Why Public Investment fails to raise economic growth in some countries?: The role of corruption

In an endogenous growth model, the government officials are given the task of procuring public goods that are used as productive inputs in the production. Due to the information asymmetry between the government and the bureaucracy, the bureaucrats can falsely report of high quality-high cost procurement, while providing low quality-low cost product. This affects the productivity of the economy and hence reduces growth. Our analysis can show that corruption not only reduces the quality of public services that are necessary for production, but also inflates the public spending beyond the efficient level. In this way, we can explain why public investment fails to raise growth in the countries where corruption is endemic. We test our results empirically by improving the methodology on previous research on this topic by explicitly recognizing the role of simultaneity between public investment, corruption and growth and the possible biases arising from omission of correlated variables from the single reduced form equation based analysis. We use three-stage least squares method in a panel set up for a system of four equations on growth, public investment, corruption and private investment. Our primary results are twofold. First, corruption increases public investment. Second, corruption reduces the returns to public investment and makes it ineffective in raising economic growth.