Abstract
This article adds to the empirical literature on the relationship between corruption and economic growth by incorporating the impact of economic freedom. We utilize an econometric model with two improvements on the previous literature: (1) our model accounts for the fact that economic growth, corruption, and investment are jointly determined, and (2) we include economic freedom explicitly as an explanatory variable. Using a panel of 60 countries, we find that for countries with low economic freedom (where individuals have limited economic choices), corruption reduces economic growth. However, in countries with high economic freedom, corruption is found to increase economic growth. Our results contradict the generally accepted view that corruption lowers the rate of growth. We use Osterfeld's (1992) distinction between expansive and restrictive corruption to explain our results. According to Osterfeld, corruption expands output if more bribes help the economy move toward greater free exchange. Thus, in economies where economic freedom is high, if bribing makes public officials less diligent in enforcing restrictions on firms' activities, output will increase. However, corruption will restrict output when bribes reduce competition and increase market rigidities. This outcome is more likely in countries where economic freedom is low due to widespread state ownership of assets (e.g., in China), monopolies and high tariff barriers granted to businesses owned by ruling elites and their cronies (e.g., the Philippines under Marcos and Indonesia under Suharto), and state-run marketing boards that are often the sole purchasers of agricultural products (e.g., in several African countries). An increase in corruption in these low economic freedom countries means even less competition and free exchange and leads to a fall in output. The policy implication of our finding is straightforward: The surest way to mitigate corruption and its adverse effects is to increase economic freedom. Private property rights need to be better protected if economic freedom is to increase. The protection of the right to one's person and property and the right to make choices about their disposition are the essence of economic freedom. When allocative decisions are made in a system where economic freedom is strong, markets lead to an efficient outcome. Societies obviously do not use such a one-dimensional system of allocation. The political system restricts or augments the economic power of individuals or groups on the basis of society's expressed preferences for goals other than efficiency. We define corruption as the use of public office for private gain. It occurs at the fault line between the society's pursuit of the expressed non-efficiency preferences and the outcome that would occur when economic freedom is complete. This fault line, however, is amorphous because individuals' desire for economic freedom and the benefits that flow from it leads them to circumvent government regulations that limit the scope of legal market transactions. Thus, corruption, as well as its economic effects, is conditioned by the degree of economic freedom that market participants enjoy.