Testimony of Susan Rose-Ackerman, Henry R. Luce Professor of Law and Political Science, Yale University, before the Committee on Banking and Financial Services, U. S. House of Representatives, September 15, 1998
The economic crises in East Asia and Russia have focused attention on the role of the state in economic development. But the problem of dysfunctional and corrupt public and private institutions goes deeper than these headline grabbing events. Many poor countries have chronically low or negative growth rates. Even some countries that are well-endowed with natural resources have poor growth records and low per capita incomes. Many countries need institutional reform, not just macroeconomic adjustment. But reform is difficult. Dams, highways, and port facilities are technically straightforward. Reforming government, limiting corruption, and nurturing a strong private sector are more subtle and difficult tasks.
Corruption is the misuse of public office for private gain. It can involve simple fraud and self-dealing, but my focus will be on bribery and other corrupt transactions involving both private parties and public officials. When bribe money changes hands, both the briber and the recipient are better off, but the transaction violates government policy. Sometimes public officials claim that bribes are simply "gifts of good will." Private individuals and firms may, nevertheless, believe that such gifts are a requirement of good service from bureaucrats, politicians, and judges. The systemic effect of permitting such payoffs is damaging. Those with discretion will be tempted to create a large number of vaguely specified rules that create more chances for payoffs. Those who have not paid in the past may be tempted to pay in the future because it appears to be the norm.
In recent studies, high levels of corruption are associated with low levels of investment and growth. Corruption reduces the effectiveness of industrial policies and encourages business to operate in the unofficial sector in violation of tax and regulatory laws. Foreign direct investment (FDI) is discouraged by high corruption levels. Asian economies are not an exception--those with high corruption levels would have attracted more FDI if corruption had been lower, and their industrial policies would have been more effective. Even when corruption and economic growth coexist, payoffs introduce costs and distortions. Corrupt high level officials support too much unproductive public investment and under-maintain past investments. In a corrupt regime, economic actors with few scruples, such as those engaged in illegal businesses, have a comparative advantage. The costs of corruption may not be obvious when other factors produce strong growth, but when a downturn occurs, those who have benefitted from their corrupt access to top officials may try to maintain their privileges. As a result, the decline is sharper, and its costs more unequally spread, than in less corrupt regimes.
A country may be caught in a corruption trap where corruption breeds more corruption and discourages legitimate business investment. In a repressive state, where many policies are harmful to all except a favored elite, corruption may be a survival strategy. Toleration of this practice, however, may permit an illegitimate and inefficient system to persist. Corruption scandals can then be a sign of a country’s growing political maturity. They show that citizens are beginning to recognize the difference between the public and the private spheres and to complain when the border is crossed.
Corruption in the banking and finance sectors is particularly harmful. Payoffs may be a precondition for obtaining loans. When banks are state controlled, loans may be provided only to those who have made large campaign gifts. Sometimes corruption in the banking sector is a response to credit controls and artificially low interest rates. The policy response, however, ought not to be toleration of corruption but should be market-friendly reforms in the credit system. An active corporate bond market, for example, can act as a check on the behavior of bankers who use favoritism and payoffs to allocate credit. The credit controls being considered by some Asian countries may simply encourage corruption and insider dealing.
When do incumbent politicians and bureaucrats have an incentive to change? The best case for reform is one where an initial change creates new beneficiaries who then support further reform. The worst case is one where corruption becomes more entrenched and widespread over time. Corruption cannot be expected to whither away just because a reform government has taken power or because economic growth is vigorous. The corrupt incentives that remain can be especially harmful for fragile new states. Reformers have to take concrete action, not just assume that entrenched habits will change with a change in top personnel. Crises, such as the financial weaknesses in Russia and East Asia can spur reform, but they are also a signal that needed reforms were not carried out in the past. A better strategy would be to begin the reform process before a crisis hits.
There is no single response that should be adopted across the board once the basic anticorruption statutes are in place. Instead, there are two different but related types of corruption-- corruption involving high level officials that often implicates multinational corporations or large domestic firms, and corruption that is endemic in the way the government carries out its routine activities such as tax collection, customs, licensing, and inspections.
A country serious about fighting corruption must determine where corruption is most harmful and where it can be most effectively attacked. First, surveys of the public can determine how corruption affects people’s daily lives. However, survey evidence is not sufficient. The corruption that is most visible to the population may not be doing the most harm. Thus a second emphasis should be on high level corruption in contracting, privatizations, and concessions that introduces serious economic distortions and undermines the fiscal health of the state. Third, people may believe that they gain from bribery that limits their taxes and reduces their regulatory burdens. Nevertheless, the cumulative impact of such payoffs can be very harmful.
An anticorruption strategy must go beyond the criminal law. It is not enough to search for bad apples or big fish and punish them. The state may need to establish credibility by punishing highly visible corrupt officials, but the goal of such prosecutions is to attract notice and public support, not solve underlying structural problems. The focus should be on the underlying causes of payoffs. Simple generalizations or a list of "best practices" are not possible. However, past experiences suggests several reform possibilities:
Tax and customs revenues may be far below the level needed to carry out basic government services, and the pattern of payments may be very inequitable due to payoffs. The response should be both to simplify the tax laws to reduce bureaucratic discretion and to reorganize the bureaucracy to improve oversight and incentives for good performance.
Regulation of business may be so complex, time consuming, and intrusive that the development of a healthy private sector is affected. Here the answer is a hard look at regulatory laws to see which can be eliminated, which can be simplified, and which require improved enforcement. Many countries have much pointless business regulation that generates bribes combined with ineffective regulations in socially beneficial areas such as environmental protection.
Another costly pattern is state sponsorship of massive infrastructure projects that are too large and complex. The cost of corruption is, not the bribes themselves, but the cost of the inefficient actions they encourage. Even if direct evidence of corruption is not available, the inappropriate scale and design of projects should be sufficient to cancel them. Such a change in direction must, however, be combined with improved procedures for future project approvals, or the pattern will repeat.
Most corrupt countries must face the difficult task of civil service reform. This will be either financially expensive or politically painful, but is a necessary part of any serious reform effort. Reform policies must reduce the size of the civil service, pay decent base salaries to the remaining officials and establish effective incentives to induce officials both to be honest and to perform efficiently.
The lack of credible institutions capable of hearing complaints and enforcing the law is a weakness in many developing and transitional countries. Thus one area for reform should be either improvements in existing institutions, such as the courts, or the creation of new bodies, such as independent inspectors general or anti-corruption commissions. These reforms need to go along with a legal regime that permits the creation of independent nongovernmental organizations and that assures press freedom.
International institutions and the international business community can help provide incentives for reform. Aid and lending institutions such as the World Bank and USAID, should take a broad-based approach. Efforts to keep aid projects clean while ignoring the rest of a government’s activities will be ultimately ineffective. Clearly, these organizations ought not abandon efforts to keep their own projects free of corruption, but the more serious that effort becomes, the more they will need to help countries reduce overall levels of corruption. Both the World Bank and the IMF are beginning to develop anticorruption programs designed to help countries limit corruption. In extreme cases, evidence of pervasive corruption is a criterion for denying aid to countries that appear unable to make good use of assistance. USAID is also emphasizing programs that help countries develop strong democratic institutions including reforms that limit corrupt incentives.
The international business community is beginning to recognize the importance of supporting anticorruption initiatives. Current activity includes multinational efforts, especially at the Organization for Economic Cooperation and Development (OECD) and the Organization for American States, and efforts by the business community to promulgate voluntary codes of conduct. The most important initiative is the OECD's Anti-Bribery Convention, designed to criminalize overseas bribery by firms based in signatory countries. It was signed in December 1997 and ratified by the United States Senate at the end of July. Implementing legislation was passed by the Senate and is now before the House. It is important for the House to act promptly to send a message to the rest of the world that the United States is firmly committed to policies that will limit corruption in international business.
In contrast to past patterns of secrecy and denial, corruption in international business dealings is now acknowledged at the highest levels in governments, international organizations, and within the business community. A major accomplishment of the past five years is to legitimate discussion of corruption. Spearheaded by the international nonprofit Transparency International, the anticorruption effort has broad international support. The next five years must move beyond the establishment of an open discourse to concrete accomplishments. Since neither a country's rulers nor multinational investors can be viewed as innocent victims, the international community must break through the present stalemate in which governments and firms each accuse the other of perpetuating corrupt systems. Reforms will not be easy to accomplish, but experiments and new initiatives are necessary if the move against corruption is to be more than just a series of rhetorical flourishes.
Corruption and the Global Economy
Susan Rose-Ackerman
Corruption, like any exchange, requires two actors--a buyer and a seller. The buyer in the private sector pays a bribe to the seller in the public sector who illicitly distributes a benefit in return for the payoff. Bribes can be used to allocate perfectly legal, but scarce, benefits such as foreign exchange, import licenses, credit, or public contracts, or they may provide illicit tax breaks, permission to carry on illegal businesses, or exemptions from valid regulations.
Corrupt buyers and sellers frequently develop systems that are mutually reinforcing and persist over time. Such systems are not just effective ways of hiding payoffs and managing the disposal of illicit funds. They may also be organized to affect the types of services and contracts the government provides. Government decisions about what kinds of public works projects to support and what types of concessions and privatizations to sponsor may be intimately linked to the corrupt system. When corruption benefits the participants on both sides, neither has an incentive to end the relationship unilaterally. There is no way to disentangle the network to affix blame on just one of the participants. All bear responsibility.
Grand Corruption
Corrupt payments to win major contracts, concessions, and privatizing companies are generally the preserve of large businesses and high-level officials. The important cases of such "grand corruption" represent a substantial expenditure of funds and can have a major impact on the government budget and the country's growth prospects. They frequently involve multinational corporations operating alone or in consortia with local partners. For example, in Korea in late 1995, the national security advisor admitted receiving large payments from suppliers, but claimed that the payments were gifts. In Germany, the public prosecutor claimed that bribes increased the cost of a terminal at Frankfurt Airport by 20-30 percent. In Italy, anticorruption efforts reportedly led to major cost reductions in a number of public projects including the Milan subway, a commuter rail link, and a new airport terminal. In parts of Eastern Europe and the former Soviet Union foreign direct investment has been deterred by concerns over corruption and other evidence of state weakness. Corruption and self-dealing have undermined the benefits of privatization in many countries. For example, in Brazil when an insider deal seemed imminent, other firms withdrew their offers.
To isolate the distinctive features of "grand corruption," consider a logging concession obtained corruptly by a company over the higher bids of competitors. Suppose, to begin, that the corruption "market" is efficient so that it operates just like an idealized competitive bidding process. Then we can distinguish between the impact of corrupt payments on government behavior and the way corruption can affect the efficiency of the concessionaire.
Suppose that as a result of corruption, the government obtains less than fair market value for the resources under its control. If corruption does not restrict entry and if the official cannot affect the nature of the concession, the high briber is the firm that values the benefit the most. The losses are the extra taxes that must be collected and the foregone benefits of public programs not undertaken. A similar analysis applies to corrupt contracts and privatization projects. The most efficient firm will be selected under competitive bribery, but the benefits to the government are reduced. In the contracting case the bribe will be extracted partly from returns that would otherwise flow to government and partly from the profits of the winning firm.
But the consequences of corruption can be deeper than this. The corrupt official may design the logging concession to maximize the profits available to share between officials and the bidding firm. In so doing he may sacrifice values that would be reflected in an honestly negotiated contract. For example, in a timber contract, environmental damage or harm to indigenous people may be ignored. The same problems may arise for privatization projects and for contracts. Corrupt officials can promise to preserve the monopoly position of a privatized enterprise or contract for "white elephant" projects with little value in promoting economic development. In Latin America, for example, some privatizations have increased market concentration. According to one study, privatization of the telephone company in Argentina and the electrical utility in Chile generated monopoly rents for winners. In contrast, privatization of telecommunications in Chile and electric power in Argentina encouraged competition. The developing world is full of capital-intensive projects built with little economic justification. Nigeria built an aluminum smelter that not only cost 60-100 percent more than similar plants elsewhere in the world, but also served no valid development objective. One review of investment in Nigeria mentions as uneconomical or excessively costly a pipeline, several irrigation projects, an export terminal, and a petrochemical plant. In the middle seventies purchasing agents accepted bribes to contract for deliveries of cement that were five times the country's needs.
Now consider the behavior of the corrupt firm. Returning to our logging concessionaire, note that if the firm has obtained a secure long-term concession, its subsequent actions should depend only on the market for timber. The fact that it has underpaid for the concession should not affect its production decisions. It still seeks to maximize profits, and the concession payment is a sunk cost. The cost of corruption is felt by the public fisc, but no inefficiency has been introduced into the international timber market.
The claim of no impact on firm behavior is too simple to reflect reality. The operative terms are secure and long term. In practice, the corrupt nature of the deal may give the firm a short run orientation. The concessionaire (or contractor or purchaser of a privatized firm) may fear that those in power are vulnerable to overthrow because of their corruption. A new regime may not honor the old one's commitments. In addition, even if the current regime remains in power, the winner may fear the imposition of arbitrary rules and financial demands once investments are sunk. Having paid a bribe in the past, the firm is vulnerable to further extortionary demands. For these reasons, the corrupt firm with a timber contract may cut down trees more quickly than it would in less corrupt countries. It may also be reluctant to invest in immovable capital that would be difficult to take out of the country should conditions change. In the electric power area, the most dramatic examples of this are the floating power stations put in place in several developing countries to make exit easy and relatively inexpensive. In short, both the timing of production and the input mix may be inefficiently chosen as a result of the corrupt nature of the system.
Furthermore, it is unlikely that corruption will stop at a one-time payment to top officials to cement the deal. Instead, the winner may be a firm more willing than others to engage in ongoing corrupt relationships up and down the hierarchy. For example, if the timber concession includes a royalty per log that is calibrated by the type of timber, the firm may pay inspectors to misgrade the logs. It may also pay to cut down more trees than the concession permits. Under a construction contract, the high briber may anticipate bribing building inspectors to approve work that does not meet the nation's safety standards. The owner of a newly privatized firm may develop an ongoing corrupt relationship with the country's regulators.
Imported Corruption and the Obligations of Multinational Business
Corruption cannot properly be described as "imported" by multinational firms into innocent developing countries. The view that a culture of gift giving and patronage in the developing world induces multinational firms to demonstrate their cultural sensitivity by paying bribes is also unconvincing. It is quite insulting to suppose that a traditional culture of gift giving will support massive payoffs to political leaders. Ordinary people make quite sophisticated distinctions between appropriate and inappropriate gifts. They do not look with tolerance on major payoffs involving high-level officials and major investors.
Sometimes multinational firms argue that antibribery laws in developing countries are dead letters that mean nothing. Even officials in international aid and lending agencies sometimes argue that nothing will get done if they do not ignore evidence of corruption. However, I want to argue that large multinationals have an obligation to refrain from bribery in the developing world and in countries in transition. International aid and lending organizations, less controversially, should also face a similar constraint. The basis for these claims is the leverage or market power that such organizations possess--leverage that can have a serious impact on the future development of poor countries. When a commercial deal represents a sizable share of a country's national income or state budget, firms cannot responsibly adopt the position that their own business interests are all that is at stake. They may claim that they ought to be under no obligation to take a broader perspective, but they cannot claim that their actions are irrelevant.
The struggle to appropriate the gains of public projects can have a destructive impact on a developing country's economic and political system. Economists call this struggle "rent seeking." Entrepreneurs may abandon the private sector and become public officials charged with allocating rents. In a democracy, people may seek political office, not to fulfill some idea of public service, but to extract as many rents as possible. Private businesspeople may concentrate on the struggle for publicly provided benefits, rather than on establishing productive enterprises. A strong natural resource base frequently does not help a country develop and does little to benefit those at the bottom of the income ladder. Capital investment often produces few long-term growth benefits in developing countries. Much investment seems to have simply disappeared. Evidence on the benefits of foreign aid is mixed at best. A secure source of foreign aid is a little like a diamond mine or an oil deposit. Countries with access to such largesse have a cushion that others lack, but this largesse can be used for good or for ill.
Weak public sector institutions are one reason why rent seeking is endemic, and one symptom of a poorly functioning state is the prevalence of corruption. Weak states may face the paradoxical situation where increases in resources undermine political stability. So long as the state is poor, few may care about controlling the levers of power. If, however, the state acquires a large foreign aid package or gains control over a newly valuable mineral, new political figures may arise seeking to claim a share of the benefits or even outright control of the state. The political struggle becomes a fight to control the state's wealth for a period of time.
Consider, for example, the case of Nigeria where the state has been described as "a national cake to be divided and subdivided among officeholders." Nigeria has massive petroleum deposits. Oil represents 90 percent of Nigeria's exports and most of the government's revenue. The oil reserves are under state control and provide huge windfall gains to those who control them and their political allies. Especially during the years of the petroleum crisis, Nigeria profited handsomely. Control of the state is a valuable prize worth fighting for. Those who seek to get rich struggle for a share of the rents, instead of engaging in productive entrepreneurship.
But such explanations based on domestic politics ignore the active role that outside investors and aid organizations can play. If multinationals actively participate in corrupt systems and if aid organizations tolerate endemic corruption, it is overly harsh to place the blame entirely on internal failures in the developing country.
International aid and lending institutions have begun to acknowledge the problem of corruption and to adopt policies to address the problem. Debate over the most effective techniques is ongoing, but the basic commitment seems clear enough. These institutions should not support aid projects that increase the value to individuals of controlling the government. My candidate for one of the most ill-advised aid projects of all time was a World Bank loan designed to reform customs and tax collection in Zaire under President Mobutu. Surely the international community should not help corrupt autocrats to collect revenues more efficiently. On the more constructive side, loans and grants should seek both to improve the performance of state institutions and increase the accountability of the public sector.
Unlike international aid organizations, multinational businesses have not generally considered the impact of their behavior on the long-term prospects of the countries where they invest and trade. One still hears expressions of cynicism and resignation from business leaders. However, in an international environment with no effective means of controlling commercial behavior, large firms have a stronger obligation to behave responsibly than in the developed world with its network of regulations and its reasonably responsive political systems. Of course, there are very few cases where a multinational firm can single-handedly influence the operation of a state. Some countries are so large that they have market power on their own. Even in those countries, however, some companies have leverage at the national level, and the regional impact of other deals is large. For example, consumer goods companies with strong international brand recognition may be such a symbol of successful development that they can successfully resist corrupt demands. Other companies with a strong market position in their fields of business can refuse to participate in corrupt arrangements. Even if such firms lose out on corrupt deals, some countries may be induced to operate more cleanly so as not to sacrifice the firms' business. Large, highly diversified firms may have a further advantage if they can credibly threaten to exit a country entirely in the face of corruption in one line of business. Such a firm may also have the bargaining power to protect local subsidiaries from acquiescing to corrupt demands. Firms that successfully use the leverage they have will not only help contribute to a country's long-run growth prospects but also generally will benefit in the short run as well.
The important issue for companies operating in a corrupt environment is whether to participate actively, quietly refuse to deal, or report corruption to local authorities and to those in the outside world. Keeping quiet is probably the worst option. The firm not only loses the business; it also has done nothing to change the underlying situation for the better. The advantage of the current interest and concern with corruption is that reporting corrupt demands can lead to international embarrassment for the corrupt officials that may, in turn, produce reforms. Companies that claim to abhor corruption while accepting it as a necessary evil, are not acting consistently so long as one assumes that the pressure of international public opinion can have an impact both on corrupt public officials and on bribe-paying business firms.
Limiting Corruption in International Business
Multinational business firms face a dilemma when they deal with corrupt regimes. Each believes it must pay bribes in order to do business, but each knows that all of them would be better off if none of them paid. The playing field is tilted toward unscrupulous, but less efficient, firms who would not fare so well in an honest system. This realization has fed recent international efforts at limiting corruption in international business. International efforts should be focused on reducing the willingness of multinational businesses to pay bribes and on enlisting them to assist the developing world to carry out reforms. Perhaps a cooperative relationship could develop between the international organizations on the one hand, and multinational businesses on the other. Current activity includes multinational efforts, especially at the Organization for Economic Cooperation and Development (OECD) and the Organization for American States, to constrain corruption, and efforts by the business community to promulgate voluntary codes of conduct. The most important are the OECD's initiatives to induce members to end the tax deductibility of overseas bribes and to criminalize foreign bribery. The OECD Anti-Bribery Convention was signed in December 1997, and the ratification process is proceeding in the United States Senate and elsewhere.
Some have recommended the creation of new international capacities to deal with global corruption. The involvement of the World Trade Organization (WTO) has been proposed, but worries over tying trade policy too closely to a range of other issues from labor conditions, to human rights, to corruption suggest that this will not be the first line of action. Within the WTO the most feasible possibility is a revision of the Agreement on Government Procurement so that more countries will join. At present only a few countries, mostly in the developed world, have adopted its provisions. One possibility is to redraft the Agreement to focus on its anti-corruption aspects in the hope of attracting more countries.
The idea of a dispute resolution mechanism deserves further scrutiny to determine if there is a feasible way to create a body to hear complaints by firms claiming to have lost business to rivals as the result of corruption. In establishing a general forum for resolving disputes, there are clearly some difficult problems of proof and standards of decision. Nevertheless, some models exist in the international legal arena that provide ideas about how to proceed.
The World Bank's International Center for the Settlement of Investment Disputes (ICSID) resolves disputes under contracts where it is the forum of choice, and its Inspection Panel reviews complaints from a broad range of petitioners who wish to protest the Bank's failure to follow its own processes. Tribunals also exist in the fields of human rights, international labor standards, and nuclear energy that might be models. Non-governmental organizations can bring complaints before them and participate in the presentation of evidence. Each of the existing bodies has its own problems, and none is a perfect model for those concerned with anti-corruption efforts. Nevertheless, a more careful examination of the possibilities for some kind of international tribunal needs further exploration.
The World Bank and the International Monetary Fund (IMF) cannot engage in individualized investigations of corruption. That is for the legal systems of the member countries. However, they can seek to control corruption in their own programs and can help countries design control programs. The World Bank has reformed its procurement guidelines to discipline corrupt firms by restricting their access to future Bank-financed projects. Both the IMF and World Bank seem more willing than in the past to refuse aid to countries where corruption affects a government's ability to function effectively. Perhaps these organizations could also become a clearinghouse for allegations of corruption brought by both firms and public officials. If both sides complain, this would be a way of revealing that high-level corruption is a game in which the developing country is the loser and in which neither private nor public actors can absolve themselves of responsibility. These revelations might set the stage for meaningful reforms. Without trying to affix blame, the international organizations could begin a dialogue with a country's leaders and major investors on ways to improve the situation for the benefit of ordinary citizens. Reducing corruption requires a commitment from both sides of potentially corrupt deals, even though only one side actually needs to be honest to eliminate bribery. The problem is expectations. If everyone thinks that everyone else is corrupt, then all but the saints will be tempted to engage in malfeasance. If expectations can be changed by clear statements on both sides followed by consistent actions and a credible commitment to report corrupt pressures, progress seems possible.
The international business community is beginning to recognize the costs of corruption to the global investment environment. Insofar as this is true, it suggests another approach to reform in the developing world and in countries in transition. Perhaps international businesses themselves could contribute to the effort by providing funds and technical assistance to countries interested in reform. This is already being done through professional associations such as the American Bar Association, but the aid and lending organizations might explore the possibility of collaborative projects. The international organizations might provide a neutral forum in which the experience of these companies could be tapped and their suggestions for reform canvassed.
Conclusions
In contrast to past patterns of secrecy and denial, corruption in international business dealings is now acknowledged at the highest levels in governments, international organizations, and within the business community itself. A major accomplishment of the past five years, spearheaded by the international nonprofit Transparency International and by many people both inside and outside these institutions, is to legitimate discussion of corruption. The next five years must move beyond the establishment of an open discourse to concrete accomplishments. Since neither a country's rulers nor multinational investors can be viewed as innocent victims, one role for the international community might be to break through the present stalemate in which governments and firms each accuse the other of perpetuating corrupt systems. I have reviewed current efforts and suggested both the creation of an international tribunal and the possibility of enlisting multinational firms and developing country governments directly in the reform effort. None of these reforms will be easy to accomplish, but experiments and new initiatives are necessary if the move against corruption is to be more than just a series of rhetorical flourishes.
Susan Rose-Ackerman is the Henry R. Luce Professor of Jurisprudence (Law and Political Science) at Yale. This paper is was published in the Yale Law Report, volume 45, number 2, Summer 1998. It derived from remarks made at a workshop organized by the UNDP-PACT and the OECD Development Centre, "Corruption and Integrity Improvement Initiative in the Context of Developing Countries," October 24-25, 1997, Paris. Her book, Corruption and Government: Causes, Consequences and Reform, is forthcoming from Cambridge University Press in 1999.