Corruption in a simple Keynesian model of income determination

This paper elaborates on a simple Keynesian model of income determination allowing for corruption to affect the aggregate level of production via its impact on public finances and aggregate demand. The model accounts for three different types (and effects) of corruption in the economy: (a) taxpayers bribe corrupt public tax collectors in order to evade taxes thereby causing lower tax revenues; (b) the embezzlement of public resources by corrupt bureaucrats raises the cost of public goods provision; and (c) corruption distorts the allocation of public expenditures towards less productivity-enhancing projects thereby discouraging private investments. We derive two main results. Firstly, we show that the presence of corruption of the types (a)-(c) reduces the short-run equilibrium level of production as compared to the «corruption-free» scenario. Secondly, we show that fiscal policy is less effective in the presence of corruption and – under certain conditions – depresses economic activity. Both results stem from two effects: the decrease in the demand of public goods caused by corruption of types (a) and (b), and the crowding-out effect on investment induced by corruption of type (c).