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Elisabeth Paul is an FNRS Research Fellow at the University of Liege.
One consequence of rent seeking is that productive resources are diverted toward inappropriate activities, resulting in a misallocation of resources in the economy. For instance, agents may have higher incentives to allocate productive resources to rent seeking rather than to production activities (Chakraborty and Dabla-Norris, 2005), and government officials may endogenously increase the amount of red tape in order to extract more rents (Banerjee, 1997).
In this paper, we use the terms corruption and rent seeking interchangeably, while acknowledging that the latter is more general than the former.
The significant interrelationship between legal ineffectiveness and corruption suggests that strong forces tend to perpetuate corruption. For example, Damania and others (2004) show that, in politically unstable regimes, the institutions necessary to monitor and enforce compliance with regulations are weak, which, in turn, increases incentives for rent-seeking behavior, resulting in a higher level of noncompliance with existing regulations.
For instance, Di Tella and Schargodsky (2002) argue that when control mechanisms are too weak or too strong, wages do not have any impact on corruption.
Examples of such conditionality in IMF-supported programs include steps to strengthen revenue and customs administration (e.g. Bolivia and Armenia) and expenditure management (e.g. Azerbaijan and Côte d’Ivoire). In some instances, such as in Cambodia and Kenya, programs have had to address corruption that have important macroeconomic implications (IMF 2003).
The Fund’s Code of Good Practices on Fiscal Transparency and regular assessments of fiscal management practices through Reports on the Observance of Standards and Codes (ROSCs) rest on the following general principles of fiscal transparency: clarity of roles and responsibilities; public availability of information; open budget preparation, execution, and reporting; and assurances of integrity.
We do not differentiate between outputs, outcomes, and results, and use these terms interchangeably.
Such rent seeking is not exclusive to the government sector or to developing countries. Dickens and others (1989) provide some examples of employee crimes in the United States, showing that rent seeking by workers can generate large financial losses in many industries. They report that as much as 80 percent of shipping losses in the freight and airport cargo-handling industries arises from employee theft; 30 percent of retail employees steal merchandise from the workplace or misuse discount privileges; 27 percent of hospital employees steal hospital supplies; and 9 percent of workers in manufacturing falsify their time cards.
Niskanen (1991) notes that the primary advantage of a bureau is that it has much better information about the costs of supplying the public service than does the principal. More generally, we can think of the agent as using his powers of information collection and expenditure oversight to either manipulate the principal or to extract rents for himself. For example, in preparing an itemized budget for submission to the principal, he can spend more effort identifying attractive infrastructure projects from which he can extract rents relative to identifying pressing needs for social expenditures than the principal would in his place.
A general functional form that satisfies these desired properties is Π(C, R) = CφRϕ for any φ > 0 and ϕ>1.
Note that, as we have assumed total effort to be normalized to one, we abstract from “disutility of work” in the agent’s utility function.
Note that the derivative of (1) with respect to e1, ∂U/∂e1 = ε − (1 − α) + 2C (1 − α)2 (1−e1), can either be positive or negative depending on the underlying parameter values.
A study of corruption in Senegalese hospitals states that rent extraction practices are tolerated and legitimized by society (see http://www.idrc.ca/en/ev-87470-201-1-DO_TOPIC.html). Another explanation lies in the social importance of “big men,” whose power and wealth is a factor of pride for their networks (Medard, 1992).
Martens and others (2002) note that foreign aid funds are subject to a “broken feedback loop” which reduces accountability.
In a similar vein, Akerlof (1982) examines the idea that labor contracts are partial gift exchanges. In his model, workers’ efforts depend on the work norms of their group, so that the firm can succeed in raising group work norms and average effort by paying workers a gift of wages in excess of the minimum required.
The Revelation Principle asserts that the principal cannot do better than offering an incentive-compatible contract.
High wages may be necessary not only to eradicate corruption, but also to give appropriate incentives for performance. For instance, a study on Indonesia shows that it would require multiples of current pay levels to get doctors to live in West Papua (Chomitz and others, 1998).
In general, the higher the costs of investigating and deterring corruption, the more corruption we would expect to see in the economy. To see this, consider a cost parameter λ that multiplies a general cost of control function of the form Ω(C), where Ω’(C) > 0, Ω”(C) ≥ 0, Ω(0) = 0, and Ω’(0) = 0, such that the cost of investigating corruption equals λΩ(C). An increase in λ, raises the marginal cost of the principal’s control effort, for any given level of investigation/monitoring effort chosen by the principal. This leads to a lower level of control effort expended, and consequently a higher level of corruption in the economy.
Note that if the principal wanted to induce the agent to devote all his effort to the production of the public output, by solely using controls and no performance premiums, the IC would be such that: w + ε(1 + θ) ≥ w + ε(1−e2 + θ) + (1−α)e2−C[(1−α)e2]2. Controls would have to satisfy the condition C ≥ [(1 − α − ε)/(1−α)2 e2]. As
Recall that an agency problem occurs only if 1 ≥ α + ε, otherwise the agent’s and principal’s interests are aligned without control. Note also that when the principal exerts heavy controls, the agent does not engage in rent seeking
Note that if ε were an endogenous variable, the principal could also increase the agent’s effort devoted to producing the public good by raising ε, as long as C >1− α −ε.
Acemoglu and Verdier (2000), for instance, note that corruption arises as part of an optimal allocation of government activities when there are incomplete contracts and incentive problems.
Note that increasing controls may take different forms. Public expenditure management encompasses different types of control, including internal and external, ex ante and ex post, centralized and decentralized, compliance and performance controls. The design of the control function is an important question which is not dealt with in this paper (see Leruth and Paul [forthcoming] on that issue).
Note, however, that in reality one generally observes some positive controls. This could render two cases: either the principal does not choose the optimal level of control when MRC is binding due to political or externally imposed constraints, or MRC is binding at the agent’s optimal level of rent capture, i.e.
Fiscal transparency “should lead to a better informed public debate about the design and results of fiscal policy, make governments more accountable for their implementation of fiscal policy, and thereby strengthen credibility and public underst credibility and public understanding of macroeconomic policies and choices” (IMF Survey 1998, p. 122).