Corporate profitability and the global persistence of corruption
Stephen P. Ferris, Jan Hanousek, Jiri Tresl 30 April 2020
Corporate corruption exerts a number of adverse influences on a nation’s economy (Mauro 1995). The presence of corruption encourages the growth of unofficial economies and affects the ability of a nation to efficiently allocate resources or sustain economic growth (Tanzi 1983, Slemrod 2007). Corruption also impedes the development of market-supporting institutions such as independent legal or regulatory systems (de Soto 1989, Shleifer and Vishny 1993).
In spite of these adverse effects, corruption persists. It remains a global phenomenon despite increased corporate transparency, expanded international capital flows, and enhanced institutional monitoring. We contend that corruption persists because of the economic and financial advantages it provides to firms. We also contend that corporate corruption continues to exist because it provides benefits to a firm. The access to regulators, bureaucratic waivers, and accelerated/more favourable administrative decisions are profitable for firms and encourage them to continue their corrupt practices. In this sense, corporate corruption persists because it represents a positive net present value project for the firm. More formally, we hypothesise that corporate corruption persists because it provides financial benefits to the firm. We refer to this as the ‘corporate advantage hypothesis’.
Measuring corporate corruption
To examine the persistence of corruption within a firm, we must measure it at firm-level. Our approach uses the concept of firm inefficiency, derived from a production function. Since a production function describe optimal output relative to inputs, any deviation from these levels can be seen as inefficient. After netting out common industry- and economy-wide factors, a residual inefficiency remains (Ferris at al. 2020).
We then introduce the concept of an ‘honest firm’. An honest firm is one that is headquartered in a country with a low level of corruption. Foreign firms headquartered in countries with low levels of corruption should have a lower propensity to engage in illegal activities, even when operating abroad. This is because such firms tend to adhere to their home cultural and legal practices, regardless of their immediate operating environment (Stopford and Strange 1991, Fisman and Miguel 2007). We recognise that even these honest firms will engage in some level of corrupt activity, but we contend that whatever corruption these firms might engage in represents a lower bound for such activities within that country. We then subtract the residual inefficiency for an industry-year matched honest firm from that of a sample firm. The resulting measure is our estimate of corporate corruption. The advantage of this approach is that it can be estimated using the firm’s financial statements.
It is important to note that we use the term corporate corruption to include a broad range of illegal activities undertaken by firms. These consist of bribery, extortion, kickbacks, sweetheart contracts, tunneling, tax evasion, accounting fraud, and a variety of other activities that are prosecutable. These activities are reflected in a firm’s internal inefficiency because they increase labour and operating costs. These expenses are often unassociated with any economic purpose and can represent theft, graft, or expropriation of corporate resources. In many cases, these expenses are incurred due to regulators or government administrators exploiting their position for personal financial gain.
Data and findings
The study examines 12 countries from Central and Eastern Europe from 2001 to 2015. We draw our data from the Amadeus database, which is maintained by Bureau van Dijk (BvD) and contains comprehensive financial and ownership information for private European firms. Our sample consists of 188,994 firm-year observations, spanning 15 years. To determine the extent to which corruption persists across our sample economies, we report the Corruption Perception Index (CPI), constructed by Transparency International (shown in Figures 1 and 2). The average score for our sample countries is 55.6. The least corrupted countries on the European continent (as of 2016) are Denmark (1), Finland (3), Sweden (4), Norway (6), the Netherlands (8), and Germany (10). The average CPI value for these six nations is 14.
Figure 1 Geographical distribution of country corruption by mean of the reversed CPI (100-CPI, i.e. a higher value means greater corruption)
Figure 2 Reversed CPI by country (100-CPI, i.e. a higher value means greater corruption)
In our analysis of corporate profitability, we find that corruption has a positive influence. This result holds whether we examine a firm’s return to total invested capital (ROA), or to the return on equity (ROE). These results are consistent with the Corporate Advantage Hypothesis. That is, corruption persists because of its ability to improve overall corporate profitability.
It might be the case that the various changes in financial reporting, and the expanded oversight of the financial system following the crisis of 2007, have made corruption less possible (or capable of generating profitability improvements) for the firm. We find that the 2007 Global Crisis did not have a meaningful effect on the relation between corruption and corporate profitability. This relation remains persistent and appears invariant to regulatory or disclosure changes mandated following the crisis.
To gain further insight into how corruption affects corporate profitability, we decompose the ROA and ROE measures into a firm’s turnover, margin, and multiplier components. We conclude that corruption enhances investor returns as suggested by the Corporate Advantage Hypothesis. It appears to accomplish this by improving margins and turnover. These improvements occur through increased sales, or perhaps by reduced expenses. Corruption allows a firm to achieve both.
Given that corruption is persistent (and is associated with increased profitability), we now examine precisely how this occurs. That is, we investigate exactly what channels firms use to divert capital to fund their corrupt practices. We identify four such possible channels. These candidate channels are partially selected on the basis of Moeller’s (2009) observation that poor screening procedures for new employees, frequent related party transactions, close relations to suppliers, and inventory mismanagement are all common sources of corporate fraud.
In Figure 3 we summarise the findings for our channel analysis. We report the number of sample countries in which channel expenditures are positively associated with corporate corruption. We observe that staff costs are positively associated with corruption in eight of our sample countries. This is often due to the use of phantom employees to fraudulently transfer wealth from firms. Overstatement of material costs is yet another way that managers can steal money from their corporate employers. This is a common practice for firms in half of our sample countries. The intentional mismanagement of inventory to extract corporate wealth is a less popular approach and is observed in only two of our sample countries. Accounting adjustments to the cost of goods sold is probably the least employed technique and does not demonstrate any measurable consistent national usage.
Figure 3 The number of sample countries in which channel expenditures are positively associated with corporate corruption
Summary and discussion
We find that corruption influences the returns enjoyed by a firm’s investors. To understand how corruption improves profitability, we decompose our return measures into their margin, turnover, and multiplier components. Corruption works its effect on profitability through the improvement of both margins and turnover. We also find that corruption persists even after the extensive regulatory reforms following the Global Crisis of 2007. The additional disclosure requirements, and increased monitoring of the global financial system, enacted after 2007 appear to have had no effect on the proclivity of firms to engage in corrupt practices. For corruption to occur, there must be a channel to create the actual off-balance capital accounts from which firms can make their payments. Our analysis reveals that materials and staff costs appear to be the most common channels for the diversion of corporate funds.
These findings have important implications for policy development and future research. Our examination of the channels through which corruption occurs identifies a target for regulators, lawmakers, and other parties who have an interest in eliminating corruption from the greater political economy. Our analysis of corporate sales, margin, and profitability could be useful for the design and implementation of public policy aimed at economic growth and efficiency. Our results are also relevant for governance research since the monitoring and oversight of executives is the essential charge of corporate governance. The relationship between corporate governance processes and the extent to which the firm makes extra-legal payments to secure financial advantage warrants a much deeper analysis.
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