Corruption, the unofficial economy and the provision of public goods in transition countries

For more than a decade, the countries of Central and Eastern Europe and the former Soviet Union have been attempting to transform their centrally planned economies into market economies. In some of these countries a considerably large unofficial economy has become a serious obstacle to economic growth and public finances. Studies by Johnson et al. (1997), Johnson et al. (1998), and Johnson et al. (2000) show that transition countries with large unofficial economies tend to have excessive regulations, high levels of taxation and high incidence of corruption. As well, bureaucratic corruption in tax and customs administration appears to be an important element in defining the underground economy in some transition countries. Given the potential impact of the unofficial economy on public finances and the provision of public goods, the purpose of this dissertation is to examine how corruption affects the unofficial economy in transition countries, with a particular focus on the unofficial economy that results from tax non-compliance. More specifically the study examines tax cheating as it relates to corruption in tax administration, to the business culture in the economy and to the tax-regulation policy-making process. The thesis looks at the feedback effects of decisions of different agents in the economy, and the implications of these decisions for the provision of public goods. The research is conducted along two lines. First, the thesis examines the nature and the extent of corruption in Albania, focusing particularly on the informal sector and corruption in customs and tax administrations. The thesis also examines the implications of the informal economy on the tax revenues available for the provision of public goods. Then the thesis examines the pattern of government spending in public education and transport infrastructure in Albania to reveal the priorities that these sectors are being given during the transition period. Second, the thesis develops a number of theoretical models to examine some of the issues raised in the analysis of Albania. The theoretical models provide a framework to examine the incentives for different agents in the economy to engage in tax cheating and corruption. More specifically, this section of the thesis examines: the feedback effects between the decision of tax inspectors to engage in corruption and firms' cheating activities; the firms' tax compliance as tax cheating and corruption are more accepted practices when they become increasingly widespread; how government affects the degree of cheating and corruption through auditing; and how corruption affects policy-makers' decisions to allocate the revenue obtained from tax collection between public education and infrastructure. Results from the theoretical models show that widespread bureaucratic corruption among tax inspectors can perpetuate an unofficial economy that in turn sustains these and other corrupt practices. In such situations, intense auditing and penalties serve as cheating deterrents only if cheating and engaging in corruption is very costly for both firms and tax inspectors. When cheating becomes cheaper as the size of the unofficial economy grows, a multiplier effect in the economy gives rise to Pareto-ranked multiple equilibria. In an economy with a widespread tolerance for corrupt tax enforcers, tax non-compliance and a low enforcement of penalties, the Pareto inferior (large unofficial economy and an under-provision of public goods) stable equilibrium can prevail. Changes that will move an economy from an inferior equilibrium to a superior equilibrium have a strong political dimension and are complex. Modeling the ways in which policy-makers affect the unofficial economy indicates that, due to the high cost of auditing, the government must allow for some cheating and corruption in order to maximize the revenues available for the provision of public goods. Only if a government views illicit activities as a "public bad", and is willing to eliminate these activities at any cost, will it choose to perform very intense auditing. The government's decision to allocate revenues between education and infrastructure depends on the returns generated by these public goods in the economy and on the private benefits from corruption. A government will allocate funds to education only if education generates relatively higher returns, and if the government favours at the margin the provision of public goods relative to private benefits from corruption. If at the margin the government favours the private benefits from corruption and cheating, then all revenues are allocated to infrastructure even though education generates higher relative returns in the economy. When infrastructure generates higher social returns in the economy, the government commits revenues to infrastructure either to provide the most beneficial public good, or to facilitate opportunities for corruption benefits. Overall the thesis shows that illicit activities (cheating, and political and bureaucratic corruption) can sustain each other regardless which actors in the economy (firms, enforcers, and politicians) undertake them