Chapter 1

Governance, Corruption, and

Public Finance: An Overview
Vito Tanzi

Introduction
Growing attention has been directed in recent years to the role
of government. Governance in general and corruption in
particular have been much discussed because of the way they
affect, and are affected by, the role of government. Dictionaries
generally define governance as government. Thus, good
governance is good government. In recent writing, however,
governance has taken on a more substantive, though still not
precisely defined, meaning.
Good governance is an essential part of a framework
for economic and financial management which also includes:
macroeconomic stability; commitment to social and economic
equity; and the promotion of efficient institutions through
structural reforms such as trade liberalization and domestic
deregulation.
Poor governance may result from factors such as
incompetence, ignorance, lack of efficient institutions, the
pursuit of economically inefficient ideologies, or misguided
economic models. It is often linked to corruption and rent
seeking. A good part of this paper will thus deal with corruption.
However, it should be understood that corruption is not
identical with poor governance, which extends well beyond
corruption, although poor governance often leads to
corruption and corruption is an important element of poor
governance.

GOVERNANCE, CORRUPTION, AND PUBLIC FINANCIAL MANAGEMENT

Before dealing with governance and corruption issues

vis--vis public revenue and public expenditure, I would like
to note two simple relationships emerging from international
experience: (i) corruption is generally less frequent in richer
countries; and (ii) there is a negative correlation between the
rate of growth and corruption. Thus, more corrupt countries
tend to be poorer, and to grow slower (if at all).

Corruption
Views about corruption have undergone a great change in recent
years. Not too many years ago, the economic successes of the
countries of South East Asia were attributed by some observers
to a presumably positive impact of corruption on facilitating
decision making. However, after the crisis of 19971998, these
views changed and many observers, both inside and outside
the crisis countries, blamed corruption for the crisis. For
example, it was pointed out that some individual investors had
been able to borrow very large sums from banks at low rates,
sums which had been invested in highly questionable projects.
After the crisis there has been a strong interest in increasing
the transparency of institutions and in promoting more arms
length relationships in economic deals. Whether this interest
will generate concrete changes remains to be seen.
Corruption has also attracted a lot of attention in Russia,
Pakistan, Kenya and many other countries. Many observers
have connected the poor functioning of these economies to
various governance problems. In fact, there is now a growing
awareness among economic observers and economists that
these governance problems have a negative impact on economic performance. For this reason, the new architecture for
the world financial system is paying a lot of attention to
transparency and governance issues. Standard and codes of
conduct are being developed and countries are being urged
to adhere to them.

Governance, Corruption, and Public Finance: An Overview

Several international organizations including the

Asian Development Bank, the International Monetary Fund,
the Inter-American Development Bank, the OECD, and the
World Bank have intensified their work in this area and have
been promoting a campaign against corruption and for more
transparent and well-governed economies. The work of these
institutions has been complementary and with a common
objective, namely, to promote good governance and by so
doing to improve the quality of policy making. It is hoped
that this improvement will reduce the frequency and severity
of financial crises and will promote economic growth.
Until recent years, some economists presented what
could be called a romantic view of corruption. Such a view made
corruption seem almost a virtuous activity. For example, it was
argued that corruption oiled the economic mechanism or
greased the economic wheel and made economies more
efficient by removing rigidities which put obstacles to
investment and economic activity in general. Some argued that
corruption allocated investment to the most efficient uses
because the most efficient investors would be able to pay
the highest bribes. Some argued that even the efficiency in
the use of time could be improved by corruption because
those whose time was most valuable could save on its use
by paying the highest bribes to move in front of bureaucratic
lines. Finally, it was even argued that corruption made it
possible for the government to keep wages lowbecause the
bribes that the public sector employees received made them
accept lower wages. Low wages allowed taxes to remain low
and low taxes stimulate growth. Various theoretical articles
supported these somewhat unorthodox and at times even
bizarre conclusions.
This romantic view of corruption has been replaced, in
more recent years, by a more realistic and much less favorable
view. In fact, the more recent view is that, rather than being the
oil that lubricates the economic mechanism, corruption is the
rust that slows it down. It has been argued that rigidities created

GOVERNANCE, CORRUPTION, AND PUBLIC FINANCIAL MANAGEMENT

by regulations are not God given but are, rather, man created
and thus endogenous to the system. Once bureaucrats realize
that they can take advantage of regulations, they will produce
more of these. There will thus be more regulations and these
will probably become less transparent. The highest bribes will
be paid not necessarily by those most efficient at producing
but by those most efficient at rent seeking. Furthermore, the
potentially most able individuals will channel their energies
towards rent seeking rather than towards socially productive
activities. It has also been pointed out that corruption is
contagious so that its nefarious effects spread with the passing
of time and affect a progressively larger proportions of the
relevant population.
Corruption can be defined in different ways. However,
the most common definition is that it is the abuse of public
power to promote private benefits. Thus, a public employee
who abuses his/her public position to derive benefits for oneself
or friends, relatives or political associates is engaging in an act
of corruption. Not all cases of corruption involve the payment
of bribes.
An important question is whether corruption can be
measured directly. A moment of thought indicates that such an
attempt is unlikely to be successful. It is not even clear what
one would wish to measure. Should one attempt to measure
acts of corruption? Or amount of bribes paid? Or number of
persons involved? Or number of transactions contaminated by
corruption? It is not clear which but, in any case, none of these
attempts at measuring corruption would be successful. For this
reason, not surprisingly, there is no direct measurement of
corruption available for any country.
While no direct measurement of corruption exists,
following a trend that is becoming more and more common in
economics and in other fields such as political science and
sociology, in recent years, data have become available that
attempt to measure not corruption per se but peoples
perceptions of the prevalence of corruption.

Governance, Corruption, and Public Finance: An Overview

In this approach, presumably informed observers are

asked to rank countries, often on a score of 1 (most corrupt) to
10 (least corrupt). It is not always clear whether the samples
are random and large enough to provide statistically acceptable results. It is also not clear to which extent the data are fully
comparable across countries and over time. However, there are
now at least six institutions, including Transparency International and the World Bank, that have been generating data on
the perception of corruption. In spite of their shortcomings, the
data are being used with increasing frequency by economists
in their cross-country statistical studies. It is important to add
that the users often ignore the weakness of the data and may,
at times, draw perhaps too strong conclusions from them. At
the same time, it is important to point out that there is a high
correlation among the various indexes of corruption provided
by the various institutions. This gives some assurance that they
are broadly on target.
Various factors contribute to corruption. See Tanzi (1998)
for more details. Some of these factors have a direct impact;
others only an indirect one. Among the factors which have a
direct impact we should include (a) regulations and authorizations; (b) complex tax systems; (c) government spending
decisions; (d) public provision of goods and services at below
market prices; (e) situations in which public employees have
discretionary power over economic decisions; and (f) need to
finance political parties. Among the indirect causes must be
included (a) the quality of the bureaucracy; (b) the level of public
wages; (c) institutional controls, both internal and external;
(d) the severity of the penalty system; (e) the transparency of
rules, laws, and processes; and (f) the example provided by the
leadership of the country.
The factors listed above are probably the most important
that in various ways determine the extent of corruption in a country.
In the next section we discuss in some detail the relationship
between the structure of public revenue and public expenditure
and governance in general and corruption in particular.

GOVERNANCE, CORRUPTION, AND PUBLIC FINANCIAL MANAGEMENT

Governance and Taxation

Good governance calls for taxes that are based on clearly written
laws and do not require frequent contacts between tax payers
and tax administrators, which are more likely to lead to acts
of corruption by tax administrators. Corruption is likely to
be a major problem to tax and customs administrations in
the following situations (Tanzi, 1998):
The laws have many exemptions and special
treatments.
The laws are difficult to understand and are subject
to different interpretations so that taxpayers need
assistance in complying with them.
Frequent contacts between taxpayers and tax
administrators are required to determine tax
liabilities and pay taxes.
Tax administrators are paid low wages.
Acts of corruption on the part of tax administrators
are ignored, not easily discovered, or, when discovered, are not penalized or penalized only mildly.
Administrative procedures (e.g., the selection of tax
payers or audits) lack transparency and are not
closely monitored within the tax or customs
administration.
Tax administrators have discretion over important
decisions, such as those related to the provision of
tax incentives, the determination of tax liabilities,
the selection of audits, and litigations.
More broadly, the state (the principal) exercises weak
control over the agents that carries out its functions.
In case of political corruption, those who represent the
state (president, prime minister, ministers) or their close relatives
and cronies may use the tax and customs administrations to
pursue rent seeking and corrupt practices. They can even write
the laws to their own advantage.

Governance, Corruption, and Public Finance: An Overview

In some countries (e.g., Peru and Uganda), the tax

administration became so riddled with corruption that the
government decided to close it down and replace it with a new
and more independent one. Several countries have had very
corrupt customs administrations. This has led in some cases to
the jailing of the director of customs and in others to the
replacement of the domestic customs organizations with foreign
companies providing preshipment inspection services.
Reports from several countries indicate an unusually
large number of applicants for poorly paid jobs in tax or
customs administration, suggesting that the applicants are
aware of the opportunities for extra incomes that these jobs
can create.

Governance and Public Spending

Corruption can affect public expenditure in different ways. The
categories of public expenditure most affected by corruption
are discussed below. In all these areas, lack of transparency and
of effective institutional controls are the main factors leading
to poor governance.
Public investment projects have frequently lent themselves to acts of high-level corruption or rent seeking. Because
of the discretion that some high-level public officials have
over decisions regarding public investment projects, this type
of public spending can become distorted, both in size and
in composition, by corruption and rent seeking. Public
projects have, at times, been carried out specifically to
provide some individuals or political groups with opportunities to receive commissions from the project
implementers, or to benefit particular areas or individuals.
This has reduced the efficiency of such expenditures and has
resulted in projects that would not have otherwise been
justified on the basis of objective criteria of investment
selection such as cost-benefit analysis.

GOVERNANCE, CORRUPTION, AND PUBLIC FINANCIAL MANAGEMENT

Procurement, i.e., the purchase of goods and services, is

another area that is often affected by poor governance. To lessen
the possibility of corruption, some countries have developed
complex and costly procedures which may have reduced
corruption at the cost of sharp increases in the prices of some
goods and delays in the corresponding government activities.
Extrabudgetary accounts for given types of expenditure
or revenue are common in many countries. Some of them are
set up for legitimate purposes (pension funds, road funds, etc.).
Others may be set up to reduce the political and administrative
controls that are likely to accompany budgetary spending.
In some countries, the money received from foreign aid or from
the sale of natural resources such as oil and other minerals
is channeled into special accounts which are typically less
transparent and less closely controlled than budgetary funds.
Some of this money may find its way into illegitimate uses
or pockets.
Ghost workers, dead pensioners, etc., are often used by
unscrupulous individuals to collect unearned payments, in the
absence of adequate human resource databases and poor
expenditure controls.
Goods and services provided at below-market prices in most
countriesforeign exchange, credit, electricity, water, public
housing, some basic commodities, access to educational and
health facilities, access to public land, and so onhave provided
fertile ground for abuses and corruption by individuals who
benefit enormously from access to such goods and services.
At times, because of limited supply and large demand,
rationing or queuing becomes unavoidable. Excess demand is
created and decisions have to be made to apportion the limited
supply. These decisions are often made by public employees.
Those who want these goods (the users) are often willing to pay
bribes to get access (or greater access) to what the government
is providing. It is thus not surprising that cases of corruption
have been reported in all the areas mentionedabove. Often, poor
institutional capacity hinders the control of abuses.

Governance, Corruption, and Public Finance: An Overview

Other Discretionary Decisions

Besides the areas mentioned above, public officials in many
countries may be granted discretion over important decisions;
in these cases, corruption, including high-level or political
corruption, can reach significant proportions. The most
important of these discretionary decisions are as follows:
Provision of tax incentives against income taxes,
value-added taxes, and foreign trade taxes, which
may be worth millions of dollars in reduced future
liabilities to those who benefit from the exemptions.
Decisions regarding the particular use of private land
(zoning laws), which determine its market value. A
piece of land that can be used only for agriculture will
have low market value, while land on which highrise buildings can be built becomes very expensive.
Decisions regarding the use of government-owned
land (e.g., for logging). Major cases of corruption
related to permissions granted to cut trees in publicly
owned forests or to exploit public lands for their mineral wealth have been reported in several countries.
Decisions authorizing major foreign investments,
often in conjunction with domestic interests, which
provide the investors with monopoly power or
access to valuable natural resources.
Decisions related to the sale of public-sector assets,
including the right to extract natural resources.
Decisions on the privatization of state-owned
enterprises and on the conditions attached to that
process, such as the degree of regulation of the industry.
Decisions providing monopoly power to particular
export, import, or domestic activities. Crony
capitalism has often been linked to such decisions.
Decisions such as those described above are often worth
a lot to individuals or enterprises. Some of these will naturally

10

GOVERNANCE, CORRUPTION, AND PUBLIC FINANCIAL MANAGEMENT

attempt to get favorable decisions, in some cases by paying

bribes and in other cases by simply exploiting close personal
relations with public officials. The bribes may be paid to lowpaid public officials whose temptation price may be far less
than the value of the potential benefit to the bribers.

Some Quantitative Results

Corruption and poor governance may affect economic
performance through their impact on tax revenue, public
spending, and fiscal deficit. In particular, a study to investigate
empirically the impact of corruption on tax structure shows that:
High-level corruption reduces tax revenue.
Corruption reduces most the revenue from social
security tax, then sales tax revenues; it reduces
personal income taxes least.
A one-point increase in the corruption index reduces
tax revenue collected by 2.7 percent of GDP.
Corruption increases tax evasion. The sample
showed a negative relationship between corruption
and the productivity of the value-added tax (VAT)
per unit of nominal rate.
Using some of the indices of corruption now available,
various researchers have tested several hypotheses bearing on
the relationship between corruption and growth. These results,
summarized below, show that governance matters a lot in the
allocation and management of public resources.

Corruption and investment

Most economists accept that a positive connection exists between
investment and growth. Therefore, if corruption affects investment, it must also affect growth. Corruption may affect investment

Governance, Corruption, and Public Finance: An Overview

11

in different ways. It may affect the amount of total investment,

the amount of foreign direct investment, the size of public
investment, and, of course, the quality of investment decisions.
In several papers, Paolo Mauro of the IMF has shown
that corruption can have a significant negative impact on the
ratio of total investment to GDP (Mauro 1997). Regressing the
investment ratio in relation to the corruption index, GDP per
capita in 1960, secondary education in 1960, and population
growth, he showed that a reduction in corruption could
significantly increase the investment/GDP ratio. On the other
hand, a drop in the investment/GDP ratio as a result of
corruption was shown to have an important effect on growth.
Mauro estimated that a reduction in corruption equivalent to
two points in the corruption index would raise the annual
growth rate by about 0.5 percent through its positive effect on
the investment/GDP ratio. In addition, as discussed later,
corruption is likely to affect adversely the quality of investment.
Corruption and foreign direct investment. In a paper
focusing on foreign direct investment (FDI), Shang Jin Wei
(1997a) showed that while a one-percentage-point increase in
the marginal tax rate on foreign investment reduces FDI by
about 3.3 percent, an increase in the corruption index by a single
point reduces the inflow of FDI by about 11 percent. Thus, an
increase in the corruption index from, say, the Singapore level
to the Mexican level, would reduce FDI almost as much as a
one-fourth increase in the marginal tax rate.
In a related work, Wei (1997b) also showed that the
unpredictability of corruption (as measured by the dispersion
of individual ratings of corruption) has a further negative impact
on FDI. A higher level of dispersion makes corruption behave
like an unpredictable and random tax. Wei concluded that the
effect of uncertainty on FDI is negative, statistically significant
andlarge. An increase in uncertainty from the level of
Singapore to that of Mexicois equivalent to raising the tax
rate on multinational firms by 32 percentage points.

12

GOVERNANCE, CORRUPTION, AND PUBLIC FINANCIAL MANAGEMENT

Corruption and public investment. Tanzi and Davoodi

(1998) have argued that corruption is likely to increase public
investment because public investment can be easily
manipulated by powerful political or bureaucratic personalities,
and often gives rise to the payment of higher commissions
by those who carry out the project. Regressing public investment
as a share of GDP against the corruption index, real per capita
GDP, and the share of government revenue in GDP, Tanzi and
Davoodi showed the corruption index to be highly significant
(at the 1 percent level). The more corruption there is, the more
public investment there will be. (See also Ades and Di Tella [1997].)
The reduction in the total investment ratio and the FDI
ratio can be assumed to have a clear negative impact on growth.
However, an increase in the share of public investment in GDP
has a more ambiguous impact on growth. More evidence is
needed to reach a definite conclusion.
Corruption and operation and maintenance
expenditure. Despite great difficulties in getting good data,
Tanzi and Davoodi have provided evidence that, other things
being equal, high corruption is associated with: (i) low operation
and maintenance expenditure; and (ii) poor quality of
infrastructure.
In terms of statistical significance, the impact o f
corruption is strongest on the quality of roads, power outages,
and railway diesels in use. Most of these relationships survive
when real per capita GDP is added to the equation as an
independent variable. Thus, the costs of corruption should also
be measured in terms of the deterioration in the quality of the
existing infrastructure. These costs can be very high in terms
of their impact on growth.
Ades and Di Tella (1997) have also tried to estimate the
impact of industrial policies (identified with procurement
preferences for national champions and unequal fiscal
treatment of different enterprises). They found corruption to
be higher in countries pursuing an active industrial policy.

Governance, Corruption, and Public Finance: An Overview

13

To sum up, corruption reduces total investment, distorts

its composition, and reduces the quality of a countrys
infrastructure. The combined impact of these changes on
economic growth is bound to be negative and substantial.
Corruption and the composition of public spending. In
addition to the above, corruption may have other effects on
expenditure, which may be important for growth. Mauros
research has shown that more corrupt countries spend less for
education and health. This result has been confirmed by Gupta,
Davoodi, and Alonso-Terme (1998). Because these categories
of expenditures are generally assumed to promote growth,
corruption in this regard can also have a negative effect on growth.
Finally, both Mauro (1997) and Tanzi and Davoodi (1997)
have shown that in countries with high corruption, the GDP
share of tax revenue collected tends to be lower because some
of the tax revenue is diverted to the pockets of tax administrators.
Thus, the true burden of taxation on the taxpayers is not reduced.
An overly high level of taxation may lead to a suboptimal level
of public spending and, perhaps, to higher fiscal deficits.

Policy Conclusions
Governance problems may arise in connection with many
principal-agent relationships. In any one of the relationships
shown in the figure below problems of poor governance can
emerge. These problems exist in any society but tend to be more
severe in some countries and under certain conditions. What
can be done?
One strategy is to pursue a zero-tolerance approach to
corruption without changing the role of the state. Such an approach
would rely on:
ethics offices;
anticorruption commissions;
tighter controls on public officials;

GOVERNANCE, CORRUPTION, AND PUBLIC FINANCIAL MANAGEMENT

Figure 1.1
Principal-Agent Problems in Policymaking
Ideal Government
?

Actual Government
?

Individual Ministers
?

Principal Secretaries, Heads of Institutions

?

Heads of Departments

Heads of Divisions
?

Individual Civil Servants

Taxes

14

Spending

Other

Governance, Corruption, and Public Finance: An Overview

15

higher penalties for those who are caught in acts of

corruption;
higher wages for public-sector employees;
reduction in the right to privacy of government
employees and those who deal with them (for
example, by requiring employees to report on the
value of their assets);
anticorruption efforts undertaken at the international
level, such as those sponsored by the OECD, the
ADB, the World Bank, and other regional or
international organizations, or at the national level by
active civil society and a free press.
This approach would undoubtedly help in improving
governance but, unless accompanied by efforts to modify and
reduce the role of the state in the economy, it may not go far
enough. To make significant progress against corruption and
poor governance, it is also important to modify the role of the
state by reducing its reliance on regulations, authorizations,
quasi-fiscal activities, and other activities and tools that lend
themselves to abuse by public officials. It is also important to
make the states actions more transparent.
In the context of the architecture of the international
financial system, the IMF in 1998 developed a Code of Good
Practices on Fiscal Transparency aimed at increasing transparency
in fiscal policy. The Code contained several principles that could
be followed by countries to increase fiscal transparency. The
application of these principles would make fiscal policy more
transparent and in the process reduce the scope for poor
governance. Among the principles are the following:
The government sector should be clearly
distinguished from the rest of the economy, and
policy and management roles within government
should be well defined.
There should be a clear legal and administrative
framework for fiscal management.

16

GOVERNANCE, CORRUPTION, AND PUBLIC FINANCIAL MANAGEMENT

The public should be provided with full information

on the past, current, and projected activity of
government.
A public commitment should be made regarding the
timely publication of fiscal information.
Budget documentation should specify fiscal policy
objectives, the macroeconomic framework, the policy
basis for the budget, and identifiable major fiscal risks.
Budget data should be classified and presented in
a way that facilitates policy analysis and promotes
accountability.
Procedures for the execution and monitoring of
approved expenditures should be clearly specified.
The integrity of fiscal information should be subject
to public and independent scrutiny.
In conclusion, actions to improve governance and to
fight corruption need to be taken on several fronts. Both the
demand for acts of corruption and the supply of such acts would
need to be reduced.

References
Ades, Alberto, and Rafael Di Tella. 1997, National Champions
and Corruption: Some Unpleasant Interventionist
Arithmetic, Economic Journal, Vol. 107 (July), pp.
1023-42.
Gupta, Sanjeev, Hamid Davoodi, and Rosa Alonso-Terme. 1998.
Does Corruption Affect Income Inequality and Poverty?
Washington, D.C.: International Monetary Fund.
Mauro, Paolo. 1997. Why Worry About Corruption? Washington,
D.C.: International Monetary Fund.

Governance, Corruption, and Public Finance: An Overview

17

Tanzi, Vito. 1998. Corruption Around the World. IMF Staff

Papers. Washington, D.C.: International Monetary Fund
(December).
_______, and H. Davoodi. 1998. Roads to Nowhere: How Corruption
in Public Investment Hurts Growth. Washington, D.C.:
International Monetary Fund.
Wei, Shang-Jin. 1997. Why is Corruption So Much More Taxing
than Tax? Arbitrariness Kills. Cambridge, Massachusetts:
National Bureau of Economic Research.
_______. 1997. How Taxing is Corruption on International
Investors? NBER Working Paper. Cambridge,
Massachusetts: National Bureau of Economic Research.