This research deals with corruption and growth in Latin America. Given the region’s institutional volatility, constant change and lack of compliance with regulations, the question arises as to whether there is a trade‑off between growth and corruption control at a certain level of institutional capacity. A panel analysis of 26 Latin American countries (2002‑2021) was conducted using robust dynamic panel data models to test the hypothesis. The results revealed a quadratic relationship between growth and corruption, considering the endogeneity between institutions, corruption and growth, using Autoregressive Vector panel data.

Corruption and its effects on institutional change, income and economic performance continue to be debated in political science, public management and economics. According to Quesada et al. (2013), corruption is a complex phenomenon with both a political and an administrative dimension. Political corruption refers to collusion between the political class and spheres of power to obtain benefits in the absence of institutional controls and reliable accountability mechanisms. Administrative corruption refers to fraudulent acts committed by public officials who use their technical-professional spheres to violate regulations or favor individuals.

The discussion on corrupt practices in the developing world is far from over. Some argue that corruption mainly occurs in the civil service and that a high level of transparency can be achieved through administrative measures. Others argue that corruption is a political problem rooted in culture, which can lead to political failure due to cronyistic tendencies in all societies (Fukuyama, 2014).

Much academic work has focused on determining whether corruption can boost or limit economic growth, especially in developing economies. One hypothesis of economic literature is that corruption can severely limit economic performance in contexts with strong institutions and efficient bureaucracies. However, in contexts where institutions do not function adequately and bureaucratic inefficiencies occur, corruption can spur economic performance in the short term, especially in the developing world, by acting as a "greaser" of the economy. It is clear that corruption can also arise from actions between private parties interacting in markets and organizations; however, this phenomenon requires the participation of the public sector to become entrenched in the institutional fabric of a country.

The relationship between corruption, growth and institutions is not limited to the idea that the presence of functional institutions leads to more or less corruption and, therefore, to better or worse economic performance. It is important to consider how the effect of corruption relates to institutional change. When studying the effects of corruption from an economic and institutional point of view, sometimes too much attention is paid to formal rules for containing corrupt actions and neglects the fact that institutions in the developing world (especially in Latin America) still have limitations when it comes to combatting corruption as an institutionalized practice.

This paper seeks to empirically study the relationship between corruption and economic growth, considering that the evolution of institutional arrangements can influence economic performance. The hypothesis is that strengthening formal arrangements can improve economic performance by providing clear rules. However, in weak institutional contexts, corrupt practices may persist and limit progress.¹ In other words, the idea is to empirically validate that, in Latin American countries with a colonial past and low institutional development, there is a sacrifice rate between control of corruption and per capita income. This rate would depend on the strength of the institutional framework and its recent evolution, measured using indexes that capture the countries' institutional capacities.

This six-part paper discusses corruption and Latin American institutions in the 20th century, from the formation and nature of the region's democracies to the present day. Relevant literature on the relationship between corruption and economic performance was also consulted to analyze how malicious acts affect economies in the long run. Sections four and five detail the empirical strategy and discuss the model's results. The last part presents conclusions and perspectives for Latin America today.

To understand corruption in Latin America, the formation process and the dynamics of its democracies must be considered. To this end, we need to define what is meant by institutions. North (1990) understood institutions (formal and informal) as a set of socially constructed rules that allow individuals to make strategic decisions in contexts of uncertainty. In this respect, institutions can be formal or informal, the former referring to discourses (Dryzek, 1996), unwritten rules, conventions, and social standards, while the latter is linked to written legal regulations endorsed by the legal-political regime (in a broad sense, through the State).

On this basis, the literature explores the existence of a relationship between institutions and the development of countries (Acemoglu et al., 2001), but in the case of Latin America, this aspect is still not clear (Levitsky and Murillo, 2012). Following O'Donnell (1994, 1997, 2001, 2004 and 2010), democracies in the region are largely "delegative" and lack effective horizontal accountability mechanisms. This democratic typology is linked to a problematic institutional legacy (Acemoglu and Robinson, 2015), where corruption and political cronyism are institutionalized.

Delegative democracies mainly emerge from transitions from authoritarian regimes to democratic systems (O'Donnell, 1997). Although they allow for some level of vertical accountability through elections and legal guarantees, these structures often fail to control the illegal behavior of elected officials. These failures are due, in part, to the absence of effective societal and horizontal accountability, crucial elements for good governance and prevention of corruption (Gómez, 2022; Ostrom, 2000).

The problem also lies in the persistence of deficient institutional designs and practices inherited from dictatorial times (Acemoglu and Robinson, 2015), typical of the Latin American social and institutional past. In these contexts of institutional weakness and democratic deficits, there is no effective link between civil society and institutions to ensure accountability (O'Donnell, 2004). This disconnection undermines the effectiveness of horizontal governance mechanisms and, in some cases, is exploited by the executive power to strengthen its dominance (O'Donnell, 1994).

This weakness in accountability mechanisms affects state capacities (Grassi and Memoli, 2016; Taş, 2015) and is associated with lower support for consolidated democracy (Kang and Lee, 2018). One consequence is that delegative democracies and weak accountability mechanisms in the region result in institutions prone to corruption and economic malfunctioning (Levitsky and Murillo, 2012; O'Donnell, 1994). This institutional fragility is compounded by instability and "constant substitution" in institutions, linked to political volatility, persistent inequality, and the rapid and often imitative design (institutional mimicry) of institutional mechanisms (Fukuyama, 2014).

The region's colonial and authoritarian history also influences its institutional development (O'Donnell, 1994; Przeworski, 1988). Economic reforms and the inability of governments to regulate effectively have reduced incentives for public ethics, favoring corruption (Acemoglu et al., 2011; Soto, 2003). These conditions allow the elite to use bureaucracy for their own ends instead of for correcting market failures (Acemoglu et al., 2021; Acemoglu and Verdier, 2000).

Another aspect to consider is the approach based only on economic efficiency to manage public organizations, as reflected in the implementation of the New Public Management paradigm. This model has led to a flexibilization of institutions and organizations without an adequate assessment of the risks of governance (Gaebler and Osborne, 1992; Ramió and Salvador, 2005), calling into question the institutional capacities that make it possible to fight corruption and drive economic performance. Corruption resulting from these contexts has serious economic effects, particularly in countries with weak institutional counterweights (Bayley, 1966; Gerring and Thacker, 2004; Sandholtz and Koetzle, 2000; Seligson, 2002).

In short, this complex web of historical, political and economic factors in the Latin American region generated a cycle of corruption and institutional instability that persists. Despite advances in understanding the economic costs of corruption, the question remains about how an apparently successful economic performance can coexist with a weak institutional framework and common corrupt practices as a more or less generalized reality, despite contexts, realities and narratives that may be disparate across Latin American countries.

The relationship between corruption and economic performance is relevant in academic literature. Some studies suggest that corruption could have ambivalent effects on the economy. For example, Leff (1964) argues that it can function as an insurance for businesses against inefficient regulations and poor government policies, which could stimulate entrepreneurial activity (Godinez and Liu, 2015). He argues that efficient firms could pay bribes to avoid regulatory obstacles, thus increasing their productivity.

However, other scholars raise concerns about the adverse effects of corruption. De Vaal and Ebben (2011), for example, propose that corruption could reduce investment in productivity and the provision of public goods, harming economic growth, especially in contexts with solid institutions.

Furthermore, it is argued that corruption can act as a lubricant in environments with weak institutions, normalizing actions that would not be possible in an environment with solid institutions and accountability. Although Méon and Weill (2010) found evidence that corruption can stimulate efficiency in developing countries with deficient institutions, Aparicio et al. (2016) refute this alleged benefit by showing that proper control of corruption and the effective functioning of institutions increase opportunities for entrepreneurship.

Most literature generally leans toward the idea that corruption negatively affects economic performance. Mauro (1995), for his part, shows how persistent corruption can adversely affect flows of private investment and, therefore, economic growth.

In this context, he also determines statistically significant relationships between corruption and a reduction in private investment. In his findings, Mauro (1995) points out that corruption decreases investment in two different ways. It indirectly strengthens bureaucratic inefficiency and, as a result, discourages private investment. The direct effect on investment occurs when public officials intentionally divert private investment from some sectors to others, following a criterion of seeking personal profit rather than economic benefit.²

A second area of research focuses on the impact of corruption on income levels, income distribution and business efficiency. Studies by (Gupta et al., 2002; Johnson et al., 1999; Kaufmann and Wei, 1999) have significantly impacted subsequent research. Gupta et al. (2002) found that corruption can increase inequality by up to 11 points, according to the Gini coefficient, and can affect the income of the poorest people. In addition, Kaufmann and Wei (1999) found that corruption benefits wealthier groups by institutionalizing advantages for specific powerful interests through business survey data.

The study by Kaufmann and Wei (1999) highlights the fact that businesses that spend a lot of time negotiating with public officials to obtain benefits often face significant capital losses. Li et al. (2000) contribute to the field by examining the relationship between corruption and income inequality, as measured by the Gini coefficient. Their findings suggest that corruption significantly affects income inequality across countries.

Literature in this area is extensive and covers various dimensions of economic performance, including income distribution, foreign direct investment, public debt and more (Anokhin and Schulze, 2009; Borja, 2017; Chong and Gradstein, 2007; to name a few). In general, these studies conclude that corruption hurts the economy and increases inequality.

Ahmad et al. (2012) explore a quadratic relationship between corruption and GDP, suggesting that there could be a "tolerable level" of corruption that does not harm economic growth. Dobson and Ramlogan-Dobson (2010) also address a trade-off between corruption and inequality, especially in the Latin American context. Saha and Gounder (2013) take a non-linear approach and suggest that corruption could catalyze growth in the preliminary stages of development, although this effect is reversed over time.

Recently, Albrecht and De la Torre (2021), more in line with the focus of this paper, have added to the available evidence that, in the short term, corruption and political instability could have positive effects on Latin American economic growth, although these effects are unsustainable in the long term. Thus, corruption has multiple and complex implications for economic performance and inequality. In this respect, although some studies suggest that certain levels of corruption may be “tolerable” or even beneficial in the short term, the general view is that corruption is detrimental to the economy and contributes to income inequality.

This study reviews the impact of institutions on economic performance, with a particular focus on the regions of Latin America, the Caribbean and South America. Unlike previous research, corruption is modeled in quadratic terms, suggesting an effect of diminishing returns in developing economies. Two strategies are employed: the first considers multiple variables related to state capacity to assess the non-linear impact of corruption, and the second is based on the theoretical model of Acemoglu et al. (2011) and De Vaal and Ebben (2011), but with adaptations of the work of Levitsky and Murillo (2012) and O'Donnell (1994, 1997 and 2004) regarding the model of constant substitution in institutional terms, which occurs in the delegative democracies studied by the latter. This mixed approach permits the capture of the non-linear effect of corruption while controlling factors such as government effectiveness and population growth, validating bidirectionality between institutions and economic growth through the use of autoregressive data panel vector techniques where bidirectionality is supported by evidence from Granger causality tests (Qamruzzaman, 2017; Saadaoui and Chtourou, 2022).

The study uses the World Bank's Governance Indicators database (s. f. a) and that of Kaufmann et al. (2010), covering 26 Latin American countries from 2002-2021 and considers heterogeneity through dummy variables referring to colonial origin. The selected strategy and basis provide complete and relatively uniform data, facilitating an empirically corroborative analysis. Variables include GDP per capita (slope variable) and population size as a control variable. Table 1 summarizes the modeled variables.

Based on a linear model with distributed panel lags:

(1)

Where i expresses the number of individuals and t represents the time periods. Y_it refers to the variable of interest in the study, γ refers to the vector of coefficients of interest, α_i represents the unobservable heterogeneity, C_i,t-k refers to the vector of variables of interest k is the optimal number of lags³ and X_it refers to the vector of k institutional independent variables, β to the vector of k coefficients and ν_it to idiosyncratic error.

For this study, the resulting reduced form is:

(2)

Where Ln(PIB)_it refers to the natural logarithm of GDP per capita PPP in dollars, CO is the corruption perception index of the World Bank (s. f. b), CO² refers to the returns to scale (or quadratic) of corruption.

LE refers to freedom of expression, capacity for political articulation and association (voice and accountability), EP to political stability, EG to government effectiveness, CR to regulatory quality, IL to the rule of law, P to population, δOC to a vector of dummy variables reflecting the colonial origin or countries and ε_it to compound error . For the estimation of the model, variance estimates such as Beck and Katz (1995) and Driscoll and Kraay (1998) were used, which correct the model for the presence of heteroscedasticity, autocorrelation⁴ and contemporaneous correlation, given the diagnoses carried out on the models.

Where * represents the number of k equations of the autoregressive panel, the set of vectors of k equations of the system variables (and the t - k vector refers to said regressed variable in k periods), is the independent variable vector within each of the reduced-form equations of the system, and is the vector with the error terms of the equation system. To deal with the bias of dynamic panels, generalized methods of moments (GMM) estimation is used, using lags of the dependent variables as instruments. First differences were used to remove specific panel effects.

Table 2 shows the paired correlation between the variables in the model. All state capacity measures, from corruption control (CO) to regulatory quality (CR), show a solid positive relationship with the dependent variable. Only the variable of the logarithm of the total population (Ln(P)) shows a weaker but negative relationship. In turn, this shows a negative but less intense relationship with the governance indicators, except for regulatory quality, for which no strong or statistically significant association exists.

Figure 1 shows a box plot of GDP per capita by region and colonial origin of the countries. Although there are differences in the average level between countries of Spanish colonial origin in the regions of South America (SA) and Latin America and the Caribbean (LA&C), we can see that, in the lower limit of the first quartile, there are more countries in LA&C with less than US$10,000 per capita than in SA. On the other hand, the Latin American countries of English colonial origin are diverse in terms of income levels (in other words, there is a significant level of variability in their per capita income levels). They show more substantial growth in the region in terms of the median, while countries of Dutch origin in South America show average levels of per capita income and with much less variation than countries of Spanish colonial origin in SA.

Figure 2 shows the total population broken down by colonial origin and region. Countries of Spanish colonial origin in South America have an average population of 10 million, although the third quartile range extends to 50 million in 2011-2019, with Colombia, Argentina and Peru having the highest. In the case of countries of Spanish origin, the range from the first to the third quartile is much lower than in South America, but atypical data exists, exceeding 120 million inhabitants by 2019 (in the case of Mexico). This indicates that heterogeneity among countries in terms of total population is extremely high.

Figure 3 shows several significant trends linking institutional variables with per capita income. In general, all the variables studied show a positive correlation with per capita income, although they vary in strength and regional adjustment.

For example, government effectiveness has a relatively high adjustment in LA&C with an R² of 0.4842, compared to an R² of 0.4235 in South America. Political stability also demonstrates regional differences: a one-point increase in the scale is associated with an increase in per capita income of US$181.05 in South America and US$291.16 in LA&C, although with a lower R² in the latter region. Judicial effectiveness (the rule of law) demonstrates significant variability between the two regions; a one-point increase in the index is associated with an increase of US$335 in LA&C, compared to US$178.69 in South America.

Finally, although participatory institutions generally better predict per capita income in the US$10 to US$20,000 range in Latin America, the correlation is more robust in certain ranges of the institutional participation scale.

For the specification of the VAR model, unit root tests were performed (Hadri, 2000; Levin et al., 2002; Pesaran, 2007)⁵ where the variables in level and first differences were tested and the variables in first differences were found to be stationary.⁶

Table 3 presents the results of the proposed estimations, with several approximation methods, ranging from fixed effects with robust standard errors with the presence of autocorrelation and heteroscedasticity to methods corrected by contemporaneous correlation (estimations by Driscoll and Kraay (1998) and PCSE panel models by Beck and Katz (1995)). Some significant lags are shown in the corruption control index, but generally, all show expected signs in all specifications. Regulatory quality is a statistically significant variable with expected signs in almost all specifications, in the same way as government effectiveness. In contrast, voice and accountability show no significance except in one of the proposed regressions (corrected standard error panel with no fixed effects (5)), while the rule of law shows importance in almost all model iterations depicted in Table 3.

The robust Hausman and Mundlak tests show that there is a systematic difference between the fixed and random effects coefficients. Although they are based on different estimates, it should be noted that the model that best minimizes the mean square error is the fixed effects model with a corrected standard error panel because it corrects autocorrelation by applying the Prais-Winsten transformation to the estimation in question. Post-estimation tests indicate that the model has corrected the contemporaneous correlation by applying the Pesaran CD statistic.⁷

Based on the fact that model (6) is the one that minimizes the variance, it was decided to test the coefficients to observe the quadratic relationship described in this paper. Since the model chooses to observe the cumulative temporal effect, the following equation is used to test the hypothesis that the relationship between growth and corruption is:

Where COγ_tp is the cumulative non-linear effect of corruption on economic growth. The hypothesis test shows that there is a quadratic relationship in the coefficients. From an average of 32.10 points on the corruption control scale, we begin to observe decreasing returns to scale of corruption control.

Figure 4 shows the results of the model in a scatter plot concerning the corruption control index according to colonial origin. The countries in the sample of Spanish colonial origin follow the expected trend, as do those of English origin, although with increased dispersion. In turn, the results of the model are observed according to regions, with both regions (South America and LA&C) following the sacrifice rate.

The empirical strategy of the previous section may suffer from a problem referred to in the empirical strategy section, which is the endogenous and bidirectional relationship between growth and institutions, especially between growth and corruption. North (1990) discusses that, even in contexts of low economic regulation, corruption can affect the allocation of resources (financial, factor inputs, including human capital), which may be reflected in future growth. In the previous strategy, variables reflecting state capacity dimensions were included in an attempt to obtain the best possible estimate with a one-equation model.

To verify consistency, a scenario was proposed in which the relationship between state capacity, growth, and corruption is non-linear and endogenous. For this purpose, a panel data autoregressive vector model was specified. Likewise, as in the previous section, there is a quadratic relationship between corruption and growth, in addition to the fact that the Granger test shows a bidirectional relationship between growth and corruption.⁸

Hansen's test of over-identified restrictions indicates that the instruments used (four lags of the endogenous variables) permit the solution of endogeneity and the problems associated with the dynamic panel bias evidenced by Nickell (1981). The tests to determine the optimal number of lags for the Autoregressive Vector showed that one lag is the optimal level to specify the model based on information criteria, thus incorporating institutional path dependence into the data-generating process.

Hypothesis tests of the CO_i,t-1 and CO²_i,t-1 coefficients show a quadratic relationship between growth and output. From 47.12 points out of 100 on the growth scale [39.26-54.97] per capita, income growth starts to decline.

Figure 6 shows that, despite the heterogeneity by region and colonial origin (insofar as there are specificities in the economic development paths of each country), the "sacrifice rate" is more evident in countries with a Spanish colonial past and those in the Latin America and Caribbean region.

This paper aimed to estimate whether there is a sacrifice rate or a trade-off between growth and corruption, especially in the context of countries with institutional drift, volatile institutions, and institutionalization of distrust due to the lack of accountability mechanisms in various dimensions (vertical and horizontal societal). The research is consistent with the work of Aparicio et al. (2016), Méon and Weill (2010), Albrecht and De la Torre (2021), as well as an empirical corroboration of the theoretical model of De Vaal and Ebben (2011) and that of Acemoglu et al. (2011), concerning countries with low economic development and institutional design problems, which hinder economic performance in the presence of weak institutions or, in O'Donnell's terms, institutionalized malicious practices.

According to the results of this study, this phenomenon is because, in countries with lower GDP per capita, the income elasticity concerning control of corruption is higher before reaching a score of 32 points out of 100, a stage from which diminishing returns begin to be observed. In other words, the 32 points of the corruption control indicator are the breakpoint where the so-called "sacrifice rate" occurs. When correcting for possible endogeneity and dynamic panel bias, the sacrifice rate is 47 points out of 100. This indicator illustrates that although the gains in transparency and mitigation of political and administrative corruption generate initial dynamics of economic growth in the short term by freeing the economy from certain rules (both formal and informal) that hinder business activity, in the long run, these improvements in transparency are not sustained because they are dependent on the institutional framework where corruption tends to be entrenched and manifests itself in the mature stages of the process.

With regard to the political and institutional issue, there is a certain consensus in economic, political and public management literature that institutional conditions (understood as norms, practices, values and cultures) can hinder or accelerate GDP growth processes and, consequently, economic development. However, in many cases, these dynamics have been studied linearly from a strictly economistic approach, leaving aside the institutional dynamics that can modify countries' per capita GDP growth trajectory. This is a particular issue for Latin American countries, many of which, throughout the 19th century, exhibited economic indicators similar or superior to their peers in the developed world, especially Europe and Asia. According to the results of this research, a worthy explanation is the weakness of institutions, which in the long run ends up institutionalizing practices that may permit short-term economic growth but limit the strengthening of democracies and formal rules that characterize developed economies that maintain a long-term development path.

This is consistent with the idea of Levitsky and Murillo (2012) that institutions in Latin America cannot enforce design standards due to their volatility over time. This indicates that even improvements in accountability and institutions, as shown by O'Donnell (1994, 1997 and 2004), may not be sufficient for several reasons: horizontal accountability (which are usually the counterweights, separation and autonomy of the branches of government) can be highly reactive to cases of corruption so that, without improvements to the institutional framework in other dimensions such as regulatory quality, accountability and political participation, legal security and government effectiveness, a correct transition to institutionalized democracies is not possible.

This paper evaluates whether there is a sacrifice rate in improvements in state transparency to fight corruption (in other words, improvements in horizontal accountability) and economic growth, as measured by the countries' per capita income over the period 2002-2021. Despite the heterogeneity between nations and the limitations of a one-equation model, a trade-off between growth and corruption is observed, even when adjusting for indicators that capture State Capacity. This adds an empirical contribution to the discussions on the institutional history of the region of Latin America and provides indirect evidence regarding the constant institutional replacement model as a possible explanation for the region's unique economic and social development situation.

This means that unless institutional volatility is reduced, in other words, institutional mimicry is eliminated. Reforms are adopted on a state level, which are based on informal discourse and social norms; formal improvements to increase the transparency of public administration will only result in limited economic growth in countries like these, with a colonial past and an institutional drift that is generally extractivist and not very inclusive (except some countries).

However, the empirical contribution is not without limitations. The World Bank's governance indicators (s. f. b) measure people's perceptions of the dimensions of governance and governability, which these indicators attempt to assess. Thus, the result ends up being consistent with other research that uses institutional indicators with similar consistency. The research opens up the possibility of investigating the specific mechanisms that facilitate this phenomenon.