Saturday, 24 October 2015

"Does the Wage Gap between Private and Public Sectors Encourage Political Corruption?"

A paper of mine (co-authored with Boris Podobnik and H. Eugene Stanley) got published in PLOS ONE! Since PLOS is an open-access journal you can read the whole paper here.

It is primarily a theoretical paper focused on designing a model of corruption networks in democracies. The intuition for the model was a growing disparity between public sector and private sector wages and how this corresponds with greater corruption. This is, naturally, only a correlation, but it served as a motivation to search deeper and uncover how corrupt networks can sustain themselves within a democratic environment. 

There were three main findings/contributions in the paper:
  1. The greater the public sector wage premium (higher public sector wages than private sector wages) in a given country, the greater the possibility of corruption
  2. We design and propose a new reward-to-risk ratio for labor economics (taking into account the relative riskiness of working in each sector)
  3. Democracy does not create corruption, but it can serve as a mechanism to preserve it in the long run. A transition from a corrupt to a non-corrupt state, and vice-versa, can only be purely random. 
And here is the full abstract:
"We present a dynamic network model of corrupt and non-corrupt employees representing two states in the public and private sector. Corrupt employees are more connected to one another and are less willing to change their attitudes regarding corruption than non-corrupt employees. This behavior enables them to prevail and become the majority in the workforce through a first-order phase transition even though they initially represented a minority. In the model, democracy—understood as the principle of majority rule—does not create corruption, but it serves as a mechanism that preserves corruption in the long run. The motivation for our network model is a paradox that exists on the labor market. Although economic theory indicates that higher risk investments should lead to larger rewards, in many developed and developing countries workers in lower-risk public sector jobs are paid more than workers in higher-risk private sector jobs. To determine the long-run sustainability of this economic paradox, we study data from 28 EU countries and find that the public sector wage premium increases with the level of corruption."
Findings in depth 

Much research in labor economics has been focused on uncovering whether workers in public sector occupations are overpaid or underpaid relative to workers in the private sector. However, many of these research efforts failed to take into account that occupations in private and public sectors generally have different rights assigned to them and more importantly different risks of losing a job. This implies that in labor economics we are faced with a similar problem that has existed in finance before Markowitz and Sharpe, where risk was not taken explicitly into account when assessing an investment. Markowitz revolutionized both investment theory and practice by accounting expected return and risk in portfolio construction ("Portfolio Selection", The Journal of Finance 7 (1): 77-91). Inspired by the Markowitz mean-variance model and the Sharpe ratio (The Journal of Portfolio Management 21 (1): 49-58), and in order to quantify how well wages compensate employees for risk in a given sector, we propose an analogous reward-to-risk ratio for labor economics as the ratio between annual wage and sector risk. We define sector risk as the reciprocal business lifetime in a given sector. If it is inappropriate to evaluate an investment return without taking into account its risk, it is equally inappropriate to discuss whether a job in a given sector is underpaid or not without taking into account the risk of that sector. 

Furthermore, according to economic theory, and related to the previous issue, higher risk investments should lead to larger rewards. In contrast to economic and common sense, there is a paradox on the labor market: in many developed and developing countries lower-risk public sector jobs are paid more than higher-risk private sector jobs. In order to determine the long-run sustainability of this economic paradox, we study data from 28 EU countries and find that the wage gap between public sector and private sector jobs in a country increases with the level of corruption. This result inspired us to propose an intriguing hypothesis that the wage gap between public and  private sectors can serve as a motivation for corruption. The greater the public sector wage premium, the higher the motivation for those without adequate skills and education to enter the public sector to achieve private benefits. Even in the US, jobs in the public sector carry greater advantages than jobs in the private sector. They are more secure, less stressful, offer a wider selection of health-insurance plans, better retirement benefits, flexible work arrangements, and more holidays and vacation days per year. The question is: how is this discrepancy, in which the less riskier sector is rewarded with higher wages, sustainable in the long run?

We hypothesize that a democratic system (understood under the principle majority rule), creates an enabling mechanism for corruption persistence, even though it is not responsible for creating corruption in the first place. If we operate under a plausible assumption that a large majority of people are generally uncorrupt, why can corrupt subjects in some countries prevail and take power? To resolve this question we apply a network concept based on the model recently published in Nature Physics (Majdandzic, Podobnik, Buldyrev, Kenett, Havlin & Stanley (2014) "Spontaneous recovery in dynamical networks." Nature Physics 10, 34-38). We propose a dynamic network model of corrupt and uncorrupt employees representing two states in the public and private sector. In our model, corrupt employees are more intra-connected to one another and more unwilling to switch their attitudes regarding corruption than the uncorrupt. Inter-links between corrupt and uncorrupt employees serve to switch the attitudes of agents in the competing group. With such inter- and intra-links, corrupt subjects can prevail and become a majority through sudden transitions even though they initially represented a minority. This way it is obvious that in many democracies corruption can be persistent over a long period of time, and the only way to break the mold and flip from a corrupt to a non-corrupt state is via random selection of a non-corrupt individual as head of state.

Wage gap and corruption

A potential criticism may be directed at the assumption of modelling the labor market as a securities market. This is a mere allegory. The point is to suggest that wages in any job have to take into account the relative riskiness of that job (potential of job loss, benefits received, industry risk, etc.), not just the usual factors like location, hours or level of education. Furthermore the standard economics literature linking the wage gap to corruption finds an opposite conclusion to our own - countries which have a greater public sector wage premium usually have lower corruption. These findings are however limited primarily to low-income, developing countries. Naturally, we factor for this difference and observe all types; low-income, middle-income and high-income countries. Here is how that looks:

Source: Podobnik, Vukovic, Stanley (2015) "Does the Wage Gap between Private 
and Public Sectors Encourage Political Corruption?" 
PLoS ONE 10(10): e0141211. doi:10.1371/journal.pone.0141211 
We can see three types of countries corresponding to a concave relationship between the public sector wage premium and the corruption index. There is a group of low-income countries where corruption is rampant and public sector wages are much lower than private sector wages. This phenomenon is well established and explained in the literature. Given the low public sector wages in these countries the bureaucrats, doctors, and teachers are naturally more open to corruption in order to earn some money on the side. However in the group of medium-income countries the situation is reversed; the public sector has higher wages than their private sector counterparts (read the methodological part of the paper to see how we make this comparison) and corruption is still high. Only in the group of high income countries where corruption is low is the wage gap low as well. Finally, only a few high-income countries have private sector wages higher than public sector wages (albeit by a small margin), and these countries are also the least corrupt in the world. Of course, we're talking about Scandinavian countries, Sweden, Denmark, Finland and Norway. Again, this isn't to say that their negative public sector wage premium is the cause of low corruption. But it is interesting to notice a trend in which rich countries with low levels of corruption do not bias domestic wages too much in favor of any sector. 

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