Numerous studies have concluded that corruption is inversely correlated to economic growth, entrepreneurship and innovation. That is, as corruption goes up, economic indicators go down. The effect of corruption on business is mediated by several factors, all of which are related to the ability of state and market institutions to reliably enforce the laws and rules of trade.
Loss of Trust
Innovation and entrepreneurial activity require trustworthy institutions in order to flourish. When trust is undermined by corruption, it becomes risky to rely on partners and providers, as there are no guarantees about the enforcement of contracts. Productivity is reduced because the coordination of complex economic activity becomes prohibitive as a result of increasing monitoring and transaction costs.
Loss of Motivation
Entrepreneurs and innovators are motivated by the portion of the value created by the venture that they are able to capture for themselves. As corruption increases, entrepreneurs face the risk of losing some of those profits to opportunists taking advantage of the corruption on the value chain. As a result, some potential entrepreneurs become discouraged and abstain from pursuing new business opportunities.
The dampening effect of corruption has often been compared with that of taxes. Under this conception, corruption would differ from taxation only in the lack of public revenue generated. However, studies indicate that a 1-percent increase in bribery rates translates into a reduction of 3 percent in firm growth, an effect three times greater than that of taxation. This disproportionate effect may be attributed to the uncertainty and loss of trust in institutions.
Because there is little legal recourse for contract enforcement in corrupt countries, trust must be built on alternative foundations. Thus affect, ethnic identity and kinship are often seen as valid criteria for business partnership formation because they reduce the risk of breaches of contract. Those criteria will limit the size of the provider pool, however, often leading to economically inferior results and increasing the risk of adverse selection.