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August 2, 2009

A Theory of Corruption

Corruption in India is so pervasive that it is scarcely in public consciousness. While there are incidents like DMK ministers holding out for “ATM ministries”, scandals about auctions of seats in colleges, and most recently Anil Ambani’s broadside upon the Petroleum Ministry, these are seen more as political point-scoring rather than as outrages. With the rise of identity politics, it appears that corruption is an issue only when the wrong side is doing it. India has clearly come a long way from the 80s, when a corruption scandal could dislodge the government from power, and when Arun Shourie’s campaign against Reliance rule-breaking captured the public imagination. What explains the persistence of corruption?

Andrei Shleifer and Robert Vishny wrote a landmark paper on government corruption in 1993, in which they pointed out that opportunities for corruption will be created whenever an individual or business is dependent on government to provide a good – this may be an actual good or a right or enablement to conduct business – such as road access, or an import license, or a business registration. If the government does not monitor the behaviour of its officials; or if there is no competition between various divisions or agents of the government to provide these goods, corruption becomes more likely.

This means that India has always provided wonderful opportunities for corruption. There are, or used to be, a plethora of regulations – taxation, labour welfare, how much installed capacity a factory could have, and so on. Moreover, each of these are managed by a different government agency, and so businesses have to pay multiple independent bribes. But what sort of bribes are these?

Consider  one of India’s many small factories. It faces regular inspections by excise inspectors, labour inspectors, fire safety inspectors, and pollution control inspectors. Complying with every item on these inspectors’ lists needs expertise and money that it does not possess. So, it bribes the inspector to ensure that the violation is overlooked – until the inspector’s next visit.

Over time, the business will pay out a steady stream of money to various government officials, which it will try to make up for by giving its customers substandard products, by cheating its employees of pension contributions, or by cutting corners on safety – after all, the inspector is being paid off anyway.

Now, consider the situation as it applies to every small company in India. They will all be bribing inspectors and cutting corners on safety or employee welfare purely to remain competitive. Thus, thousands of crores of rupees will flow to inspectors, and thereafter up the bureaucracy to the secretaries and ministers who auction the posts of inspectors.

What makes this interesting is how different it is from corruption in the developed world. There, corruption is replaced by its genteel cousin, lobbying. Businesses in the First World lobby legislators and capture regulators so that the rules are set to their advantage; rather than endlessly pay off inspectors to ignore their violation of the rules.

The reader will be tempted to ask why Indian businesses do not follow in the footsteps of their Western counterparts and convince legislators to end the regime of inspectors once and for all rather than pay inspectors in perpetuity. After all, there is always the risk that the business will one day run up against an incorruptible or excessively greedy inspector. And if the management is able to turn its attention away from paying off bureaucrats, it can focus on making better products, or keeping its employees happier.

The reader is overoptimistic.

India is filled with a huge number of small companies or individual enterprises in all its sectors – subsistence-sized farms in agriculture, small shops in retail, barely viable manufacturing units, and small time service providers. This industry structure – thousands of pygmies – is a legacy of Indian policy and regulations. These regulations include a small scale industry (SSI) policy that only allowed certain products to be manufactured by small companies – and thus prevented their manufacturers from ever growing. Financial policy directed bank credit to the priority sector, which meant that a farmer could get a loan to buy a cow; but a dairy owner could not get a loan to expand his premises. The overall economic environment was not conducive to growth, either – tiny spots in industrial parks were rationed, there was no transport or communication infrastructure, purchasing land was incredibly difficult, as was finding employees with the right skill set.

The politically well connected, and large incumbents were always able to get through this. Professors Khanna and Palepu have theorized that the reason that conglomerates were successful in India is that they allowed each subsidiary to access the parent’s skill in obtaining licenses and dealing with regulations in an economy  that was starved of factor inputs like capital and skilled managers. More unscrupulous promoters would set up joint ventures with state Industrial Development Corporations, saddle them with debt, and decamp with the cash. Large companies which were already manufacturing a product that would get an SSI reservation could get a grandfathering exemption – and so Colgate was gifted years of monopoly power in the Indian toothpaste market.  Research by Subhrajit Guhathakurta showed that the SSI reservation policy led to  a monopoly or oligopoly of large companies serving the higher end of the market, and a panoply of small manufacturers serving the lower-end of the market with poor quality products.

India’s market structure provides us an insight into India’s corruption. The fact that there are so many small low-quality producers is the reason the endless payments to government inspectors persist. The small enterprises are too small to influence politicians to cancel the system of regulation, and so are forced to make the recurring small payments. There are so many of them that the costs involved in them banding together to influence policy are also prohibitive. And as Shleifer and Vishny point out, being competitive means you have to be corrupt when everyone else is doing it.

But it is not just a question of the lack of ability to influence policy. The victims of corruption are happy to see it continue.

This is for two reasons. First, while there is always the risk of an incorruptible or overzealous inspector shutting down your own enterprise, you also have the option of bribing that inspector to go after a competitor, or in fact your own enterprise if you want to force other shareholders out.

Secondly, freedom for the whole industry can be dangerous. If all your competitors are cut down to the same level as you, everyone makes a little money; but in a free environment, your nimbler and smarter competitors may quickly outstrip you. The risk of extinction by competition balances out the risk of extinction by an incorruptible bureaucrat. Building the skills required to win in a free environment is difficult for small enterprises to do. The result is a business environment where shareholders and inspectors profit at the expense of government, customers, and employees.

India is no stranger to large-scale corruption or bending of rules. Long before Anil Ambani’s outburst against the petroleum ministry, the SEZ policy, the recent controversy over allocation of new telecom licenses, and corruption in defence expenditure such as the Bofors purchase had rightly attracted outrage and media attention.

The bigger corruption appears more repugnant, but it is the smaller corruption that is more outrageous. This is because it corrupts the officials who interact directly with the weakest and poorest – beat constables, excise inspectors, and electricity board linesmen. Moreover, by making these posts lucrative, it encourages senior officials to auction them, and spreads corruption throughout the bureaucracy. Despite this, petty corruption does not attract attention, except in the occasional email forward or vigilante movie.

Policy moves that lead to systemic changes are more likely to work than Anniyan or Dombivili Fast style vigilantism, though. These can take the following forms:

  1. The government uses technology to ensure that it’s agents do not or can not seek bribes – for example, the computerization of railway ticket reservation in the 1980s
  2. The government removes its right to grant necessary permits, or at least creates competition within its arms to grant these – for example, ending industrial licensing.
  3. Most interestingly, a disruption in business models could mean that the game of all competitors bribing inspectors and passing the costs on to their customers or employees is no longer feasible. This could be triggered by one enterprise obtaining funds to invest and change the cost structure of the industry, or by new entrants, or the purchase of new technology. All of these will accelerate in an economic environment in which the markets for capital, corporate control, and technology are freed up. This is most visible in the Indian construction and highway building industry. The Golden Quadrilateral project allowed its contractors to be partially foreign-owned, creating a new breed of contractors who saved money by using capital intensive processes, not by cheating on material quality or specifications.But this disruption in business models will also be caused by reducing government intervention in some other area – FDI limits, financial regulation, or tax and labour laws – which restrict business dynamism.

India has taken baby steps in market liberalization. Industrial licensing has gone. The number of products reserved for SSI manufacture is down from a peak of 873 in 1984, to 21 today. For a medium enterprise to obtain formal financing is far easier today than it was fifteen years ago. These steps were not taken to reduce corruption by agents of the state, but have unintentionally accomplished it. Further liberalization will free not only markets, but also India’s many small enterprises from predation by state agents.


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