# **1. Introduction**

The adverse effects of corruption on growth and development across countries are the subject of much attention in economics and finance<sup>1</sup> and among policy makers.<sup>2</sup> It is also widely recognized that innovation and entrepreneurship are the engines of economic growth and that understanding the determinants of innovation is a crucial first step in understanding the differences in technological progress and income levels across countries.<sup>3</sup> However, there has been very little research exploring the link between these two key determinants of growth. While there is evidence that corruption reduces growth at the macro level, we know little about whether the effects of corruption are particularly adverse for certain types of firms such as innovators. Similarly, while the existing empirical literature on firm innovation has focused on the characteristics of the entrepreneur and the firm, we know little about whether innovators pay more bribes because it enables them to avoid bureaucratic regulation or whether innovators are particularly targeted by corrupt officials.

In this paper, we study bribery of government officials and tax evasion and how these activities are associated with innovation and financial development. We investigate whether firms are victims, who pay more in bribes than they gain by underreporting revenues to tax authorities, or perpetrators, who gain more by avoiding taxes than they lose in paying bribes.<sup>4</sup> Of particular interest is the effect of corruption and tax evasion on innovative firms. Murphy, Shleifer, and Vishny (1993) argue that innovators are more vulnerable to public corruption than established firms since they have a high (and inelastic) demand for government-supplied goods such as permits and licenses.

> 1 See Shleifer and Vishny, 1993; Mauro, 1995; Ades and Di Tella, 1997. Svensson (2003, 2005) provides detailed reviews on this subject.

> 2 Over the period 1990 to 2006, the World Bank Group approved more than $20 billion in public sector reform programs, a key component of which were anti-corruption and governance programs. In 2007, the World Bank launched the Governance and Anticorruption (GAC) Implementation plan to heighten its focus on combating corruption as an integral part of its mandate to reduce poverty and promote growth.

> 3 See, for example, Schumpeter (1934,1942), Baumol (2002) and Aghion and Durlauf (2005) on the importance of innovation for growth and development. Hall and Jones (1999) show that differences in income levels across countries can be explained by differences in their technological progress.

> 4 Thus, we focus on corruption that is costly to the firm rather than being a benefit to the firm and a cost to society. While both kinds of corruption exist, the literature has generally reached a consensus that corruption is a cost to entrepreneurs rather than “grease”. Several papers using surveys report corruption as being an important obstacle to doing business (Beck et al., 2005; Fisman and Svensson, 2007; Johnson et al., 2002; Hellman et al., 2003). On a cross-country level, other studies show that corruption hinders growth and investment (Mauro,1995; De Soto,1989; Frye and Shleifer, 1997; Berkowitz and Li, 2000; Safavian, 2001;Svensson, 2003and Ahlin and Pang ,2008)

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