Corruption and Innovation

Research by Vojislav Maksimovic

Innovative firms are more victimized than other firms in emerging economies.

Emerging economies need to encourage investment and innovation to create economic growth and raise the standard of living for their citizens. Unfortunately, government corruption can hold innovation hostage. It is not uncommon for firms to be extorted to pay bribes for routine services like getting their utilities connected or their phone service turned on, or to apply for government permits or licenses to upgrade their physical plant, open a new store, import a new category of goods or register a new trademark.

Innovative firms are the victims of corruption more often than other firms, according to a study by Vojislav Maksimovic, Dean’s Chair Professor of Finance, and co-authors Meghana Ayyagari, PhD ’04, and Asli Demirguc-Kunt of the World Bank.

Maksimovic and his co-authors used data from the World Bank Investment Climate Surveys, sampling over 25,000 firms, 80 percent of which were small and medium enterprises, in 57 countries. The surveys provided information on firms’ innovation projects, bribe payments, tax evasion, their perception of government, and their sources of financing. About 23 percent of the firms in the sample both paid bribes and under-reported their revenue for tax purposes, 14 percent only paid bribes, and another 23 percent only under-report revenue. Smaller and younger firms reported paying a larger percentage of their sales as bribe payments. Individual or family-owned firms paid higher bribes than firms owned by a corporation, bank, investment fund, managers/employees or the firm, or the state.

Corruption seems to act as a tax on innovation, says Maksimovic. Controlling for other variables, the authors found that innovators had to pay more bribes than non-innovators. And unfortunately those bribes don’t seem to result in any better services than those given to firms that don’t pay bribes. “They would still spend a lot of time talking to government officials, and they complained about getting their phones set up or electricity set up,” says Maksimovic.

Firms that pay bribes also tend to under-report their revenues more often—in effect retaliating against the government for the income lost to bribe payments, resulting in a loss of tax revenue for the country. But innovative firms tend to be victims overall, the study found—they both pay bribes and pay their taxes.

There are several steps that governments of emerging economies can take to encourage rather than hamper innovation. The more permits and restrictions there are in general, the more corruption occurs, the authors found, because more people have to approve the work the firm is doing. Simplifying the regulatory environment so that fewer people are involved can cut down on opportunities for bribery to occur.

Financial sector reform also has an important role to play in curbing corruption and tax evasion. Firms that get bank financing for their new investments and working capital are less likely to evade taxes, and more likely to pay bribes. Firms that use informal financing from family, friends or the local strongman are more likely to evade both taxes and bribes. So formal financing systems, in concert with better regulations, could create an environment that cuts down on extortion and is thus more conducive to innovation.

It is often difficult to get published data about private firms in nations with developing economies. By partnering with the World Bank, Maksimovic had access to data far in advance of when public records would become available.

“Most of the research done by finance professors used to be very U.S.-centric,” says Maksimovic, “because that’s where the data is. But we’re finding that more of our students now come from developing countries, and more students are working with companies outside the U.S. So it is important that they understand the differences between how things work in the U.S. and how they work elsewhere.”

“Corruption and Finance: Are Innovative Firms Victims or Perpetrators?” was published by the World Bank. This research was funded in part by a grant from the National Science Foundation. For more information, contact Vojislav Maksimovic.