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Rent Seeking, Institutions, and Policy Effectiveness

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International Monetary Fund. Research Dept.
Published Date:
September 2005
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Era Dabla-Norris

A large body of earlier theoretical and empirical research at the IMF analyzed the impact of corruption and rent seeking on economic efficiency, equity, and growth, while providing insights into its origins, effects, and possible remedies. Recent IMF research has focused on the nexus between rent seeking and weak institutions, as well as on ensuing implications for the effectiveness of government policies. This article provides a selective review of research in this area.

Chakraborty and Dabla-Norris (2005) develop an economic model of the relationship between rent-seeking behavior, distribution of wealth, and economic performance in order to address the question of what drives entry into rent-seeking activities. They show that in the presence of weak institutions for property rights protection, imperfect credit markets, and a fixed cost to rent seeking, only wealthy agents choose to engage in rent-seeking activities, as this enables them to protect their wealth from expropriation by others. In this environment, simply taxing the rich and redistributing tax revenues to the poor may be counterproductive if it raises the post-tax endowments of the poor and gives them incentives to engage in rent seeking.

A better policy option would to use tax revenues to subsidize production directly, since this raises the return to investment for all. Ruhashyankiko and Yehoue (forthcoming) develop an occupational model embodied in an agency framework to analyze whether rent-seeking behavior is an outcome of a lack of outside options for public officials. They show that technologically-induced private sector expansion leads to a decline in public rent seeking, as it provides an outside option to public officials who might otherwise engage in such activities. They distinguish between public and private rent seeking, and provide empirical evidence that suggests that a decline in public rent seeking outweighs any potential increase in private rent-seeking activities that could accompany private sector expansion.

The availability of natural resources in developing countries is frequently cited as a factor that contributes to rent seeking. Sala-i-Martin and Subramanian (2003) find that the presence of natural resources that generate rents and are easily appropriable, such as oils and minerals, can exert a negative and nonlinear impact on a country’s long-run growth through its deleterious impact on the quality of institutions.

“While economists and policymakers have long recognized that institutions matter in determining economic performance, a more difficult question is why, given the high costs of rent seeking, countries do not improve their institutions and root out such behavior.”

While economists and policymakers have long recognized that institutions matter in determining economic performance, a more difficult question is why, given the high costs of rent seeking, countries do not improve their institutions and root out such behavior. A possible reason for the persistence of widespread rent seeking and low economic growth in many countries is that the more widespread the rent seeking, the lower the likelihood of detection and punishment. Such strategic complementarities and the ensuing multiplicity of equilibria that arise—a good equilibrium with low levels of rent seeking and high growth, and a bad equilibrium with pervasive rent seeking and low growth—are investigated by Dabla-Norris and Freeman (2004) and Mauro (2002). They conclude that gradual reforms are less likely to work than more ambitious ones, and that external intervention and support may be required to extract countries from the vicious circle in which they seem to be stuck. Damania, Fredriksson, and Mani (2003) develop a political economy model to examine the persistence of rent seeking and policy distortions. They show that in politically unstable regimes, the institutions necessary to monitor and enforce compliance with regulations are weak, which, in turn, increases incentives for rent-seeking behavior, resulting in a higher level of noncompliance with existing regulations.

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The role of rent seeking and weak institutions in undermining policy effectiveness has been analyzed in a wide range of contexts. Gupta and Abed (2002) provide a comprehensive review of the earlier empirical research at the IMF on the impact of corruption and rent seeking on public finances and inequality. Recent research has sought to explain why the effectiveness of uniformly provided public programs in achieving redistributive goals—for instance, in education and health—remains questionable in many developing countries. Dabla-Norris and Gradstein (2004) develop a dynamic model of public education spending designed to achieve egalitarian objectives. However, the presence of weak governing institutions allows the rich to engage in rent seeking with regard to public education funds, thereby skewing the incidence of public spending in their favor. This, in turn, has adverse dynamic implications for the distribution of income, in-tertemporal mobility, and long-run growth. It also provides an explanation for why public spending may not have the desired impact on poverty and social outcomes.

On the revenue side of the budget, Danninger, Cangiano, and Kyobe (2005) analyze how interference and inefficiencies in the revenue forecasting process in low-income countries can be attributed to rent-seeking behavior and state capture. They show that in weak institutional environments, interference in the revenue forecasting process can serve as an instrument to conceal the extraction of public resources. If the public has sufficiently little access to information, the government can hide theft or mismanagement of revenues during the collection process by adjusting revenue forecasts. The analysis highlights the importance of transparency and information disclosure in helping to reduce forecasting interference and improving the effectiveness of the budget formulation process.

Huang and Wei (2003) examine the implications of rent seeking for the design of monetary policy. Under an inflation targeting framework, they show how a socially optimal level of inflation targeting is influenced by rent capture, as measured by an erosion of the government’s ability to collect revenues through formal tax channels. They find that the optimal inflation target is higher for countries with a higher degree of rent capture. In addition, they show that the credibility of other monetary regimes, such as a pegged exchange rate regime, currency board, or dollarization, is likely to be undermined, and that these regimes fail in countries with rampant rent seeking. Moreover, the authors find that the notion that a low inflation target or a currency board can be used as an instrument to induce governments to fight corruption is questionable in environments where there are high initial levels of rent seeking.

Finally, Fredriksson and Mani (2002) adopt a common agency framework to analyze the relationship between the rule of law, rent seeking, and environmental policy. They find empirical support for their theoretical prediction that better quality institutions increase environmental stringency, but this effect is lower when rent seeking is more pervasive. Their findings imply that reform of the legal system may have important effects on environmental and, more generally, other structural policy outcomes.

References

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    RuhashyankikoJean-Francois and EtienneB. Yehoueforthcoming“Corruption and Technology-Induced Private Sector Development,”IMF Working Paper.

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    Sala-i-MartinXavier and ArvindSubramanian2003“Addressing the Natural Resource Curse: An Illustration from Nigeria,”IMF Working Paper 03/139.

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