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The Tale of the Middleman

Intermediaries as a barrier to fighting corruption

By Henrieta Isufllari

The dust is slowly settling on the scandals that broke out with the publication of the Panama Papers, but one prevailing message is still dominating: the reach of corruption does not discriminate. Corruption is not unique to developing countries, and neither does it require a malfunctioning justice system for it to flourish. As the Panama Papers revealed, corruption can acquire a veneer of legality when it is performed through third parties whose ownership is difficult to ascertain, and whose sole purpose is to make it difficult for anyone to trace illegal payments. In the case of the latest scandal, the intermediary in question was the law firm of Mossack Fonseca based in Panama, whose alleged clients include drug lords and government officials alike. The sheer size of the data dump reveals that intermediaries such as Mossack Fonseca can earn really hefty premiums for their services. What’s more concerning is that even countries with strong legal protections against corruption have difficulty preventing corrupt transactions when intermediaries of this size are involved. 

Where does the need for intermediaries come from? What makes them trustworthy to government officials? These questions are part of the focus of “Intermediated Corruption”, a recent theoretical paper[i] by Elton Dusha, MIPP researcher and Professor of Economics at Universidad de Chile. The study looks at the instance of corruption defined as “The sale, by a government official, of government property for private gain", in which government property refers to anything from owning real estate to issuing business licenses. As Professor Dusha explains, “Government property is hard to define, as it also includes abstract concepts such as the right of the state to use legal violence to achieve its ends. In this light, corruption involves the sale of all government property, including less concrete examples as legislation, concessions, jurisprudence, etc.” As the paper emphasizes, corruption is a large market around the world; researchers at the World Bank estimate that the size of the bribery market as of 2004 was at least USD 1 trillion, which amounts to around 3% of the world GDP. The paper aims at building an economic framework to capture intermediation and its impact on the prices of government issued licenses, and on state measures to combat corruption.

When dealing with governments with very high costs of doing business through legal channels, the need for intermediaries comes from both sides of the market: the legal risk government officials are confronted with by dealing directly with the persons who are ready to pay the bribe, and the difficulty private citizens face in their search for a corrupt government official. In the paper’s theoretical model, intermediaries are agents that carry on the transactions between corrupt government officials and the end users of government licenses. The involvement of intermediaries covers a wide spectrum of transactions, from facilitating routine business licenses for opening a new bar or restaurant, to larger impact cases such as the Total corruption case, in which intermediaries recommended by Iranian government bureaucrats were used by the French oil and gas firm Total in order to channel corruption payments for the development of two gas fields. The intermediary agent first secures a government official who is willing to sell a particular type of license, for an agreed upon price. After entering into an agreement with said official, the agent then searches for an entrepreneur to sell the license to. Payment to the government official is contingent upon two factors: selling the license to an entrepreneur, and the agent’s willingness to compensate the bureaucrat. The second factor is essential for the willingness of the bureaucrat to use intermediaries, as it sets up an interesting problem for the bureaucrat: if no agents are used, the risk of being caught increases. On the other hand, if intermediaries cheat, the bureaucrat loses his bribe payment.

The paper shows that the preference of dealing with “honest” agents – agents who keep their word and pay the bureaucrats their share - makes bureaucrats willing to give up a higher fraction of the bribe, which in turn makes agents less likely to cheat. Intermediation in this setting resembles a profession, with new agents entering the market and increasing the frequency of corrupt transactions. Corruption becomes an industry in itself, and gives a larger proportion of the population an economic stake in its survival.  From an entrepreneur’s point of view, paying a bribe is an appealing solution, as it bypasses red tape costs, one of the major difficulties in obtaining a license. They are often so onerous that entrepreneurs prefer to always bribe bureaucrats rather than obtain permits through legal means. For this reason red tape costs are a major policy variable, and their effects are at the center of the paper’s analysis and conclusions. The findings show that, as red tape costs increase entrepreneurs prefer to bribe bureaucrats in order to avoid going through the regulatory requirements. This in turn increases the total amount of bribes available to both bureaucrats and intermediaries. As the bribes increase, intermediation increases as well, as agents are more willing to dedicate a larger proportion of their working hours to intermediating corrupt transactions because the returns to doing so are higher.

But what happens if we decide to increase the frequency with which the bureaucrats are audited in an attempt by governments to reduce corruption? Would this reduce the size of the corruption market? When governments increase the frequency of auditing bureaucrats, the latter are more reluctant to receive bribes directly from entrepreneurs as doing so increases the likelihood of being caught, making corrupt bureaucrats more willing to use intermediaries in order to avoid detection. This fact is reflected in the higher proportion of the bribe that bureaucrats are willing to pay to intermediaries. As these payments increase, intermediation becomes more lucrative and again more working hours are dedicated to it. “In a sense – says Professor Dusha – increasing vigilance tends to have perverse effects on the frequency of corrupt transactions when the payoffs to corruption in the form of red tape costs are high. As we increase the frequency of audits we tend to transfer income from corrupt bureaucrats to intermediaries, without having the desired significant impact on reducing the number of licenses that are obtained through corrupt means.” Under this scenario, as intermediaries earn more, the total amount of hours dedicated to corrupt activities increases in the general population. In terms of policy recommendations, the paper suggests that unless governments reduce what they extract from entrepreneurs in the form of red tape costs, measures to combat corruption will tend to be ineffective because they act as income transfers from bureaucrats and entrepreneurs to intermediaries.

Approached from a different angle, as incomes increase, agents dedicate less time to intermediation, because the opportunity costs of being an intermediary increases and agents can earn more by doing their daily jobs. This approach provides a new way of explaining the adverse effects of an increase in the income per capita on corruption; intermediaries leave the bribery market when outside employment options offer a higher payoff, decreasing thus the opportunity of engaging in corrupt transactions for both bureaucrats and private citizens. This inverse relationship between corruption and GDP per capita can be clearly seen in the graph below.

Interestingly enough in the case of Chile this relationship is not as strong as the paper’s findings suggest. In most recent indicators of corruption, Chile is often an outlier; the World Bank indicators for 2015 report its GDP per capita at USD 14,500 while Transparency International gives the country a corruption score of 73, with a score of 100 assigned to the least corrupt country. In comparison, the corruption score of the United States is 74 while its GDP is around four times higher than that of Chile. Other measures of corruption also put Chile at lower levels of corruption than even the OECD average. The Enterprise Survey by the World Bank reports that for 2010, the percentage of firms that were asked for a bribe by Chilean authorities was 1.3% while the OECD average was 1.7%. In other words, the current figures indicate that further growth might not contribute much towards lowering the corruption levels. But even though low-level corruption is largely absent in Chile, a recent string of high profile corruption scandals such as the “Caso Penta” indicate that serious work still needs to be done to eradicate the high-level corruption present in certain government institutions.

When choosing the right policy for fighting corruption, Professor Dusha’s research suggests that unlike the negative effects of increasing audits in an attempt to cut down on corruption, policy recommendations that aim at increasing a country’s per capita income, combined with reduced red tape costs, result in better overall long-term payoffs. However, the results from such policies tend to take a long time to materialize, and most governments who want to remain in power in the immediate future shy away from radical reforms. As the paper concludes, “In a corrupt country that holds free elections, government officials who have a record of being corrupt may not be thrown out of office because a substantial fraction of the population may have a real economic interest in the status quo. In this way corruption makes society myopic by overemphasizing the short-term gains and ignoring long-term losses.”

 


[i] International Economic Review, Volume 56, Issue 3, pages 997–1017, August 2015

 

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