This paper explores the role of corruption in a two-country model with fiscal spillovers. In the absence of cooperation on governance issues, countries always have a strategic incentive to appoint policymakers whose aversion to corruption is lower than average. An international agreement is a precondition for placing corruption fighters at the head of governments.Corruption; Fiscal policy; International cooperation

Pierre-Henri Faure

English

Research Papers in Economics

Does the fight against corruption require international cooperation? 
 
 
Pierre Faure 
a 
a Larefi, Department of Economics, University of Montesquieu - Bordeaux 4, Avenue Léon 
Duguit, 33608 Pessac, France 
 
Tel.: +33 0556846554; fax: +33 0556848534 
E-mail address: pierre-henri.faure@u-bordeaux4.fr 
 
 
 
 
Abstract 
 
This paper explores the role of corruption in a two-country model with fiscal spillovers. In the 
absence of cooperation on governance issues, countries always have a strategic incentive to 
appoint policymakers whose aversion to corruption is lower than average. An international 
agreement is a precondition for placing corruption fighters at the head of governments. 
 
 
Keywords: Corruption; Fiscal policy; International cooperation 
 
JEL classification: D73; F42 
 
 
 
 
 
 
1. Introduction 
 
 
It is well-established in economics that society can sometimes make itself better off by 
delegating decision-making authority to an agent who does not share its own preferences. The 
present article applies this general principle to the case of developing countries plagued by 
poor governance and corruption, and looks at the potential incentive to strengthen institutional 
quality by appointing an agent with a greater dislike for corruption than the rest of society. To 
this end, I consider a two-country fiscal policy game in which weak governance structures and 
corruption are modelled as a revenue leakage in the budget constraint (Huang and Wei, 2006; 
Hefeker, 2010). The model of the paper thus combines the analysis of strategic policy 
interactions with the issue of institutional quality. 
Several results will be highlighted within this framework. In the absence of any 
cooperation, strategic considerations associated with fiscal spillovers induce countries to be 
always more permissive towards corruption. Such a choice, however, proves to be beneficial 
under positive externalities. In fact, the ex ante incentive to appoint corruption fighters can 
only occur through international collaboration, which seems to be in line with the United 
Nations Convention against corruption (UNCAC), entered into force in December 2005. 
 
 
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12. The model 
 
 
Two countries, A and B, are interrelated through fiscal spillovers. Output (y) depends 
on both domestic and foreign corporate tax rates (t): 
 
  i i j y at bt = - +   (1) 
 
with a > |b| ≥ 0 (i, j = A, B; i ≠ j). 
In the absence of lump-sum taxation, a rise in home taxes leads to a fall in home 
output owing to distortions. No sign is imposed on b because the cross-country transmission 
of fiscal shocks has an unclear impact on economic activity. A rise in one country’s tax rate 
may boost the other’s output when inducing firms to relocate towards the most attractive 
fiscal environment. However, an increase in the domestic tax burden can also have a negative 
effect abroad if the slowdown in domestic activity results in a fall in imports. 
Public spending (g) is financed solely by taxes. Each country is supposed to suffer 
from a revenue leakage caused by weak institutions and corruption. The revenue shortage is 
simply modelled by an additional variable (c) in the budget constraint: 
 
  i i i g c t = -   (2) 
 
c can be interpreted as a rough measure of the corruption level in the economy or, 
equivalently, as an inverse measure of the effort made to combat corruption. In this model, c 
is a control variable to choose as the same time as the tax rate. 
Government i’s objective function is: 
 
  ( ) ( )
2 2 2
i G i i i i L y g g c c m d = + - + -   (3) 
 
Its loss increases in the deviations of output from its natural level, normalised to zero, 
and in the deviations of public spending from a target  g  ( 0 g > ). The third argument in the 
function (3) implies that fighting corruption comes at a political cost (Hefeker, 2010). c  can 
be viewed as the average degree of corruption in the economy ( 0 c > ). A corruption level 
above c  entails a loss due to, for instance, a fall in foreign investments or less support from 
international lending agencies. A level less than c  is supposed to be costly as well for the 
incumbent policymaker, because of the resistance of interest groups to institutional reforms, 
or because of personal income losses. µ and di are both positive and denote the relative 
weights placed on the last two objectives. In particular, a larger value of di indicates a lower 
dislike for corruption: the more costly is the gap with respect to c , the more reluctant are i’s 
authorities to adopt anti-corruption measures and so to set a lower value of ci. 
Society i’s welfare function is: 
 
  ( ) ( )
2 2 2
i S i i i L y g g c c m l = + - + -   (4) 
 
The loss function (4) can be interpreted as that of a benevolent social planner who 
would represent the voters’ median position. l is an inverse measure of the median distaste 
for corruption (l > 0). Thus, the incumbent policymaker has a reputation as a corruption 
fighter if l > di and is more tolerant of corruption if di > l. 
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1The game takes place in two stages. Both countries must first decide on the relative 
importance to attach to the combat against corruption in their government’s objective function 
(design stage). Then, the tax rate and the institutional effort level are chosen simultaneously 
(implementation stage). Note that a country-specific weight in the objective function (3) is 
needed to distinguish the cooperative solution from the non-cooperative one at the design 
stage: under the Nash regime, A and B disregard their similar preferences and take the other’s 
weight as a given parameter, whereas cooperation involves dA = dB = d ex ante. 
 
 
3. The non-cooperative case 
 
 
This section examines the full Nash equilibrium (denoted N). The game is solved 
backwards (see Appendix A for calculation details). Government i’s reaction function 
associated with fiscal policy is (i, j = A, B; i ≠ j): 
 
  ( )
2
i j
i
c g m abt
t
a m
+ +
=
+
  (5) 
 
The impact of a change in the foreign tax rate depends on the sign of fiscal spillovers: 
taxes are strategic complements if b > 0 and strategic substitutes if b < 0. 
The first-order condition concerning the anti-corruption effort level gives: 
 
  ( ) i i
i
i
g c
c
m t d
d m
- +
=
+
  (6) 
 
Algebraic substitution yields the following welfare loss for society i: 
 
 
( ) ( ) ( ) ( ) ( ) ( )
( )( )( ) ( )
2 2 2 2 2 2
2
2 2 2 2 2 2
i
j j i i
S
i j i j i j i j
c g
L
a b m a a b d m a a b d a d ml md
m d d a a b m d m d a m d d m d d
    - + + + + + + +     =
    + - + + + + +    
  (7) 
 
The socially optimal weight as regards corruption is determined by solving the first-
order condition  / 0
i S i L d ¶ ¶ = , which gives:
1 
 
  ( )( ) ( )
( ) ( )( )
2 2 2 2 2
2 2 2
2 j j j NN
i
j j
l m d a a b m d a m m d
d
a m md a b m d
  + - + + +   =
  + + - +  
  (8) 
 
NN
i d l >  provided that  0 b > . An immediate consequence follows: 
 
Proposition 1. In the absence of international cooperation at the design stage, every country 
ex ante prefers a government with a lower distaste for corruption, whatever the sign of fiscal 
spillovers. 
                                                           
1 The first and second superscript letters in the expressions of the optimal weight indicate the nature of the game 
at the first and second stages, respectively. 
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1Greater permissiveness towards corruption thus appears as a strictly dominant strategy 
in the full Nash game. Note that the manipulation of preferences is due to the existence of 
policy spillovers (i.e. 
NN
i d l =  if  0 b = ). Both countries are engaged in a tax competition 
game when b > 0. As they fail to take into account the expansionary effect of a domestic tax 
rise on the foreign economy, taxes turn out to be too low in equilibrium. A smaller effort to 
strengthen institutional quality (i.e. a rise in ci) implies a higher taxation level in order to 
provide a given amount of public goods (see Eq. (5): ¶ti/¶ci > 0). Therefore, the acceptance of 
more corruption can be analysed as a strategic mechanism for encouraging the foreign 
government to fix a higher tax rate (¶ti/¶tj > 0 from Eq. (5)), which proves to be mutually 
beneficial ex post since policy externalities, then, are internalised to some extent. 
Conversely, taxes are too high if b < 0, because no country cares about the damaging 
effect of a tax rise on output abroad. Ex ante, the choice of a policymaker who is less 
concerned with the corruption issue is regarded as a strategic device aiming at compelling the 
foreign country to reduce its tax rate in order to support domestic activity (see Eqs. (5) and 
(6): ¶ti/¶cj = ¶ti/¶tj ´ ¶tj/¶cj < 0). However, unlike the former case, such a strategy turns out 
to be counterproductive ex post since it only exacerbates the policy conflict between A and B. 
In the latter case, deliberately reducing the importance attached to the combat against 
corruption is a beggar-thy-neighbour strategy that results in excessive tax rates. 
 
 
4. The cooperative case 
 
 
This section turns to the cooperative solution (denoted C) for the first stage. It is 
shown in Appendix B that the social welfare loss in each country can then be written as: 
 
 
( ) ( ) ( )
( )( )
2 2 2 2 2
2 S
c g
L
a b m a ml d md
md a a b m d
  - + + +   =
+ - +    
  (9) 
 
Solving the first-order condition  / 0 S L d ¶ ¶ =  yields the optimal value of d under 
cooperation: 
 
  ( )
( )( )
2
CN al a a b m
d
a b a m
- +     =
- +
  (10) 
 
From Eq. (10), 
CN d l >  if  0 b >  and 
CN d l <  if  0 b < , which makes it possible to 
formulate a second proposition: 
 
Proposition 2. Cooperation at the design stage leads countries to choose policymakers who 
are more tolerant of corruption when fiscal spillovers are positive. On the other hand, under 
negative externalities, governments should attach greater importance to the corruption 
problem. 
 
If b > 0, more corruption improves welfare by forcing governments to increase their 
tax rate, thereby curbing tax competition. The misrepresentation of its relative preferences in 
the objective function (3) again requires each nation to delegate decision-making authority to 
an individual who tends to be more permissive on the matter. 
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1The main change with respect to the non-cooperative scenario lies in the choice of 
corruption fighters (that is, policymakers with a stronger aversion to corruption than average) 
in the case of negative spillovers. As seen before, taxes are excessive in the Nash equilibrium 
when b < 0. Accordingly, a larger anti-corruption effort (i.e. a decrease in c) provides each 
government some additional scope to lower taxes for supporting economic activity. A larger 
weight put on institutional quality, then, serves as a second-best substitute for fiscal policy 
coordination, thereby making countries better off. 
 
 
5. Concluding remarks 
 
 
This paper claims that the importance attached to institutional quality depends on 
strategic considerations. Two cases have to be distinguished, according to whether the design 
stage is played cooperatively or not. In the absence of international cooperation, every country 
always has an incentive to delegate decision-making authority to an individual known to be 
less corruption-averse. This result might contribute to explain the persistence of poor 
governance structures and corruption in some developing and transition economies. 
In this model, the cooperative design of the national governments’ objective functions 
appears as a prerequisite for appointing corruption fighters. This seems, prima facie, to be in 
line with the ratification of the UNCAC by many nations to date. This treaty is a legally 
binding anti-corruption instrument, and obliges its State Parties to implement a wide array of 
measures for promoting better law enforcement and improving institutional quality. However, 
cooperation at the design stage can theoretically imply here to distort social preferences in a 
more permissive direction. Thus, the model also suggests that such an agreement might be 
counterproductive under certain circumstances. 
 
 
 
 
Appendix A 
 
 
Substituting Eqs. (1) and (2) into the loss function (3) and then minimising it with 
respect to ti and ci yields Eqs. (5) and (6) in Section 3. Solving the system made of the first-
order conditions for country i and of their counterparts for country j gives the equilibrium 
expressions of the control variables (i, j = A, B; i ≠ j): 
 
  ( ) ( ) ( )
( )( )( ) ( )
2
2 2 2 2 2 2
i j j i i j
i
i j i j i j i j
c g m md d a m d d ab m d d
t
m d d a a b m d m d a m d d m d d
  + + + + +   =
  + - + + + + +  
  (A.1) 
 
 
( ) ( )( ) ( )
( )( )( ) ( )
( ) ( ) ( ) ( )
( )( )( ) ( )
2 2 2 2 2
2 2 2 2 2
2 2 2 2 2
2
2
      
2
i j j i i j
i
i j i j i j i j
j j
i j i j i j i j
c
c
g
m ab d d a a b m d d a md m d
m d d a a b m d m d a m d d m d d
a a b m a a b d m a a b d
m d d a a b m d m d a m d d m d d
  + + - + + +   =
  + - + + + + +  
  - + + + +   -
  + - + + + + +  
  (A.2) 
 
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1Substituting Eqs. (A.1) and (A.2) and their counterparts for j into Eqs. (1) and (2) 
results in: 
 
 
( ) ( ) ( ) ( ) ( )
( )( )( ) ( )
2 2 2 2 2 2
i j j
i
i j i j i j i j
c g
y
a b md a a b d m a a b d
m d d a a b m d m d a m d d m d d
  - + + + + +   = -
  + - + + + + +  
  (A.3) 
 
 
( ) ( ) ( ) ( ) ( )
( )( )( ) ( )
2 2 2 2 2 2
i j j
i
i j i j i j i j
c g
g g
a a b d a a b d m a a b d
m d d a a b m d m d a m d d m d d
  - + + + + +   - = -
  + - + + + + +  
  (A.4) 
 
Moreover: 
 
 
( ) ( ) ( ) ( ) ( )
( )( )( ) ( )
2 2 2 2 2 2
j j
i
i j i j i j i j
c g
c c
a a b m a a b d m a a b d
m d d a a b m d m d a m d d m d d
  - + + + + +   - = -
  + - + + + + +  
  (A.5) 
 
The substitution of Eqs. (A.3), (A.4) and (A.5) in society i’s welfare loss function 
leads to Eq. (7) in Section 3. 
 
 
Appendix B 
 
 
Fiscal policies remain uncoordinated in the second stage, so the reaction function 
given by Eq. (5) still stands. Cooperation during the design stage means that di is replaced 
with d in country i’s first-order condition for the effort level (Eq. (6)). Then, the equilibrium 
values of t and c become: 
 
  ( )
( )( )
c g md
t
md a a b m d
+
=
+ - +
  (B.1) 
 
  ( ) ( )
( )( )
c g
c
a a b m d a a b m
md a a b m d
- + - -     =
+ - +
  (B.2) 
 
Substitute the above results for t and c into Eqs. (1) and (2) to obtain: 
 
  ( ) ( )
( )( )
c g
y
a b md
md a a b m d
- +
= -
+ - +
  (B.3) 
 
  ( ) ( )
( )( )
c g
g g
a a b d
md a a b m d
- +
- = -
+ - +
  (B.4) 
 
  ( ) ( )
( )( )
c g
c c
a a b m
md a a b m d
- +
- = -
+ - +
  (B.5) 
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1By making use of Eqs. (B3), (B4) and (B5), one arrives at the social loss (9) in Section 
4. 
 
 
 
 
References 
 
 
Hefeker, C., 2010. Taxation, corruption and the exchange rate regime. Journal of 
Macroeconomics 32, 338-346. 
Huang, H., Wei, S.-J., 2006. Monetary policies for developing countries: the role of 
institutional quality. Journal of International Economics 70, 239-252. 
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Monetary policies for developing countries: the role of institutional quality.

Taxation, corruption and the exchange rate regime.

Does the fight against corruption require international cooperation?

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Does the fight against corruption require international cooperation?

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