Designing policies that promote innovation and growth is key to development. In many countries there is also considerable corruption, with government officials seeking bribes and many firms underreporting their revenues to the state to evade taxes. Might there be a set of reforms that allow policymakers to kill two birds with one stone, both reducing corruption and boosting innovation? New research suggests financial sector reform may be able to play this role.
In a recent paper with co-authors Meghana Ayyagari and Vojislav Maksimovic, we look at corruption—defined as both bribery of government officials and tax evasion—and how this is associated with firm innovation and financial development. Using firm-level data for over 25,000 firms in 57 countries, we investigate whether firms are victims, who pay more in bribes than they gain by underreporting revenues to tax authorities, or perpetrators, who gain more by avoiding taxes than they lose in paying bribes.
Of particular interest is the effect of corruption and tax evasion on innovative firms. Specifically, we explore the following questions:
- Which firm characteristics, e.g. size, age, industry, and legal status, are associated with bribe payments and underreporting of revenues to tax authorities?
- Does corruption operate as a tax on innovation? Are there particular innovative activities such as introducing new products or introducing new technologies associated with greater bribe payments to government officials?
- Do firms that pay more bribes also evade more taxes? Do firm characteristics explain across countries whether a firm is on balance a victim or a perpetrator?
- What is the role of the financial system in limiting the extent of underreporting of income? How do banks compare with informal financing channels in curbing illegal behavior?
To capture the net burden of corruption on firms, we construct the variable Firm Type, which takes on four values: Abiders if the firm reports paying no bribes and evading no taxes, i.e. they abide by the law; Perpetrators if the firm reports paying no bribes but does report evading taxes; Victims if the firm reports paying bribes but not evading taxes; and Retaliators if the firm reports paying bribes and evading taxes. We see that about 40% of the firms in our sample are abiders, neither paying bribes nor underreporting revenue for tax purposes; 23% are retaliators hence doing both, 14% are victims, only paying bribes, and another 23% are perpetrators, only underreporting revenue.
When we examine firm characteristics associated with bribe payments, we see that smaller and younger firms report paying a larger percentage of their sales as bribe payments. We also find the odds of having to pay bribes increase significantly for innovative firms compared to non-innovators. Thus, in our sample of countries, corruption acts as a tax on innovation. Interestingly, this is only true for corruption associated with rent-seeking perpetrated by the public sector. When we investigate the impact of private rent-seeking—for example, payments to organized crime to prevent violence—we find no such effect. This is consistent with arguments that private rent-seeking targets the productive rather than the innovative sector of the economy, whereas public rent-seeking focuses on the innovators. Overall, we find strong evidence that bribe payments to government officials are tied to innovative projects, confirming that innovative firms are taxed for their innovation. These firms pay off government officials across various departments to be able to get things done and innovate.
We also find that there is a significant association between bribes and tax evasion. Firms that pay bribes underreport their revenue on average by 6.13% more than firms that do not pay bribes. This is consistent with theories that government corruption breaks an implicit contract between citizens and the state, prompting firms to retaliate by evading taxes. In instrumental variable regressions, using time spent dealing with government officials (other than the tax inspectorate) as an instrument for bribes, we find a significant causal association between bribe payments and tax evasion.
When we examine the net burden of corruption on innovators, we find that while some innovators do retaliate by evading taxes, overall innovators are more likely to be victims, who pay bribes but do not evade taxes, than perpetrators, who don’t pay bribes but do evade taxes.
Finally, firms that rely on bank finance to pay for new investments and working capital are more likely to be victims (paying bribes but not evading taxes), whereas firms that use informal financing and financing from family and friends and other sources are more likely to be perpetrators (evading taxes despite not having to pay bribes).
We believe the analysis in our paper has significant implications for anti-corruption policy reforms and related policies geared towards improving tax collection and administration. Our results suggest that financial sector reform is integral to this debate since formal financial intermediation and bank monitoring play a critical role in helping curb tax evasion. In contrast to financing through banks, we show that informal financing channels are associated with negative outcomes such as increased tax evasion. In earlier work we have already shown  that the greater the proportion of investment a firm finances externally from formal channels, particularly from banks, the more innovative it is. Hence financial sector reform may not only help curb corruption, but also give a boost to innovation.
Ayyagari, Meghana, Asli Demirguc-Kunt and Vojislav Maksimovic, “Are Innovating Firms Victims or Perpetrators? Tax Evasion, Bribe Payments and the Role of External Finance in Developing Countries ,” World Bank Policy Research Working Paper.