Report

The Costs of Political Influence: Firm-Level Evidence From Developing Countries

Raj M. Desai and Anders Olofsgård

ABSTRACT—

Arrangements by which politically connected firms receive economic favors are a common feature around the world, but little is known of the form or effects of influence in business–government relationships. We present a simple model in which influence requires firms to provide goods of political value in exchange for economic privileges. We argue that political influence improves the business environment for selected firms, but restricts their ability to fire workers. Under these conditions, if political influence primarily lowers fixed costs over variable costs, then favored firms will be less likely to invest and their productivity will suffer, even if they earn higher profits than non-influential firms. We rely on the World Bank’s Enterprise Surveys of approximately 8000 firms in 40 developing countries, and control for a number of biases present in the data. We find that influential firms benefit from lower administrative and regulatory barriers (including bribe taxes), greater pricing power, and easier access to credit. But these firms also provide politically valuable benefits to incumbents through bloated payrolls and greater tax payments. Finally, these firms are worse-performing than their non-influential counterparts. Our results highlight a potential channel by which cronyism leads to persistent underdevelopment.

The Cost of Political Influence

Arrangements by which firms with close ties to incumbent political authorities receive favors that have economic value are a pervasive feature of business– government relationships in countries around the world. Despite the prevalence of these arrangements, however, relatively little is known about the precise form firm-level political influence takes, or its consequences. What characterizes the bargain between influential firms and governments? How do influential firms compensate governments, if at all, for any benefits they receive? Recent firm-level analyses have examined various determinants of political influence, and how these connections affect market valuation. Others have detailed the channels through which the benefits accrue. Still others, finally, have explained how ‘‘systems’’ of influence come into being, and why they survive. Much less is known, however, of how these political connections affect decisions within firms or of the strings that may come attached to political influence.

We investigate both the characteristics that define political influence among firms in developing countries as well as the effects of that influence on company behavior and performance. We argue that political influence improves the business environment for selected firms through industrial or quasi-industrial policies, but restricts their ability to fire workers. Influential firms thus relinquish a portion of their control rights — particularly over employment decisions — in order to provide benefits of political value to public officials. If influence lowers fixed operating costs for privileged firms, they may earn higher profits than non-influential firms but they will be less likely to invest or innovate, and their productivity will suffer. Firm-level political influence, therefore, can undermine the performance of politically powerful firms.

We draw on firm-level surveys in approximately 40 developing countries, consisting of over 8000 enterprises. We find that politically influential firms do indeed face a more favorable business environment than their noninfluential counterparts across several dimensions. However, influential firms also tend to carry bloated payrolls and report more (hide less?) of their sales to tax authorities, suggesting two mechanisms by which they offer political compensation: employment levels and tax revenues. Influential firms are also less likely to open new product lines or production facilities, or to close obsolete ones; they also report lower real growth in sales, shorter investment horizons, and lower productivity levels than non-influential firms. These results are robust to adjustments for a number of biases in the survey data. Taken together, our results imply that firm-specific industrial policy will be more prone to cronyism than policies that do not target individual firms. Our results can also explain why crony capitalism persists in countries despite its adverse effects on long-term economic performance. Finally, our findings offer some confirmation for the view that politically-devised restrictions that block access to technologies and preserve rents for elites are at the heart of prolonged economic under-development.


Citation:

Raj M. Desai and Anders Olofsgård (2011) “The Costs of Political Influence: Firm-Level Evidence From Developing Countries”, Quarterly Journal of Political Science: Vol. 6: No 2, pp 137-178. http://dx.doi.org/10.1561/100.00010094

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