enough data of each variable, we just have around 35 observations cross developingcountries in 2008 to do the research

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

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

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

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

“Gross fixed capital formation (formerly gross domestic fixed investment) includes landimprovements (fences, ditches, drains, and so on); plant, machinery, and equipmentpurchases; 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” Andthe growth rate of fixed capital formation is the increasement in percentage compared withthe previous year

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

- Political stability index (PI): This index is taken from the project “WorldwideGovernance Indicators” from World Bank This index “reflects perceptions of the likelihoodthat 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 Higherscore 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

CHAPTER 5: RESEARCH FINDINGS IN DESCRIPTIVE

STATISTIC ANALYSIS

In this section we will consider the relationship between each pair of variables underdescriptive statistic situation such as between corruption and every transmissionchannel 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 transmissionchannel and growth As be stated in previous section there are five transmissionchannel examined in this paper such as investment, government size, openness,political instability, human capital Here we use growth rate of gross fix capitalformation (gFC) to represent for investment variable, growth rate of generalgovernment final consumption expenditure (gGX) to stand for government size, growthrate of total trade (gTT) for openness variable, percent of number of enrolment inengineering over total population (EEPC) for human capital variable, and politicalinstability index (PI) for political instability And growth rate of GDP (g) is chosen tostand for economic growth All these data are collected in 2008

In descriptive statistic approach we are going to use graph and correlation coefficient toshow the relationship between every pair of variables, beginning with the relationshipbetween economic growth and investment

Figure 5.1: Scatter graph between g and gFC

Looking at figure 5.1 we can recognize this is nearly a linear relationship betweeninvestment and growth Slope of this linear relationship is visually upward So we caninfer that growth and investment have positive relationship This is absolutely suitablefor growth theory More investment will create more economic growth The correlationcoefficient between investment and growth is 0.534 This also shows a strongrelationship in this pair of variables

Now we come to pair of government expenditure and growth