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CORRUPTION TRAP: HOW TO GET OUT?

Victor Polterovich

CEMI RAS, Moscow

September 2010

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Norms and Transformation Costs

• A norm is a rule that large groups of people obey, or can or must obey. In any area of life and at each moment in time, a multitude of alternative norms is available, and every agent has to make her choice. For example, an official may choose either corruption or honest service.

• Each agent who interacts with partners within the framework of a certain behavioral norm has to bear the corresponding transaction costs. For example, the possibility of being caught while taking a bribe would cause a transaction cost component for an official who has chosen corruption as the norm.

• The costs of transition from one norm to another are called transformation costs. Transformation costs may be incurred by an individual, by a firm or by the state. If a firm decides to refuse from black market operation then it has to search for new partners. Searching expenditure is a part of transformation cost.

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Norm-Fixing Mechanisms-A

• For a behavioral norm to be stable, individuals should feel that it would be unprofitable or disadvantageous for them to deviate from it. The main type of stabilizing mechanism is based on the so-called coordination effect. According to this effect, the more consistently a norm is observed in society, the greater the costs incurred by each individual deviating from it. For example, the coordination effect takes place if a personal probability to be punished for a rule-breaking activity depends negatively on the number of people involved in the activity.

• With time, the transaction costs of a norm's observance decrease due to learning effect since the agents learn how to operate more efficiently. If the payment of taxes is considered the norm within a society, the taxpaying technology will improve. If, on the contrary, tax evasion is the norm, then the relevant techniques will develop. A decrease of the transaction costs fixes the norm.

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Norm-Fixing Mechanisms-B

• Another phenomenon, referred to as the linkage effect, is also important. With time, an established norm finds itself linked with a multitude of other rules, and becomes part of a system of other norms. Therefore, non-observance of this norm would trigger a chain of other transformations and, consequently, lead to high (linked) transformation costs. By increasing transformation costs, the linkage effect, too, contributes to a norm's fixation.

• There is yet another norm-fixing mechanism, cultural inertia, which denotes agents' reluctance to review those behavioral stereotypes that have already proven viable. Inertia effects may be supported by a formal or informal system of punishments and awards for past behavior. For example, a person with a good reputation tries to save it by following the respectable norms of conduct.

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Institutional Trap-A

• In cases where two or more different norms are not equivalent, a norm may be Pareto dominated or deliver less social utility than another one.

• We refer to an inefficient stable norm (inefficient institution) as an institutional trap. As with any other norm, an institutional trap's stability means that a system absorbing a small external impact will remain in the institutional trap, having perhaps slightly changed its parameters, and will return to the former equilibrium state once the source of destabilizing pressure is removed.

• An individual or a small group of people loses if it deviates from an institutional trap. However, the simultaneous adoption by all agents of an alternative norm may be Pareto improving. Thus the lack of coordination is the main cause of the institutional trap stability.

• Arthur and North use the term "lock-in".

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Institutional Trap-B

• The emergence of institutional traps is an important source of risk associated with any reform process. The universal norm-fixing mechanisms described above, the coordination, learning and linkage effects, as well as cultural inertia, are responsible for institutional trap formation.

• A system with a prevalent efficient norm, if strongly disturbed (with the set of equilibria, however, remaining structurally unchanged), may fall into an institutional trap in which it will remain even after the disturbing factor is removed. This is the so-called "hysteresis effect" which is a form of a system's dependence on its former path of development (path dependence).

• A number of unexpected phenomena observed during wide-scale reforms of ninetieth, including peak-wise raise of arrears, corruption, black market activity, and barter exchange, may be considered as institutional traps. These important examples will be used in our discussion below.

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Getting out of Institutional Traps

• There are reasons to believe that some institutional traps are stable in medium run only and that an economy could gradually develop mechanisms conducive to its exit out of institutional traps. The theory outlined above gives us a framework for systematic considerations and classifications of different mechanisms that may facilitate this transformation.

• One has to reach at least one of the following goals: a) to increase transaction costs of the prevalent inefficient norm; b) to decrease transaction costs of an alternative efficient norm;

• c) to bring down transformation costs of the transition to the efficient norm. The coordination, linkage, or/and inertia mechanisms have to be influenced for these purposes.

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Penalty and Penalty Costs• The simplest recipe is introduction of a high penalty for deviating

behavior, for example, a strong punishment for corruption or a special tax on the barter exchange. The case of China shows that the death penalty for corruption may be effective in a sense (see Table 2).

• However, high penalties are very costly.

• There are at least three sources of the penalty costs. First, enforcement of stronger penalties requires larger resources to be spent. Large fees may result in strong resistance of penalized persons. Moreover, courts would be unwilling to enforce the fees which are considered as unfair.

• Second, a penalty directed to decrease the intensity of an inefficient norm may increase the intensity of its inefficient substitutes. Fee increasing may shift the system to another institutional trap instead of shifting it to an efficient equilibrium. For example, strong punishment for arrears could create additional incentives for firms to escape into underground economy.

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Penalty is Effective?

• Third, one should take into account a possibility of mistakable decisions. Social losses from a punishment of an innocent person are the larger the stronger are punishments.

• The case of China seemingly shows that the death penalty for corruption may be effective in a sense (?)

• Table 1. PERCENTAGE OF COUNTRIES WITH HIGHER

• CORRUPTION PERCEPTION INDEX

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•   1996 1997 1998 2001 2002

• HIGHER THAN RUSSIA 13 6 11 11 27

• HIGHER THAN CHINA 8 11 39 36 42

• Source: Transparency International (Tanzi (1998)), www.transparency.org/cpi

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Reputation and Amnesty

• Development of reputation mechanisms presents another possibility to increase transaction costs of corruption, arrears, or tax evasion (Tirole 1993).

• Reputation mechanisms also decrease transaction costs of efficient norms creating incentives to observe them.

• Amnesty is an instrument of weakening inertia effects in the cases of tax evasion, arrears and corruption. Many governments use this measure. The outcome is mixed, however. To reach a success the amnesty should be an unexpected event. It shooed be conducted in an appropriate moment when fundamental causes for a trap are exhausted, and should be complemented by other measures weakening also linkage and coordination effects.

• Rotation of officials may be an effective measure to destroy unproductive coordination.

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Spontaneous Exit – Importance of Growth -A

• If the state does not take special measure to extract transitional rent then rent seeking turns out to be much more profitable than production. Increasing number of economic agents find themselves to be involved into rent seeking activity, increasing volumes of resources are diverted from productive activities. Rate of production growth falls, and this makes production even less attractive for investors. Coordination, learning, linkage, and inertia mechanisms start to work and form institutional traps.

• If, however, rate of economic growth substantially increases due to improvements of technology or term of trade then part of agents may decide to increase their investment into production. This supports growth and creates new incentives for the next cohort of agents to switch their efforts from rent seeking to production. As a result some institutional traps can disappear.

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Spontaneous Exit – Importance of Growth -B

• Growth diminishes the transaction costs of “good behavior” and facilitates improvement of institutions. Therefore one may say that growth itself is an important factor of growth. This conclusion was corroborated by an econometric calculations (Chong, A. and C. Calderon (2000) ) as well as theoretical researches ( Polterovich (2001a, 2002), Balatsky (2002)).

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Evolution of the Civic Culture

• An exit out of institutional trap is disadvantageous for each isolated economic agent but is advantageous for the society as a whole. The root of the problem is the lack of coordination. The ability of agents to coordinate their efforts depends on the civic culture prevailed and the civil society development.

• Coordination mechanism makes agents’ decisions interconnected. It does not mean that they are properly coordinated.

• Most of economic growth studies consider civic culture prevailed as a fixed and non-changing factor. However, some important parameters of the civic culture may change drastically during 10-20 years, therefore long-term considerations have to take them into account. The following table describe evolution of social trust in Germany after World War II.

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Evolution of social trust in Germany after World War II.

• Can most people be trusted? (Germany, percentage “yes”)

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• 1948 1959 1967 1973 1976

• 9 19 26 32 39

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• Source: Conradt. 1989, p.254

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Evolution of social trust in Russia

• “ I have many intimate reliable friends”.

• Russia, percentage “yes”:

• 1989 – 42%

• 1999 - 13%

• (Levada, 2000).

• Consequences: high transaction costs, low economic activity, lack of investment (Zak and Knack (2001)).

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Habitual deviationism

• “Habitual deviationism”: tolerant or even positive attitudes towards infringement of official rules and legal norms: towards petty bribes, participation in black market operations, towards exam cheating, private use or even petty pilfering of the state property. A habitual deviationist does not like law enforcement institutions and hates those who cooperate with policemen or investigators.

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Habitual deviationism-A

• Which factor is the most influential for the personal income, 1997

• (% of answers)• Personal Personal Skill in

• achievements connections evading laws Poland 48 39 13 Czech 37 36 27 Hungary 37 48 15 Russia 30 34 37

• Sourse: Haarland and Nissen, 1999

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Habitual deviationism-A

• “Do you agree that it is not obligatory to pay taxes?” (“yes”, %). 1999

• Average Businessmen Pensioners• rather, agree 31 62 21• rather, do not agree 59 32 68

• “it is reprehensible to take something out of an enterprise” – 56%

• “it is partly reprehensible” –31%• “nothing reprehensible”- 8%• (Levada, 2000).

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Attitudes towards bribe-giver A, bribe –taker B, and informer C .

Russia and Israel students, 2002, (Proportion of respondents and average evaluations; N=

84; 25)

• Attitude Towards citizen A Towards official B Towards official C • RUS ISR RUS ISR RUS ISR• 1. Strongly • Negative 6 28 30 56 17 12• 2. Negative 11 24 25 28 32 16• 3. Neutral 55 32 26 12 17 24 • 4. Positive 26 16 17 4 20 24• 5. Strongly • positive 2_ 0 2 0 _14 24• Average • Evaluation 7 - 64 -64 -136 -18 32

• Average = 2(line 5) + line 4- line 2- 2(line 1).• A- suggested payment to B; B- agreed to take payment from A• C- reported the case

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Attitudes to cheating (average evaluations)

• Country A (copied) B(gave consent) C(reported) Russia -21 54 - 173

• Netherlands -83 -5 -136

• USA - 135 -88 -25

• A (copied answers from B’s paper)

• B (gave her/his consent to A)

• C (reported the case)• Source: Magnus, Polterovich, Danilov, Savvateev ( 2001).

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Habitual deviationism-B

• Consequenses: an appropriate environment for corruption, black market, tax evasion, and criminal activities. Lack of honest competition.

• A stable inefficient equilibrium.

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Role of Civil Society -1

• If social activity is intensified and the degree of social trust increases then coordination turns out to be less costly; there are more chances to get out of institutional traps.

• The USA of 19 century is a good illustration of this statement. The time between 1815 and 1840 was a period of intensive transformations of political institutions in the United States. The property ownership requirements were abandoned to make lower classes eligible to vote. The privileged position of elites were eliminated by requiring long list of public officials to be elected. It seemed that mass –based democratic movement reached their goals. The reforms had unanticipated consequences, however.

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Role of Civil Society -2

• The political party machine turned out to be effective instrument for party bosses to get rich. They allocated public service positions (including postmasters, customs officials, policemen et cetera) among their supporters did not taken into account competence and skill. They hired “repeater gangs”, individuals who voted several times in the name of different registered voters. They used intimidation to prevent the opposition from voting. Office workers were forced to pay some proportion of their wage to the political party that got the job for them. The police turned out to be a political tool rather than a law enforcement agency.

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Role of Civil Society -3

• Corruption flourished. Businessmen paid bribes for franchises. Low-level policemen took payments for permission of the local vice operations. The money was distributed among police hierarchy and political bosses. Many people understood that the situation had to be changed but nobody wanted to make a move. This was a corruption trap.

• (The discussion based on Knott and Miller (1987).

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Role of Civil Society -4

• The USA civil society developed, however. By the turn of the century, a powerful Progressive movement had emerged. The movement combined efforts of several groups of citizens including middle-class taxpayers, small businessmen, farmers, and professionals of various sorts. Their main goal was administrative reform that would separate politics from administration. They understood that political party based administration was not efficient, and were ready to combine the administrative experience of the more authoritarian continent countries with the democratic ideals of America.

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Role of Civil Society -5

• They required administration by rules, selection of civil officers by their merit and qualification, standardization and simplification of procedures, centralization of administrative authority under a single executive in accordance to principles of hierarchy. Progressives created a number of organizations like New York Municipal Research Bureau, New York Citizen’s Union, and the Milwaukee Free Press, and occupied leading positions in both Republican and Democratic Parties. Republican President Theodore Roosevelt and Democratic President Woodrow Wilson conducted reforms in accordance to the Progressive ideas and constructed new system of governance based on independent commissions. Getting out of the corruption trap was a result of these reforms.

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Anti-corruption measures in modern societees

• Personal income declarations has to be opened (Norway)

• Conflict of Interests has to be prevented

• Institutional Design (flat tax)

• High Salaries of officials

• Anti-corruption Analysis of Laws

• Anti-Corruption Advisory Centres

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Conclusion• Corruption trap is serious obstacles to economic

development. Many countries found themselves in the trap. Some of them were able to get out. Others are searching for an exit during long time.

• The main cause of the corruption trap is the lack of coordination. Government may try to facilitate getting out of the trap by stronger penalties , by developing reputation mechanisms, implementing an amnesty, or improving administration. In many cases, however, nor market either government measures are effective in the short run. Introduction of the political democracy does not solve the problem as well. Civil society institutions have to be developed to reach necessary coordination.