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Friday, 17 July 2009

The Inequality and Corruption Trade-Off

A new paper finds a robust trade-off between corruption and inequality, working from evidence in Latin America. The result confirms what is broadly accepted reduced corruption may increase income inequality where there is a large informal sector. The paper explains this likely trade-off as follows :
Institutional reform is likely to exacerbate inequality in countries where there is a large informal sector. Firms in this sector have low operating costs arising from their lack of compliance to rules and regulations. It is for this reason that the sector tends to employ the poorest members of society. Since compliance comes with institutional reform and corruption reducing measures, firms will incur rising costs. Furthermore, the actual process of reform requires better trained personnel and support infrastructure, necessitating new taxes. Higher costs of production, new taxes and more vigilant policing will have a direct impact on employment in the informal sector.

A second plausible explanation for the trade-off focuses on the impact of reform on redistributive measures. In many developing countries income redistribution policies are promoted by corrupt elements in society whose primary interest is political power. For example, “special government projects” designed to increase employment of the poor are promoted by particular groups who can benefit from such projects (e.g., construction of roads and housing development schemes). These projects employ manual labourers who would otherwise have been unemployed. As countries introduce institutional reform, rent seeking is reduced since “special government projects” are more stringently assessed and the tendering process becomes more competitive. Projects which would have been undertaken under a corrupt system are not undertaken now because they are not economically viable. Further, contracts which are in operation may be stopped or not renewed. It is also likely that projects are more capital intensive.

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