The Efficient Corruption Hypothesis and the Dynamics Between Economic Freedom, Corruption, and National Income

Abstract

Corruption is an endemic problem in many developing economies. As a result, economists and political scientists have extensively studied corruption and its relationship to economic prosperity. An important mediating factor is the level of economic freedom. Determining causality is difficult as income, economic freedom, and corruption are arguably endogenous. We explicitly model this endogeneity using a panel Vector Auto Regression (pVAR) framework. The pVAR models we estimate are able to explicitly model this endogeneity better than the single-equation panel data models previously used in the literature. We have three primary data sources. Gross Domestic Product (GDP) per capita from the World Bank measures national income. Country-level corruption data comes from the World Bank's Control of Corruption database. The source of our country-level measure of economic freedom is the Fraser Institute's Economic Freedom of the World annual report. Our data set runs from 2002-2013 for over one hundred countries. We begin our results by finding that income, corruption, and economic freedom are integrated, but not cointegrated, thus a pVAR is appropriate. A one-time increase in corruption has a negligible effect on economic freedom and national income. An increase in economic freedom decreases corruption and increases GDP per capita. Increases in national income have no meaningful effect on corruption but have a small and positive effect on economic freedom. We then split our sample to see if there is a difference in results between high economic freedom countries and low economic freedom countries and do not find a difference. In summary, economic freedom decreases corruption and improves the economy and these results hold regardless of the level of economic freedom or whether corruption is absolute or relative. The policy implications from our research are straightforward. To the extent that resources to devote towards corruption are scarce, a focus on improving economic freedom not only leads to less corruption, but higher national income.