The Nexus Of Corruption And Higher Income Part I

[I’ve been working on this for over a week now, hope you enjoy it. Since this is a very long post, I’ve split it into three parts. This is Part I]

This post isn’t a defense of corruption. It’s not an April Fool’s joke either.

There’s no doubt that corruption weighs on an economy and on society through many different channels – through higher costs of doing business, to redistribution of income, through reducing the rewards of entrepreneurship, through social and economic inequality, through reducing the level of trust in society (indirectly contributing to all the problems listed above, and more).

But…

There’s this meme I’ve been hearing and reading that if we can just handle corruption, Malaysia would easily become a high income nation.

The basis for this view is this seemingly convincing correlation between corruption and per capita income (this is the full dataset; the charts I’ve seen elsewhere are more simplistic):

The data is taken from Transparency International’s Corruption Perception Index (CPI) from it’s inception in 1995 to the latest numbers published a few months back (with a scale ranging from zero being totally corrupt, to ten meaning completely corruption free).

The horizontal axis is GDP per capita in current international dollars adjusted for purchasing power parity, from the IMF World Economic Outlook database (September 2011 edition – 2011 data and some past years data for some countries are based on estimates).

The chart above tabulates values of the CPI against per capita income for every country which has a score under the CPI (except for Kosovo, which has no GDP numbers).

The scatter plot of the data suggests that countries with lower levels of corruption have higher levels of per capita income. Therefore, the reasoning goes, the route to becoming a higher income economy can be trodden by simply reducing the level of corruption. If corruption represents costs to economic growth and development, reducing it would ipso facto improve the income level; Quod Erat Demonstrandum.

I wish it were so easy.

You could just as easily say that as income levels increase, the incentive for indulging in corruption falls. Countries have low levels of corruption because they have high income. QED.

And if you have a background in statistics or econometrics, you could also point out that the causal relationship might be two-way (corruption drives changes in income, AND income drives changes in corruption) or that income and corruption levels might be driven by a separate independent process, in which case the inverse causal relationship between corruption and income might be completely spurious i.e. there’s no real relationship at all, they just happen to move together.

In summary, corruption might cause income; OR income might cause corruption; OR both; OR neither. Correlation on its own does not really prove anything.

Now the ideal way to solve this conundrum is to figure out all the factors that contribute to income and corruption levels, throw them into a coherent model, and test the significance of the coefficient estimates.

That’s a little beyond the scope of a blog post.

But there’re ways to determine whether there is any causal relationship between corruption and income, without bringing in other variables.

The analysis of the data will be very wonkish, so if you’re allergic to statistical analysis, I’d advise jumping straight to the end.

[Continued in Part II]