Corruption and regulatory burden∗

Ratbek Dzhumashev†
September 30, 2009

Abstract
Government has discretionary power in regulating the economy. Corruption
distorts the application and enforcement of regulations. Ex-post corruption
leads to higher non-compliance and hence decreases the regulatory burden.
Ex-ante corruption increases the burden on the private sector via predation
of bureaucracy. Therefore, the overall effect of corruption on the regulatory
burden depends on which of these effects dominates. The analytical model
that captures both of these effects predicts that the overall burden increases
with the level of corruption as the effect of predation dominates the effect of
non-compliance. This prediction is confirmed by empirical evidence.

Keywords: Corruption, Regulatory burden

JEL classification: H23, H32, H41

∗
I thank Yew-Kwang Ng, Kim Sawyer, Paul Frijters, Keith Blackburn, Mehmet Ulubasoglu, Cahit
Guven and Asadul Islam for useful comments.
†
Department of Economics, Monash University, 1 Wellington Rd, Clayton 3800, Victoria, Aus-
tralia. E-mail: Ratbek.D@buseco.monash.edu.au
1 Introduction

Corruption is defined as abuse of a public position for private gain. Some researchers

find that corruption can play a positive role for economic growth by decreasing reg-
ulatory burden. However, this finding rests on the assumption that corruption and
regulatory burden are independent from each other. In reality, this is a strong as-

sumption. In implementing regulations corrupt bureaucracy does create and extract

rents and thus deviate the regulatory burden from its statutory level. This paper
in particular aims to develop a simple model that enables to associate the level of

corruption with the regulatory burden. Then, the prediction of the analytical model

is tested empirically.1

In the literature there are conflicting views about the effect of corruption on the
economy. There are findings that corruption can be efficiency enhancing in the over-
regulated, rigid and inefficient environment. For example, Leff (1964) advocates cor-
ruption on the grounds that it helps to circumvent bad regulations and thus improves

economic efficiency. A similar rationale is used in arguments presented by Huntington

(1968), Tanzi (1998), Kaufmann and Wei (1999), Barreto (2000), Barreto and Alm

(2003). They point out that corruption can help to overcome different regulatory

obstacles and lessen the adverse effect of bad policies and governance. Dreher and

Gassebner (2007) empirically show that some regulations are important determinants
of entrepreneurial activity and that corruption is beneficial as it decreases the negative

impact of regulations on entrepreneurship in highly regulated economies. Meon and

Weill (2006) find some evidence supporting the hypothesis that corruption can be
efficiency-enhancing, and claim that corruption is positively related to the efficiency

in countries with malfunctioning institutions. Though, they find that in countries with

effective institutions the relationship between corruption and efficiency is negative.

Nevertheless, the contemporary dominating view is that corruption is a significant

impediment for economic growth. The main argument is that the regulatory burden
1
Importantly, the objective of the paper is not to examine whether corruption and regulations
are related. It rather focuses on the question if regulatory burden increases with corruption.

2
or the rigidity of the bureaucratic procedures is not exogenous to corruption. Corrupt

bureaucrats create those regulatory barriers to extract bribes from the private agents

(Myrdal, 1968). Corruption may increase number of transaction with the bureaucracy,
which offsets any efficiency gains from corruption.2 In addition, corrupt bureaucrats
create distortions in the public and private sectors to create rents or just to maintain

them.3 Empirical studies confirm the negative relationship between corruption and
growth.4
Based on the empirical evidence it is intuitive to suggest that corruption should

lead to a heavier public sector burden, and this outcome may have significant negative

growth effects.5 In this regards, Bardhan (1997) presents some insights that corrup-

tion entails higher red tape. Nevertheless, it was Guriev (2004) who first formalized
this relationship in his model. In particular, by modeling the interaction between
the corrupt bureaucracy and private agents within principle-agent framework, Guriev
(2004) finds that in the corrupt environment the equilibrium burden of red tape is

higher than in the absence of corruption. His result is similar to mine, in the sense
that corruption creates additional burden on private agents. However, I distinguish
red tape from regulatory burden. Red tape is only a type of regulation dedicated
for screening, while there are huge set of regulations (e.g. pollution, safety) that

directly affect productivity of private agents independent of the level of red tape. I
demonstrate that an increase in the burden created by corruption is manifested not
only through red tape but also through increases in regulatory burden. It is not a
2
See Bardhan (1997), Kaufmann and Wei (1999), Jain (2000)
3
See Shleifer and Vishny (1993), Kurer (1993), Tanzi (1998), McChesney (1997), Mauro (1995)
4
SeeMauro (1995), Brunetti et al. (1998), Mo (2001), and Ali and Isse (2003), Lambsdorff
(2003)
5
The burden enlarged by corruption drives the firms into a shadow economy (Dreher et al., 2008;
Johnson et al., 1998) and distorts the equilibrium outcome for the number of firms in the market
(Bliss and Di Tella, 1997). These studies suggest that the burden of regulations the firms face
increases with corruption, though it has not been explicitly analyzed. The other related literature
establishes a positive correlation between corruption and entry requirements for firms. For example,
Broadman and Recanatini (1999), Djankov et al. (2002), and Svensson (2005) find a strong
correlation between higher barriers to market entry with the level of corruption. Treisman (2000)
and Ades and Di Tella (1997; 1999) find that state intervention tends to increase corruption.
Gerring and Thacker (2005) report a positive correlation between regulatory quality and absence of
corruption.

3
trivial statement as it is possible that even if red tape is fixed, regulatory burden may

increase due to corruption. This is shown in the paper. Overall, differing from the

existing literature, this paper analyzes a model where the relationship between the
level of corruption and the regulatory burden is captured explicitly. I extend Shleifer
and Vishny (1993) model and show that the overall effect of corruption on regula-

tory burden is positive, though it has a component with opposing effects. On one
hand, corruption decreases compliance hence decreases regulatory burden. On the
other hand, corruption enables the bureaucrats to perpetrate income extortion from

private agents by applying regulations in discretionary manner. This behavior of the

bureaucrats increases the effective regulatory burden. The analytics show that effect

of extortion dominates the effect of noncompliance, and hence, the overall regula-
tory burden increases with corruption. This prediction of the model is then tested
empirically.

Empirical work in this field has found evince supporting a positive correlation

between corruption and regulatory burden with the use of firm level data (Kaufmann
and Wei, 1999 and Henderson and Kuncoro, 2006, inter alia) as well as with individual
data (Hunt, 2006). However, these conclusions are based on OLS regressions which
results in biased and inconsistent estimates, as OLS cannot account for endogeneity

of regressors and may be biased due to omission of variables. With TSLS we have a

problems related to weak instruments, hence the IV estimators can be biased. Nickell
(1981) show that the least square dummy variable (LSDV) estimator is also leads

to biased coefficient estimates when applied to equations with lagged dependent

variables and fixed effects in a panel data set with a small time dimension, T . By
employing a system GMM approach, this paper overcomes the shortcomings of the

estimations based on OLS.

The paper is organized as follows. In Section 2, I outline a simple theoretical model

and analyze the relationship of ex-post and ex-ante corruption with the regulatory

burden. In Section 3, I discuss the empirical methodology and describe the data. In

Section 4, I test empirically the prediction of the model and discuss the results. In

4
the last section I draw brief conclusions about the relationship between corruption

and regulatory burden.

2 The model

2.1 Background discussion

Government has monopolistic power in provision of public goods and services. At

the same time the purpose of government is not profit maximization, therefore, a

benevolent government should provide the goods and services at their marginal cost.
However, the bureaucrats representing the government may be corrupt and use il-

legally their public position for personal gain. Largely, the bureaucracy does it by
abusing their monopolistic power in public goods provision and enforcement of regu-

lations.6

From the corruption literature we know that corruption may happen ex-ante
or ex-post. In the ex-ante corruption or “corruption without theft” the bureaucracy
increases the price of the public goods before the interaction with the private agent.
As the bureaucracy has the monopolistic power it can charge monopolistic prices for

the public goods it is providing. The other example of the ex-ante corruption is
framing and extortion exercised by public officials abusing the public power endorsed

upon them. Since the higher cost of obtaining public goods and extortion decreases
private agents income, the ex-ante corruption increases the burden of the public

sector.

The ex-post corruption takes place when bureaucracy learns about the type of the

private agent and can conceal socially valuable information for private gain. Usually

it happens when the corrupt bureaucrat inspecting the private agent finds that the
private agent has not complied with the regulation introduced to deal with the exter-
6
Shleifer and Vishny (1993) and Barreto (2000), Barreto and Alm (2003) indicate that corrupt
bureaucrats take advantage of their monopolistic power and rent-seek. The monopolistic behavior
of the public agents leads to less public goods being offered to the private sector.

5
nalities created by private production or for other social reasons. In case of ex-post

corruption, both the inspector and the producer might gain at the expense of the

society as a whole. This type of corruption may decrease the burden of regulations
on the individual agents involved.

The corrupt bureaucrat, to maximize the bribe revenue, combines both types of
corruption. This outcome is possible if the bureaucrat not only enforces regulations,
but also can set higher compliance requirements for the regulations. Note, it includes
not only setting higher red tape as in Guriev (2004), but also increasing restriction

imposed by the regulations. Then the effective burden of the regulation depends on

which effect of corruption dominates: the burden decreasing ex-post corruption or

burden increasing ex-ante corruption. Keeping in mind these two opposing effect of
corruption on regulatory burden, I lay out assumptions about the agents operating in
the economy, their preferences, and the production technology.

2.2 The setup

Suppose that the model economy is populated with two types of agents: identical

household-producers and bureaucrats.The agents preferences are defined by a utility

function of the form:
u = u(y) (1)

where y is disposable income.7 I also assume that the utility of the agent is increasing

in disposable income, u0y > 0.

The private agent engages in production using the production technology given

by

x = A(e)f (l), (2)

where, l is a fixed amount of labour, A(e) is a productivity coefficient, and e is the

amount of negative externalities generated in production process. It is assumed that

7
I use disposable income as an argument of the utility function as I am assuming away saving in
my model, and hence, disposable income is entirely spent on consumption.

6
f 0 (l) > 0, f 00 (l) < 0, A0 (e) > 0 and A00 (e) < 0. The producer is more productive if he

cares less about the amount of negative externalities he is generating while producing

his output. The underlying intuition is decreasing the amount of negative externalities
(e.g. pollution, safety) is costly, so by employing dirtier or less safe technology the
producer can increase its productivity.

The producer choose the level of externalities generated by production process,

e, such that it maximizes his profits. Suppose that the level of e that maximizes
x = A(e)f (l) is equal to em .8 However, this level of negative externalities can be

found not acceptable by the society. The government regulates the production process

in terms of externalities generation and monitors compliance of the producers with this

regulation. In the context of this model, the government establishes a regulation that
sets a ceiling to the permitted level of negative externalities as e0 < em . It is assumed
that externalities not exceeding the ceiling, e0 , set by the regulation, is free. If the
producer exceeds the ceiling and detected, then he is fined for this non-compliance.

The fine is proportional to the amount of the excessive amount of the externalities,
ψ(em − e0 ), where ψ is the expected penalty for a unit excessive externalities. The
expected penalty rate for the excessive externalities, ψ, depends on the penalty rate
for non-compliance, φ and the probability of detection, π. Thus, ψ = πφ. In addition,

the private agent incurs additional cost due to red tape, r, which is caused by audits
and other regulation enforcement procedures.

Given the regulation and the probability of being caught and punished, the opti-
mizing producers choose the level of e that maximizes their disposable income. This

circumstance leads to the solution of the following problem:

max y = A(e)f (l) − ψ∆e − r, (3)

e

8
Since the only production factor is labour, the profits are equal to output.

7
 Figure 1: Full compliance in the absence of corruption

where ∆e = e − e0 . The FOC of (3) with regards to e yields us the following:

∂A
−ψ =0 (4)
∂e

Let us explicitly solve for the equilibrium value of the externalities, e∗ , by assuming
a specific form for the production function. Suppose that production technology is
given by:

A0 · eθ l1−θ (5)

Then using the condition given in (4) yields:

µ ¶ 1−θ
1
θA0 · l1−θ
e∗ = (6)
ψ

The benevolent government may choose π and φ in such a way that it would be

optimal for the producer to comply (recall ψ = π · φ), or the first best outcome is

∂A
ψ0 ≥ |e∗ =e0
∂e

where e∗ is the optimal amount chosen by the producer. This outcome is illustrated

in Figure 1. When the unit cost of the externalities is equal to ψ0 a producer will not
exceed the level permitted by the regulation, and generates externalities equal to e0 .

8
 Figure 2: Ex-post corruption

2.3 Ex-post corruption

Profit maximizing producers would generate more externalities if cost was lower, and
if e ≤ em . I assume that the corrupt bureaucrats can sell additional permits for

externalities at a lower cost, b0 , which is just the bribe rate (see Figure 2). It is
assumed that the corrupt bureaucrats face some costs when they allow for excessive

externalities generated by the producers. The cost schedule faced by the corrupt
bureaucrats can be non-linear in general and related to the excessive externalities
generated. However, for simplicity I assume that this cost is a linear function of the
amount of the excessive externalities allowed by the bureaucrat. Hence, this cost is

given as:

cb = γ0 (e − e0 ) (7)

where γ is a cost parameter, which in turn depends on the quality of the public
institutions and the resources spent on monitoring, though I do not model it explicitly.

Given the cost function, the bureaucrats maximize their net bribes. In this setting
the marginal cost is given by:

M C1 = c0b (e) = γ0

As a monopoly, the bureaucracy in maximizing its rents, equalizes its marginal

9
revenue M R1 and marginal cost M C1 . Note, that the effective demand by the pro-

ducers for additional externalities starts only after point e0 . Therefore, the marginal

revenue curve M R1 is effective only to the right of the vertical at point e0 (Figure 2).
The result of such a corrupt interaction is higher equilibrium amount of externalities
that satisfies e∗ > e0 . This results in higher output. Hence, the regulatory burden is

lowered by ex-post corruption.

2.4 Combination of ex-ante and ex-post corruption

Since only those, who are detected for not compliance with the regulation, are subject
to bribe-paying, it is in the corrupt bureaucrat’s interest to have more violators among

the producers. A simple way to do that is to increase red tape and make the licensing

process lengthy. In other words, the bureaucrats engage in ex-ante corruption. In

our context, this type of corruption leads to a decrease of the allowed ceiling for
externalities from e0 to ec < e0 .

Figure 3: Combination of ex-ante and ex-post corruption

The implications of such corruption is illustrated in Figure 3. With the possibility

of ex-ante corruption, the corrupt bureaucrats can collect more bribes than before.

10
Therefore, now they have a new marginal revenue curve given by M R2 , which is effec-

tive only for externalities exceeding the lower benchmark set by corrupt bureaucrats,

ec .

Since this type of rent seeking involves both ex-ante and ex-post corruption, the
expected cost of the bureaucrats in their corrupt activities should be different from the

only ex-post corruption case. In the simplest setting the cost faced by the bureaucrats
should have two components. The first component captures the cost for taking bribes
that is related to the amount of externalities allowed, whereas the second component

captures the cost related to the extortionist behavior of the bureaucrats. Based on

this rationale we assume that the cost of the corrupt bureaucrats is given by

cb = [γ0 + γ(e0 − ec )] (e − ec ) (8)

Under this condition marginal cost curve is given by

M C2 = c0b (e) = γ0 + γ(e0 − ec ) (9)

It is clear that the marginal cost of the corrupt bureaucrats is greater in these circum-
stances than in the case with ex-post corruption only, as M C2 > M C1 = γ0 . Now,

the equilibrium level of externalities is lower and is equal to e∗∗ , where e∗∗ ≤ e0 < e∗ .

Also note that under these conditions the bribes are heavier than in the case with-

out ex-ante corruption, as b2 > b1 (see Figure 3). Below it will be discussed more

rigorously.

The corrupt bureaucrats‘ objective is maximize the bribe revenue given the cost
they face for being corrupt:

Z e
max R = (b − AC)de,
ec ec

where AC is the average cost of selling an illegal permit for a unit of negative

externalities. Let us consider a specific case for illustration. Suppose that the bribe

11
obtained per unit of excessive externalities is given by

b = β0 + β(e0 − ec )

This formulation captures the idea that the lower the benchmark set by the corrupt
bureaucracy for free externalities generation, ec , relative to the legal benchmark,
e0 , the higher the bribe rate. As the bribe rate in this environment is actually the

monopolistic price, it should be greater than the marginal cost of the corruption.
Hence, it satisfies the following condition:

β0 + β(e0 − ec ) > γ0 + γ(e0 − ec )

It is easy to see that it also implies:

β0 > γ0 and β > γ (10)

Suppose, the average cost of a corrupt bureaucrat is given by

cb
AC = = γ0 + γ(e0 − ec ).
e − ec

Denoting the optimal amount of the permits for externalities demanded by e∗∗ , we

can state the bureaucrat’s problem as

max R = [β0 − γ0 + (β − γ)(e0 − ec )] (e∗∗ − ec ) (11)

ec

Solving the problem we obtain the following result.

Proposition 2.1 A combination of ex-post and ex-ante corruption results in more

restrictive regulation parameter than the statutory benchmark.

12
Proof The first derivative of (11) with respect to ec is given by

(β0 − γ0 + (β − γ)(e0 − ec ) + (β − γ)(e∗∗ + ec ) = 0.

By solving for e∗∗ we obtain,

β 0 − γ0
e∗∗ = 2ec − e0 − (12)
β−γ

β0 −γ0
By definition ec ≤ e0 , and from (10) we know that β−γ
> 0, therefore, e∗∗ < e0 .
Hence, under combined corruption the equilibrium amount of externalities is lower

than under the statutory regulation. ¥

This proposition lets us to draw conclusions about the effect of combined corrup-
tion on both effective marginal and total burden of the regulation. It is considered in
the next section.

2.4.1 Regulatory burden and corruption

Recall that the equilibrium amount of externalities, e∗∗ is determined by optimizing

producers. Specifically, producers maximize

A0 · eθ l1−θ − [β0 + β(e0 − ec )](e − ec ) − r. (13)

The solution of the problem yields:

µ ¶ 1−θ
1

∗∗ θA0 · l1−θ
e = . (14)
β0 + β(e0 − ec )

By comparing this outcome with the outcome in the absence of corruption given in
³ ´ 1
∗ θA0 ·l1−θ 1−θ
equation (6) as e = ψ
, it can be stated that e∗∗ < e0 holds only if

β0 + β(e0 − ec ) > ψ

13
is true. We state it as the following corollary.

Corollary 2.2 Combined corruption leads to higher marginal regulatory burden than

that is under the statutory regulation. That is β0 + β(e0 − ec ) > ψ.

The total regulatory burden in this model is captured as forgone output minus the
gain through the reduction in negative externality. caused by the restrictions imposed

by regulations. In the absence of corruption the foregone output due to a lower

level of permitted externalities can be found as a difference between the maximum

output in case of no regulation, xm = A(em )f (l), and the optimal output under the
regulation, x = A(e0 )f (l) − r. We assume that when the regulation parameter is

set optimally, the loss from output reduction is entirely offset by gain from negative

externality reduction, W (em − e0 ). Hence, the burden is expressed by

B0 = A(em )f (l) + r − A(e0 )f (l) − W (em − e0 ) = 0 (15)

In case of corruption with extortion, the effect of the regulation on welfare is given

by

Bc = [A(em )f (l) − A(e∗∗ )f (l)] + rc + W (em − e0 ) + W (e0 − e∗∗ ) + β0 + β(e∗∗ − ec ),

(16)
where the last two terms stand for the amount of bribes paid by the producer, while
rc is the cost of red tape with corruption. The gain from the reduction of negative

externality is stated as a sum:

W (em − e0 ) + W (e0 − e∗∗ ).

This result lets us to formulate the following corollary:

Corollary 2.3 Combined corruption leads to higher total regulatory burden than that

is under the statutory regulation.

14
Proof With the fixed labour supply, the reduced externality leads to lower output

but higher gain from externality reduction. In addition, there is a cost incurred due to

bribes paid to bureaucrats. Therefore, the change in burden is found as a difference

between the additional gain from externality reduction, W (e0 −e∗∗ ), and a loss due to
the more restrictive regulation, A(e0 )f (l) − A(e∗∗ )f (l) and the direct burden of red

tape and corruption. If the allowed externality level falls below the optimal ceiling, e0 ,
the loss in output will be higher than the gain from the reduction of the externality,
or [A(e∗∗ )f (l) − A(e0 )f (l)] > W (e0 − e∗∗ ). This implies that the regulatory burden

is higher when the bureaucracy is corrupt: Bc > B0 . ¥

Above, it has been established that regulatory burden is higher with corruption

than in its absence. However, we still have to ascertain whether an increase of the
level of corruption is related to the increase of the level of regulatory burden. The

following corollary deals with this issue.

Corollary 2.4 A rise in corruption levels results in an increase of regulatory burden.

Proof Based on the definition of corruption stating that corruption is abuse of public
position for personal gain, we can conclude that higher corruption levels means more
bribes being paid by the private agents. Recall from expression (16) for the effective

regulatory burden, Bc = [A(em )f (l) − A(e∗∗ )f (l)] + rc + β0 + β · (e∗∗ − ec ) −

W (e0 − e∗∗ ). The first derivative of the regulatory burden with regards to bribe
taking coefficient gives us:
∂Bc
= e∗∗ − ec > 0,
∂β

We infer that for the given equilibrium amount of externalities, e∗∗ , an increase in
corruption expressed as an increase in bribes paid, straightforwardly increases the

public sector burden, Bc .¥

The discussions above provides a testable hypothesis: with the increase of the

level of corruption, regulatory burden rises. Now, having established a theoretical

15
prediction on the direction of the change in the regulatory burden with corruption, I

proceed to the empirical testing of this result.

3 The empirical evidence

The theoretical model indicates that regulatory burden increases with the level of

corruption. Even though, ex-post corruption, lowers the public sector burden on the
firms by letting them not fully comply with the regulations, ex-ante corruption or

predation of bureaucrats creates additional burden on private agents. The model

predicts that the latter effect dominates the former, and therefore, higher levels of

corruption is related to higher regulatory burden.

Recall that regulatory is given by:

Bc = [A(em ) − A(e∗∗ )] f (l) + rc + β0 + β · (e∗∗ − ec ) − W (e0 − e∗∗ ).

Here, β · (e∗∗ − ec ) + β0 is the burden of bribes and constitute the direct cost of

corruption; rc + [A(em ) − A(e∗∗ )]f (l) stands for the burden stemming from the
regulations per se, which is distorted by corruption as the equilibrium level of allowed
externality, e∗∗ , differs from the statutory level, e0 . In more general setting the

productivity depends also on other variables as government inputs, level of productive

technology, overall development. The gain from reduction of negative externality,

W (e0 − e∗∗ ), is unobservable variable, so we capture it with the country effect.

Controlling for other factors that also affect the regulatory burden, we write the
equation, which estimates the effect of corruption on regulatory burden, as follows:

0
burdenit = α · corruptionit + xit β + ci + εit (17)

where burdenit is a measure of the effective regulatory burden for a given country, ci

is a country specific fixed effect, corruptionit is a measure of corruption for country

i, xit is a vector of explanatory variables, εi is an idiosyncratic disturbance term.

16
3.1 Estimators

Using OLS methods for estimation of above presented equations results in biased
and inconsistent estimates. The reason is that OLS method cannot account for

endogeneity of regressors and may be biased due to omission of variables. With

TSLS we have a problems related to weak instruments, hence the IV estimators can

be biased.

We also should note that the regulatory burden depends on the regulations, which
in turn do not change frequently. This may lead to persistence of the regulatory burden

which must be accounted for. To incorporate this dynamics we rewrite (17) in the

following form:

0
burdenit = γ · burdenit−1 + α · corruptionit + xit β + ci + εit (18)

We can write (18) in first-differences:

0
∆burdenit = γ · ∆burdenit−1 + α · ∆corruptionit + ∆xit β + ∆εit (19)

However, we may encounter several issues related to estimation of equation (19):

• corruption is endogenous as both regulatory burden and corruption may cause

each-other–thus corruptionit may be correlated with the error term;

• the explanatory variables may be correlated with country-specific fixed effects

(at least burdenit−1 is)–again it makes the error term to be correlated with the

explanatory variables;

• the inclusion of the lagged dependent variable burdenit−1 leads to autocorre-

lation in the error term;

• the panel dataset is prone to so called "small T, large N" problem.

In both the fixed and random effects settings, the difficulty is that the lagged de-
pendent variable is correlated to the disturbance, even with the assumption that the

17
disturbance is not itself autocorrelated. Nickell (1981) show that the Least Square

Dummy Variable estimator (LSDV) is not consistent for finite T in autoregressive

panel data models. Recent simulation studies in a macroeconomic context (Jud-

son and Owen 1999, Gaduh Hauk and Wacziarg 2004) have demonstrated that the
coefficient estimate on the lagged dependent variable is severely biased downwards,

whereas the other coefficients are less affected. Kiviet (1995) derived a correction for
this bias in LSDV regressions. Here we use the LSDV estimates together with OLS
regressions without fixed effects to check whether the system-GMM results differ as

predicted by simulation studies - the coefficient on lagged income should then lie

between the LSDV and OLS estimates.

When the Ordinary Least Square (OLS) technique is used to estimate this model,
the OLS estimate of α is inconsistent and likely to be biased upwards since the lagged
values of y are positively correlated with the omitted fixed effects. The Least Square
Dummy Variables (LSDV) method eliminates any omitted variables bias created by the

unobserved individual effect by using the within-group operator and estimates the new
model below by OLS: Both OLS and LSDV estimates indicate a significant positive
effect of political liberalisation on financial development although they are biased
in opposite directions. The LSDVC suggests weaker evidence at the 20significance

level. The SYS-GMM estimate provides strong evidence that the improvement in
institutional quality is associated with financial development, and the diagnostic tests,

including the first-order and second-order serial correlation tests, Sargan test and

Different Sargan test, are supportive. In general, the coefficients on the GDP level,

trade openness and aggregate investment are positively signed, while the coefficient
of the black market premium is negatively signed. The long run effects in the cases

of the OLS and LSDV estimates have been found to be positive and stable, however,

the long run effects for LSDVC and SYS-GMM are less precisely estimated

To overcome this estimation issues, Arrelano-Bond (1991) Difference GMM esti-

mators9 and Blundell-Bond (1998) System GMM estimators can be used. Arrelano-
9
Initially proposed by Holts-Eakin, Newey and Rosen (1988)

18
Bond estimator (Difference GMM) uses the lagged level endogenous variables as in-

struments. If the dependent variable is close to a random walk, the difference GMM

may not be a good estimator because past levels convey little information about
future changes, that makes lagged levels of the regressors poor instruments for the
differenced regressors.10

In our case, the preliminary specification tests prove that Difference GMM is not
a good estimator as the instruments in levels have been weak instruments. Thus,
equation (19) is estimated using the Blundell-Bond (1998) System GMM estimator.

As Judson and Owen (2000) indicate, the system estimator has a downward bias due

to smaller SEs of the estimates when cross-section dimension is small. This may

lead to false significance of the regressors. This shortcoming is corrected by using

Windmeijer (2005) procedure that allows to compute heteroskedasticity-consistent
SEs.11

Consistency of the System GMM estimator depends on the validity of the instru-

ments. For robust GMM estimators, the Hansen test for over-identifying restriction
is utilized see if the instruments are valid. In addition, the second order autocor-
relation test for the error term is performed. This tests the null that there is no
autocorrelation. The test results are reported in the results section.

3.2 Data description and variables

Regulatory burden. There is no straightforward measures of regulatory burden in

practice. I have to use some measures that can be considered as related to the actual

regulatory burden. As a proxy candidate the following indexes have been selected:
the Index of Economic Freedom , the Business Regulations Index. The data on the

Index of Economic Freedom are obtained from Heritage Foundation and the data on

the Business Regulations Index come from the Fraser Institute. The dataset used
10
See , Temple et al. (2001), Roodman (2006), Sequeira and Nunes (2009), Romero-Avila (2009),
Naudé and Krugell (2009).
11
Estimations are done using a Stata package xtabond2 developed by Roodman (2006). This
package incorporates the Windmeijer (2005) small-size correction procedure.

19
covers the time period from 2000 to 2007.

The Index of Economic Freedom is an index based on the series of 10 economic

measurements created by the Heritage Foundation and Wall Street Journal. The
higher values indicate more economic freedom. The 10 Economic Freedoms include:
business freedom, trade freedom, fiscal freedom, government size, monetary freedom,

investment freedom, financial freedom, property rights, freedom from corruption,

labour freedom.
The business freedom score measures the burden of regulations in starting busi-

nesses and obtaining licenses. The burden of tariffs and non-tariff barriers such as

quotas and bureaucratic delays is captured by the trade freedom score. The burden

taxation is captured by the fiscal freedom score. The burden of government expen-
ditures is measured by the government size score. Price stability explains most of
the monetary freedom score. The investment freedom score capture the regulatory
burden with regards to investment. The more that banks are controlled by the govern-

ment, the less financial freedom score is in the country. The score on property rights
measures protection of property rights, so not a direct measure of regulatory burden.
Another measure that does not capture regulatory burden is the score of freedom
from corruption. This score essentially weakens the Index of Economic Freedom as

a proxy of regulatory burden as it already may capture the effect of corruption on

regulatory burden. The last score measures the labour market flexibility, hence can
be considered as a measure of the burden of labour market regulations.

As a narrower measure that may avoid the weaknesses of the Index of Economics

Freedom, I use Business Regulations Index. This index captures the burden on the
private agents due to price controls, administrative procedures and other obstacles

that hinder starting a new business, time cost of senior management in dealing with

government bureaucracy (denoted as BU RCOST ), irregular payments or bribes: ir-

regular, additional payments connected with permits, licenses, exchange controls, tax

assessments, police protection (denoted as BRIBE). This index and its components

signify less regulatory burden when values are higher.

20
 I also have run additional regressions for two components of the Business Regu-

lations Index, namely: BU RCOST and BRIBE. These two measures most closely

capture the additional burden imposed by corruption on private agents. Hence, the
regressions can reveal at least some effect of corruption on regulatory burden, because
an increase in both bribes and cost of dealing with bureaucracy adds to the effective

burden of the regulatory system.

Corruption measures. As the indicator of the level of corruption I use the
Corruption Perception Index (CPI) complied by the Transparency International, The

Control of Corruption Index (CC) from Governance Indicators Dataset complied

by the World Bank (Kaufmann, 2004). These measures of corruption is based on

the surveys of the private agents perception of corruption related to their economic
activities. The CPI values are determined in the range of (0,10), and the higher value
signifies the less corruption in the economy. The Control of Corruption Index ranges
within (−1.5, 2.5), and again the higher values indicate the lower corruption.12

Control variables and exogenous instruments. As a control variable, I

used GDP per capita, (GDPPC ), secondary gross enrollment rates, (SCH2 ), a share
of urban population, (URB), government size, (GOVSIZE ). The data on GDPPC ,
URB, and SCH2 are obtained from the World Bank databases: WDI and EdStats.

The data on GOVSIZE is obtained from the dataset provided by the Fraser Institute.

4 Results

The results of the estimations are reported in Table 1-4. The effect of the level of

perceived corruption on the magnitude of the Index of Economic Freedom is signifi-

cant. The overall effect of the current and lagged values of the corruption measures is

positive as expected. This positive relationship is due to the fact that with an increase
both CP I and CC indicate less corruption (Table 1). Using a narrower measure as
12
Though there are some concerns that the perception based corruption measure may not be
good quantitative data, the lack of an alternative more reliable measure of corruption limits the
empirical analysis to them. For discussions see Galtung(2006)and Sik(2002).

21
the Business Regulation Index does not change the regression results qualitatively

(Table 2). This generally indicates that there is a robust relationship between overall

regulatory burden and corruption.

Table 1: Regression results for the Index of Economic Freedom

LSDV Sys-GMM OLS LSDV Sys-GMM OLS

l.efi -0.14 0.1 0.29 -0.12 -0.008 0.28
(-3.3* ) (1.3) (5.4*) (-3.1*) (-0.14) (6.0*)
cc -0.89 5.8 4.2
(-0.38) (2.53**) (5.4*)
cpi 0.95 2.3 2.04
(1.0) (1.9***) (5.5*)
judin -0.006 2.1 -0.01 0.026 2.5 0.02
( -0.01) (2.2**) (-0.07) (0.05) (2.6**) (0.12)
govsize 0.48 1.7 1.4 0.48 1.53 1.37
(0.73) (2.5**) (5.5*) (0.7) (1.76***) (5.6*)
gdppc 0.037 -0.2 3.9e-03 0.062 -0.29 0.028
(0.1) (-1.2) (0.08) (0.18) (-1.8***) (0.55)
R2 0.22 0.53 0.14 0.52
AR(2) 0.27 0.26
Hansen 0.39 0.52
No. group 116 116 119 119
No. obs 554 554 554 587 587 587
No. instr 92 95
Note: Heteroskedasticity-consistent t-statistics are reported based on the finite-sample
correction factors proposed by Windmeijer (2005). Wald tests for the joint-significance of
all coefficients included in the regression and is distributed as χ2 with degrees of freedom
equal to the number of restrictions. The Hansen test is used to test the null hypothesis
that the instruments are valid. This statistics is distributed as χ2 with degrees of freedom
determined by the number of instruments and the number of regressors. AR(2) tests the
presence of autocorrelation in levels. (*), (**), and (***) denote statistical significance at
1%, 5%, and 10% level, correspondingly.

The measures that capture the indirect burden faced by private agents in dealing

with regulations, BRIBE, and BU RCOST (note, both measures indicate, respec-

tively, less bribes and bureaucracy cost with an increase in the magnitude) also exhibit

a positive relationship with the corruption measures (Table 3 and 4). These last two
regression results demonstrate that the higher levels of corruption are associated with

larger bribes and higher costs in dealing with the bureaucracy. In other words, the

analytical result suggesting that with corruption the extortionist behavior of the bu-
reaucracy increases finds some supporting empirical evidence. Overall, the results of

22
 Table 2: Regression results for the Index Business Regulations

LSDV Sys-GMM OLS LSDV Sys-GMM OLS

l.busreg 0.16 0.2 0.47 0.18 0.24 0.28
(2.9* ) (4.6*) (10.3*) (3.48*) (5.5*) (6.0*)
cc 0.16 0.61 4.2
(0.94) (3.4*) (5.4*)
cpi 0.18 -0.04 0.14
(2.0**) (-.24) (4.4*)
judin 0.17 0.34 0.09 0.18 0.15 0.02
( 3.8*) (3.7*) (4.4*) (4.5*) (2.2**) (0.12)
govsize 0.09 0.33 0.09 0.09 0.3 1.37
(1.9**) (4.5*) (4.9*) (2.26**) (4.3*) (5.6*)
gdppc 0.047 0.03 2.7e-03 0.05 -5.5e-03 0.028
(1.6) (1.28) (0.67) (1.74***) (-0.4) (0.55)
R2 0.77 0.76 .77 0.52
AR(2) 0.11 0.31
Hansen 0.16 0.2
No. group 118 118 122 119
No. obs 544 544 544 568 568 587
No. instr 92 95
Note: As in Table 1.

Table 3: Regression results for the Index of Cost of Bureaucracy

LSDV Sys-GMM OLS LSDV Sys-GMM OLS

l.burcost -0.007 0.04 0.37 -0.009 0.029 0.35
(-0.14 ) (0.72) (9.1*) (-0.2) (0.46) (8.7*)
cc -0.15 0.99 0.64
(-0.35) (2.28**) (5.1*)
cpi 0.34 0.48 0.23
(1.3) (1.84***) (4.3*)
judin -0.007 -0.09 -0.05 0.013 -0.24 -0.09
( -0.07) (-0.69) (4.4*) (0.14) (-1.1***) (-2.1**)
govsize 0.02 0.13 0.02 0.04 -0.025 0.025
(0.16) (1.2) (0.69) (0.31) (-0.2) (0.6)
gdppc 0.47 7.9e-03 0.018 0.05 0.025 0.017
(5.7*) (0.2) (2.2**) (6.0*) (0.83) (2.1**)
R2 0.34 0.45 0.32 0.45
AR(2) 0.77 0.73
Hansen 0.23 0.2
No. group 117 117 121 121
No. obs 537 537 537 561 561 561
No. instr 92 95
Note: As in Table 1.

23
 Table 4: Regression results for the Bribe Index

LSDV Sys-GMM OLS LSDV Sys-GMM OLS

l.bribe 0.018 0.36 0.59 0.02 0.36 0.62
(0.36 ) (4.6*) (16.5*) (0.41) (5.1*) (19.3*)
cc 0.33 0.84 0.43
(1.73**) (5.3*) (6.8*)
cpi 0.006 0.42 0.21
(0.08) (3.5*) (6.9*)
judin 0.35 0.08 0.09 0.36 0.07 0.08
( 6.83*) (1.1) (4.9*) (7.4*) (1.37) (4.6*)
govsize -0.008 0.014 -0.023 0.009 -0.01 -0.018
(-0.15) (0.25) (-1.5) (0.19) (-0.22) (-1.2)
gdppc -0.6e-03 -5.7e-03 -3.0e038 -0.012 -1.4e-03 -1.2e-05
(-0.02) (-0.38) (-0.96) (6.0*) (-0.18) (-0.0)
R2 0.69 0.91 0.75 0.91
AR(2) 0.09 0.037
Hansen 0.22 0.23
No. group 117 117 121 121
No. obs 542 542 542 566 566 566
No. instr 92 95
Note: As in Table 1.

the estimations lend a support to the hypothesis that increasing corruption leads to
heavier predation and thus the overall regulatory burden increases with it.

When we use the Arellano-Bond GMM dynamic estimator, which effectively ad-

dresses both autocorrelation and endogeneity in the time-series analysis, the results

show that in particular government stability, internal and external conflicts, law and
order, ethic tensions, bureaucratic quality and, to a lesser degree, corruption and

democratic accountability are important determinants of foreign investment flows.

Based on our results, these political risk and institutional indicators matter the most

when multinational corporations confront decisions about where to invest in develop-

ing countries.

24
5 Conclusions

It is reported by some researchers that corruption can be growth-enhancing by de-

creasing excessive red tape, though the empirical evidence indicates that corruption
is negatively correlated with economic growth. This paper rationalizes this existing
discrepancy between theory and evidence. I investigate the mechanics of the rent-

seeking of corrupt bureaucracy within a simple model, and propose that bureaucracy
not only assists private agents in non-compliance for bribes paid, but also actively uses
excessive red tape to extort bribes. Therefore, ex-ante corruption effectively increases

regulatory burden, whereas ex-post corruption decreases the burden for exchange of

bribes.

Considering the ex-post corruption only, one may conclude that corruption is effi-
ciency improving as decreases regulatory burden. However, it is clear the state of the
efficiency should only be judged on the basis of the resulting outcome after taking into
account both types of corruption. The analytical model predicts that the predation

effect dominates over the non-compliance effect, and therefore, corruption generally
increases the effective regulatory burden above its statutory level. Furthermore, this

burden increases with the level of corruption in the economy. Empirical evidence

supports this hypothesis. Hence, the stylized fact about the negative correlation be-

tween corruption and growth is reconciled with the existence of growth enhancing
characteristics of corruption.

The limitation of this analysis is that the other adverse effect of corruption ema-

nating from the public sector inefficiencies are entirely ignored. It can be a question
to tackle in the future research.

6 Data sources

1. Worldwide Governance Indicators: 1996-2005,

http://info.worldbank.org/governance/kkz2005/tables.asp;

25
 2. World Development Indicators 2006, http://econ.worldbank.org.

3. EdStats, http://devdata.worldbank.org/edstats

4. Transparency International,
http://www.transparency.org/policy_research/surveys_indices/global/cpi

5. Heritage Foundation, http://www.heritage.org

6. The Fraser Institute, http://www.fraserinstitute.org

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