Evidence Suggests Windfall Government Revenue Worsens Corruption

Blog, Commentary, Equalization, Steve Lafleur

A study published in this month’s American Economic Review demonstrates that increased federal transfers to municipalities in Brazil lead to increased corruption (this post will quote the non-gated working paper available here which forms the study’s basis). While one can quibble over whether the effect is as strong in more developed countries, the results are precisely what should be expected, given the incentives facing politicians.

The authors describe the model below:

The model highlights three specific channels of operation of windfall government revenues through the political process. First, an increase in resources available to a government leads to an increase in corruption of the incumbent (a moral hazard effect). This happens because, with a larger budget size, the incumbent has more room to grab political rents without disappointing rational but imperfectly informed voters. Second, a larger budget induces a decline in the average ability of the pool of individuals entering politics (a selection effect). This is a byproduct of the first result (that rents increase with budget size) and of the assumption that political rents tend to be more valuable for political candidates of lower ability. Third, there is an interaction between these two effects that further increases the adverse consequences of a windfall of revenues on political corruption: an incumbent facing less able opponents can marginally grab more rents without hurting his reelection prospects. Finally, the selection effect highlighted above also implies that windfall revenues increase the equilibrium probability of reelection of the incumbent, despite his grabbing more rents.

The results match up well with the above theory:

The empirical findings accord well with the implications of the theory. Specifically, an
(exogenous) increase in federal transfers by 10% raises the incidence of a broad measure of corruption by 12 percentage points (about 17% with respect to the average incidence), and the incidence of a more restrictive measure—including only severe violation episodes—by 10.1 percentage points (about 24%). At the same time, larger transfers (by 10%) worsen the quality of the political candidates challenging the incumbent, decreasing the fraction of opponents with at least a college degree by 3 percentage points (about 7%). As a result, the incumbent who receives higher transfers experiences a raise in his probability of reelection by 4.1 percentage points (about 7%).

This theory has significant implications for Canada, since our provinces have become so dependent on federal transfers, and our municipalities are dependent on both federal and provincial transfers. Corruption, low quality candidates, and lessened political competition would be pretty serious side-effects of our inter-governmental fiscal transfers, especially given that these fiscal transfers are already counter-productive without accounting for the above considerations.

If the theory applies in Canada, have-not provinces (and those with huge windfall revenues) and cities that are highly dependent on federal and provincial transfers should have the lowest quality governance (e.g. Manitoba, Quebec, Alberta, Toronto). I leave it up to the reader to judge whether this sounds plausible.