The Externalities of Corruption: Evidence from Entrepreneurial Firms in China

The Externalities of Corruption: Evidence from Entrepreneurial Firms in China
Mariassunta Giannetti, Guanmin Liao, Jiaxing You, Xiaoyun Yu
Review of Finance, Volume 25, Issue 3, May 2021, Pages 629–667,

Firms around the world attempt to obtain political favors, such as land and other natural resources, government contracts, lenient taxation, relaxed regulatory oversight, or generous financing. The costs and benefits of these behaviors, which can be assimilated to corruption, have been subject to intense debate.

On the one hand, corruption may represent a second-best equilibrium because it allows the interests of the private sector to prevail in highly regulated economies (Leff, 1964; Huntington, 1968). On the other hand, even if some firms appear to perform better than others, corruption may be harmful for the economy as a whole (Murphy, Shleifer, and Vishny, 1993). Firms with more resources to corrupt officials or stronger political connections may fare better than others, but ultimately most firms are compelled to make transfers to corrupt officials and end up having less resources to invest and to enhance their technologies. Put differently, corruption creates negative externalities. Evidence on whether an environment of corruption hampers an economy’s performance is, however, scarce.

In this paper, we ask whether corruption indeed causes negative externalities and inefficiencies that go above and beyond the benefits that it might yield to corrupting firms.

Using a large-scale proprietary dataset of public and private firms in China and the anticorruption campaign as an exogenous shock, we study how the performance of firms that operate in an ex ante more corrupt environment changes after the crackdown. We expect that a decrease in government officials’ willingness to concede favors would be associated with weaker firm performance in ex ante more corrupt industries and provinces if corruption facilitated economic activity. Firm performance should instead improve in these industries and provinces if corruption can be viewed as an inefficient equilibrium.

We document that a negative shock to the effectiveness of corruption is associated with an improvement in the performance of firms operating in ex ante more corrupt environments. The changes in performance following the anti-corruption campaign appear to be brought about by an improvement in technological efficiency, an increase in sales growth, and a decrease in the cost of debt. There are significant distributional effects as the profitability and total factor productivity of smaller and younger firms increase to a larger extent. Importantly, a high level of corruption prevents labor and capital from being allocated to the most productive firms and deters entry and small firm growth.

Corruption also appears to have an effect on industry structure and the geographical distribution of entrepreneurial activity. Following the start of the anti-corruption campaign, the proportion of young firms increases particularly in the provinces and industries with ex ante high entertainment expenses. This is especially the case for young firms with high productivity, whose shares of employment, assets and sales increase.

In sum, we provide the first evidence that corruption is an inefficient equilibrium for an economy and that a generalized decrease in the effectiveness of corruption improves firm performance and the allocation of resources in an economy.

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