Most of the developing economies face the problem of inherent inefficiencies in economic, political, and legal systems. In such inefficient environments, it is questionable if undertaking innovative activity is free of any nonmarket effects. Financial leakages like bureaucratic corruption are assumed to affect innovative activity adversely, but never a proper study was undertaken to validate this assumption. Interestingly, Leff (1964) also claims that bureaucratic corruption helps to speed-up processes and help economic growth. Also, before a claim is made that innovation helps raise finance, one needs to also consider financial leakages that hinder or may encourage innovative activity in inefficient economies. The step to link innovation to corruption is important because, on the one hand, the innovation research scarcely considers nonmarket factors and, on the other hand, public choice literature scarcely considers the role of innovation.
Considering the possible adverse effects of corruption, the following arguments are put forward in this study. First, innovative firms need faster approvals of permits, new licenses, and permissions to get new technology as fast as possible. If these have to come through a heavily bureaucratic structure, the time lag involved would ultimately cost the firms a market lead advantage. Second, if the financial markets were thought of as perfect, any loss to investment due to corruption costs could have been made up for. On the investment angle therefore, corruption can be seen as hindering R&D investment or early stage investmentsmainly in the presence of imperfect financial markets. Third, in centralized economies parallel projects involving high uncertainties are discouraged by bureaucracy. This is especially true if projects are government funded rather than private funded. In such cases, the firm’s optimal R&D is either not reached or never undertaken, making the firm stick to routinized activities in the industry it belongs to. Hence corruption can sand the wheels of innovation.
On the other hand, corruption has a beneficial feature too, especially in inefficient economies. If the officials allot permits to the firm that has a higher ability to bribe, then it wins the innovation race and therefore a market lead. When firms undertake or wish to invest in incremental innovation, corruption can act as a regular feature that a firm has to undertake to avoid any uncertainty. The third dimension is jumping the policy hurdle. Leff (1964) and Bailey (1966) view corruption as a reaction to bad policies and hence helps jump the policy hurdle
Which kind of innovative activity does corruption affect in what way? A firm can be having more than one kind of innovative activity and not all of them might be affected by corruption at all! Considering bureaucratic corruption, activities that require exclusive involvement of government (permissions, etc.) might be affected and not necessarily the others. For streamlining the argument, the “grease the wheels” vs. “sand the wheels” hypothesis is tested on the four types of innovation – product, process, marketing, and organizational innovation. To test the grease/sand effect, countries in the African continent are considered where governance structures are often considered to be weak and therefore become a right set of countries to use.
This study tries to contribute to the literature on innovation and public choice by exploring this issue by using a large-scale firm-level database – the World Bank Enterprise Survey conducted in 2004.3 Using probit and instrumental variable probit models, the results show that corruption (as a percentage of sales revenue) hinders product innovation and organizational innovation and has a positive effect on marketing innovation. Process innovation, however, does not get affected. Hence in inefficient economies, while giving any policy advice on innovation, one needs to account for nonmarket factors such as corruption.