The Externalities of Corruption: Evidence from Entrepreneurial Activity in China
China is the largest emerging market, which has experienced spectacular growth over the last three decades, and is currently in the upper end of middle-income countries. Entrepreneurial activity and entry of new firms are crucial for spurring growth at this stage of development and avoiding middle-income traps. Corruption being associated with special privileges for connected companies and preventing a level playing field for new entrants can be an important impediment to growth for economies at this stage of development.
For this reason, widespread corruption in China has been considered a serious threat to sustained economic growth. In this context, President Xi Jinping’s administration, which viewed corruption as a threat to the Communist Party’s survival, initiated an anti-corruption campaign on November 8th, 2012, only 19 days after taking power. Xi’s anti-corruption drive has been considered the most far-reaching and lasting than any previous attempts.
In our recent paper, we exploit the anti-corruption campaign as a negative shock to the effectiveness of corruption, which should have benefitted small entrepreneurial firms in more corrupt industries to a larger extent. We show that extensive corruption in China may indeed have hampered the process of development and that the anti-corruption campaign has been an effective step forward in favoring an efficient allocation of resources and entrepreneurial entry and ultimately sustained growth.
Our paper explores the effects of competing with highly corrupted incumbents on small entrepreneurial firms’ performance and entry patterns using a large-scale proprietary dataset. Our data provide comprehensive information on a sample of public and private firms, which is largely representative of the distribution of firms in the Chinese economy across geographic regions, industries, and size classes. This allows our analysis to have direct implications on the effects of corruption on the economy’s allocational efficiency.
We find that corruption has significant negative effects on the performance of entrepreneurial firms. Small firms are less profitable and have lower total factor productivity when they compete with large industry peers that devote more resources in corrupting officials. This appears to be the case because, under these circumstances, small firms invest less, have lower growth of sales, and face higher financing costs than the median firm in the industry. Importantly, in all our tests, the negative spillover effect of corruption is muted after the start of the anti-corruption campaign. This indicates that a negative shock to the effectiveness of corruption benefits entrepreneurial activity.
Finally, we provide evidence that large firms’ corruption efforts hamper an efficient allocation of resources.Labor (capital) is less likely to be allocated to firms with high marginal productivity of labor (capital) if these firms operate in high corruption industries. Also in this case, the allocation of capital and labor improves after the start of the anti-corruption campaign.
Corruption also appears to have an effect on the geographical distribution of entrepreneurial activity. Not surprisingly, since corruption lowers their profits, the proportion of young firms is lower if large firms in the same province and industry spend more on corruption. This is the case not only for young firms in general, but also for young firms with high productivity.