U4 Helpdesk Answer 2017:12 Harmful rents and rent- seeking By Nieves Zúñiga Disclaimer All views in this text are the author(s)’, and may differ from the U4 partner agencies’ policies. Partner agencies Australian Government – Department for Foreign Affairs and Trade – DFAT German Corporation for International Cooperation – GIZ German Federal Ministry for Economic Cooperation and Development – BMZ Global Affairs Canada Ministry for Foreign Affairs of Finland Ministry of Foreign Affairs of Denmark / Danish International Development Assistance – Danida Swedish International Development Cooperation Agency – Sida Swiss Agency for Development and Cooperation – SDC The Norwegian Agency for Development Cooperation – Norad UK Aid – Department for International Development About U4 U4 is a team of anti-corruption advisers working to share research and evidence to help international development actors get sustainable results. The work involves dialogue, publications, online training, workshops, helpdesk, and innovation. U4 is a permanent centre at the Chr. Michelsen Institute (CMI) in Norway. CMI is a non- profit, multi-disciplinary research institute with social scientists specialising in development studies. www.U4.no [email protected] Cover photo Keywords anti-corruption institutions - donor coordination Publication type U4 Helpdesk Answer The U4 anti-corruption helpdesk is a free research service exclusively for staff from our U4 partner agencies. This service is a collaboration between U4 and Transparency International (TI) in Berlin, Germany. Researchers at TI run the helpdesk. Creative commons This work is licenced under a Creative Commons Attribution-NonCommercial- NoDerivatives 4.0 International licence (CC BY-NC-ND 4.0) Table of contents Query 1 Caveat 1 Summary 1 Understanding rents 2 Economic approaches to rents 3 Critique of neoclassical and classical economics’ analysis of rents 4 Political variables in the analysis of rents and rent-seeking 5 The outcome of rents 7 Harmful rents and rent-seeking tendencies 8 The role of the state in the economy 9 Competition 10 Institutions and the social order 11 Collective action and interest group politics 13 Rent-seeking agency 14 Preventing harmful rents and rent-seeking 17 References 20 a About the author Nieves Zúñiga Research and Knowledge Coordinator U4 HELPDESK ANSWER 2017:12 Query What approaches are there to identify policy-induced harmful rents, what are their respective strengths and weaknesses, and how have donors used them? Caveat The identification of policy-induced harmful rents has been approached mainly from a theoretical perspective. There is a lack of information on how donors have used those theoretical approaches. Summary Corruption and rent-seeking are often used interchangeable, being corruption frequently considered one form of rent-seeking. However, the literature shows two important distinctions to make regarding the relationship between corruption and rents. One is that rent-seeking does not always involve corruption and vice versa. The relationship between corruption and rent-seeking depends on two main aspects: if there is personal gain by public officials from the rent-seeking activity, and if there is transfer of income or unproductive use of resources. Two, the definition of rents as harmful does not always mean that there is corruption. The analysis of rents and rent-seeking has been dominated by an economic perspective focused on assessing rents according to their impact on efficiency and economic growth. Contrary to a political approach to rent- seeking, which tends to assume the negative impact of rents and their potential to derive from corrupt activities, economists classify rents as growth-retarding or growth-enhancing. The classification of rents as “harmful” or “not harmful” does not respond to the characteristics of the different types of rents but, rather, on the conditions and incentives that make them have a positive or negative impact on the economy. The reflection on rents have evolved from a neoclassical economic approach of rents framed in an ideal competitive market to more realistic perspectives 1 U4 HELPDESK ANSWER 2017:12 incorporating political elements influencing rents and rent-seeking, such as institutional frameworks and power structures. The identification of harmful rent-seeking tendencies is challenging due to their dependency on the circumstances in each case. Nevertheless, the literature identifies certain conditions with explanatory power to influence the outcome of rent-seeking as either positive or negative. Among those conditions are the state-market relationship, the influence of institutions and the social order, rent-seeking competition, collective action dynamics and the agency in pursuing rent- seeking. The impact of these aspects is assessed in this article in relation to frequency of rent-seeking activities and the potential of generating harmful rents. An increasing acknowledgment of the presence of rents in every economic and political system is leading the reflection on rents and rent-seeking towards the question of how to manage rents to ensure they have a positive impact. Conditions, such as a political context free from political constraints that could prevent the implementation of rent management strategies, and capabilities like learning and policy experimentation capacity, are among the capacities considered necessary aspects for successful rent management. The transformation of the relationship between the public and the private sectors towards collaboration, mutual learning and accountability, and anticorruption tools such as integrity pacts are crucial in this regard. Nevertheless, successful rent management will also depend on how we define when they are successful, their effects in the context, and whether if those effects are wanted or not. Understanding rents In economics, the term “rent” is defined as an “income that is higher than the minimum that an individual or firm would have accepted given alternative opportunities” such as the income that they would have received in a competitive market or the extra income that a civil servant might receive for the transfer of the right to a good or service that are not available on the open market (Khan 2000a, p. 5). For example, the extra money that a company is willing to pay above the rental price to rent an exclusive property in order to secure the lease against other interested companies would be the owner’s rent. Rents might come from different sources, such as monopoly profits, import and export quotas, extra income from subsidies or from owning a resource when the market structure for that resource is 2 U4 HELPDESK ANSWER 2017:12 oligopolistic or there is price cooperation, agricultural price supports, occupational licensing, bribes operated through political mechanisms, or short-term super-profits made by innovators before competition enters their sector (enabled by patent rights). These excess incomes are generated through the creation, maintenance or transfer of rights to a service or good (Khan 2000a) in exchange for a payment for example in the form of money, debt or equity. The fact that rents involve extra income implies the existence of strong motivations and incentives to maintain those rents, which might lead to corrupt or otherwise illegal behaviour. For instance, the creation of rents can be a way for governments to secure political support and favouritisms according to the principle ‘you help me and I will help you’ -reciprocity (Aidt 2016). The activities seeking to create, maintain or change the rights and institutions on which particular rents are based is known as rent-seeking (Khan 2000a). In the literature, both rents and rent-seeking activities have been mainly analysed from an economic perspective, in terms of their impact on efficiency and economic growth. However, the limitations of that approach and the need to distinguish between rents in different sectors have motivated the introduction of political elements in the analysis as explained next. Economic approaches to rents The economic analysis of rents has been dominated by two main traditions: classical and neoclassical economics. Neoclassical economic theory has analysed rents in terms of the efficiency of rents in relation to a model of perfect market competition, where the income that recipients in an industry would accept and the income that they would need to produce their goods or provide their services are equal (Buchanan, Robert and Tullock 1980). The efficiency of rents is assessed by looking at the immediate net social benefit (the difference between the social value of the output and its costs) associated with the rent and comparing it with the net social benefit achieved in its absence (Khan 2000b). For example, monopoly rents, created by entry barriers that allow firms in protected markets to charge higher prices for their products, are inefficient because they reduce the utility or social benefit of the product by producing less for a higher price. However, in a perfectly competitive 3 U4 HELPDESK ANSWER 2017:12 market, where the prices cannot be manipulated by companies and are determined solely by the equilibrium between supply and demand, the social benefit is maximised. Thus, according to neoclassic economics, institutions and rights protecting rents should be removed to achieve efficiency and good economic performance. The way to do that is by regulating markets to secure free and fair competition. Classical economics has focused the analysis of rents on