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Why More Corruption Created Fewer Problems for Companies?

Sebastian Eckardt's picture

A Ukrainian paradox
 
Kremenchug Hydroelectric Power PlantVZ-UK002 When Ukrainians took the streets in the winter of 2013/14, protests – sparked by the then Government’s decision to suspend the signing of the association agreement with the EU – reflected widespread discontent over deep-seated corruption. From its independence over two decades ago, Ukraine has struggled with corruption and state capture.  So-called oligarchs dominate large sectors of the Ukrainian economy, extracting rents and controlling the state through direct representation in the Parliament. This allowed oligarchs to tap into rich sources of corruption, including energy subsidies, discretionary public procurement, privatization of state assets and wide spread tax fraud and evasion. These governance failures created an economy largely built around redistribution of rents. Arguably, this accounts for much Ukraine’s dismal economic performance despite an abundance of natural resources, qualified human capital and a strategic location in the center of Europe.

Recent survey evidence suggests that corruption spread more rapidly during the years leading up to the protests on the “Maidan.” In the latest Business Environment and Enterprise Performance (BEEPS, 2013) survey, more than half the Ukrainian firms reported paying a bribe at least once during the past 12 months (up from 38 percent of firms in the 2008 BEEPS survey).  In addition, the reported cost of corruption also increased by more than four times relative to firm revenue.


Paradoxically, the same survey also shows that fewer firms perceive corruption to be a major problem. If more firms are paying higher bribes, how can we make sense of this? It is likely that corruption became more institutionalized and an accepted and expected practice in dealing with the authorities in the past few years. In fact, corruption – at least in some cases – benefited not only the officials receiving bribes but also the firms paying them. The economic benefit of the extracted “favors” exceeded the cost of bribes. For example, bribes were used to reduce or even avoid paying larger official tax payments. Even more effectively, through legislative capture, the tax code was eroded allowing large, well-connected companies to transfer most of their profits to off-shore havens with low taxes.
 
Why is it so difficult to get rid of corruption? It is clear that corruption imposes large costs on the economy as a whole. It weakens tax collections and therefore means fewer resources for investment in critical infrastructure and public services. It creates unfair and uneven treatment of firms, limits competition and erodes the regulatory environment and enforcement. However, viewed from the perspective of individual firms and officials who are part of the system, bribes may be entirely rational transactions. These individual incentives are the reason why it is so difficult to fight endemic corruption.
 
Among the many challenges faced by Ukraine today, combating corruption and building a rule-based system of governance based on trust between citizens and public institutions is vital not only for political stability but also for securing a prosperous future. How can it be done? Fundamentally, incentives need to change - both for citizens and firms paying bribes and for the officials receiving them. This will require bold reforms of public administration systems, including provisions for reducing opportunities for corruption, strengthened transparency and accountability, and effective administrative (and in severe cases criminal) sanctions when corruption is discovered. Most importantly, these reforms need to drain corruption at the source. The recent adoption of a new law on public procurement which eliminated exemptions and required open public tenders for most of public procurement is key in this regard. Equally important are reforms of the energy sector to reduce price differentials especially for natural gas which create opportunities to extract rents from arbitrage between different gas prices. Finally, tax and business climate reforms, in particular of the inspections and tax audit regime are critical to reducing opportunities for corruption and extortion in the interaction with businesses.
 
The incoming Government needs to accelerate these reforms and implement them systematically, even when resistance from vested interests is strong. After the political events of the past year, Ukrainians now have heightened expectations that the government will deliver on its promise of real change and transparent governance. These expectations are the strongest counterweight to oligarchic power and state capture. An engaged and vocal citizenry is Ukraine’s best bet at breaking the vicious cycle of corruption.

 

Comments

Submitted by Roland on

This is an excellent and quite insightful blog. Thank you for it. Is there any disagregated information on the distribution of the cost of corruption for businesses depending on their size? Arguably, mostly big companies or collectively organized ones can have leverage on policy making or influence tax administration. So smaller firms may pays a higher net price for corruption.

Submitted by Oleksii on

Thank you for your comment, Roland. There is disaggregated data, which we split into small (<20 employees) and other businesses. The price of corruption for small businesses has increased from 1.74 to 5.76% of annual revenue, while large and medium companies have the cost increased from 0.84% to 4.46%. That said, the inequality may be understated since large financial industrial groups would be the ones exercising considerable leverage over both policy making and tax administration, and they are likely underrepresented in the survey. In addition, the revenues that individual companies report will not capture profits of the largest companies (and thus large bulk of revenues) shifted outside of the country to offshore jurisdictions.

Submitted by Ahmad on

Great and timely blog! This is not just an Ukranian paradox but a problem that many countries share and your recommendations can certainly work in other countries as well. Another measure that should be adopted is raising the salaries of public employees such that the incentives for corruption are less. Right now bribes to some public sector employees exceed their annual salary by many folds. Hence, the other paradox: The government has to spend more money (it does not have) on improving the business environment, public sector capacity and wages before it can see an increase in its revenues.

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