Research: When Companies Cozy Up to Politicians, the Economy Suffers

When old technologies succumb to new creative ideas, competition thrives, innovation increases, the economy grows, and consumers benefit. In 1942, Joseph Schumpeter referred to this as the “gale of creative destruction” and deemed it the engine of sustained economic and technological progress. However, many things impede such creative destruction. In particular, some firms can secure preferential treatment in the market, thanks in no small part to their political connections. In such a world, new, productive firms may struggle to out-compete politically-connected incumbents, leading to a reduced business dynamism and less innovation. In our study, we try to understand how widespread such political connections are and how they affect firm dynamics, market competition, innovation, and the overall productivity of the economy. We study Italian firms and their workers to answer these questions. We analyzed a newly available data from the Italian Social Security office on the firms and the employment histories of all private-sector workers from 1993-2014. And we matched this data to the national registry of local politicians, a dataset with millions of observations on politicians at the municipal, provincial, and regional levels, as well as to the local elections data. In Italy, local politicians are allowed to work in the private sector while they hold political office — such as being a mayor, council member, etc. We identify a firm as being politically connected at a point in time if the firm employs at least one local politician at that time. To better understand performance of these firms, we also match this data on firms and politicians with the firms’ balance sheet data and patent data from the European Patent Office. The nature of this data allows us to explore how political connections affect companies and the broader economy. The focus on local politicians — at the municipal, provincial, and regional levels — is also an important feature of our analysis since local-level connections are much more pervasive and usually harder to detect. In addition, local politicians hold extensive power: among other duties, they have authority over and responsibility for the provision of local public goods and services; administrative authority over the issuing of various permits and licenses; and are responsible for the majority of the administrative burden faced by private firms in Italy. Overall, we found that employing local politicians is a common practice, especially among large and/or old firms. Across all industries, politically-connected firms account for third of total employment. Consistent with what you might expect, we found that the more regulated the industry the more pervasive the political connections in that industry. For example, industries such as utilities, pharmaceuticals, finance, and telecom face high levels of regulations and bureaucracy and private firms in those industries have high incidence of political connections. How do these political connections affect competition? While new competitors may try to leapfrog the market leader with new products or technological innovation, the leader often relies on various defensive strategies to maintain its market position. These defensive strategies could include the establishment of political connections. In our analysis, we found strong evidence to support this leadership paradox. Relative to their direct competitors, market leaders are more likely to be politically connected, but less likely to innovate, as measured by quantity and quality of patents and investment in intangible capital. Nevertheless, politically-connected firms are more likely to survive in the market and to grow in terms of revenue and employment. These benefits are larger the more powerful the politician the firm employs. However, we find that this growth in size is not accompanied by the respective growth in firms’ productivity. It’s reasonable to ask whether political connections actually cause these dynamics. To explore that, we take advantage of the fact that some local elections are decided on a very thin margin (for example, a 49%-51% split). These elections conceivably could have gone either way, much like a coin flip. We can therefore compare how different connected firms fare after the election, depending on whether the politician they employ was a member of the winning party. We find that differences in post-election outcomes between marginally winning and marginally losing firms are large. Firms on the winning side grow much more in terms of size but not in productivity. These finding are consistent with the view that political connections help firms remove particular market frictions or block competition, as opposed to helping them push the productivity and technology frontiers. Some of the benefits that these connected firms accrue are also shared with the politicians they employ. Employed politicians earn significant wage premiums relative to their co-workers — premiums that cannot be explained by their individual characteristics. Not surprisingly, this premium increases with the political rank of a politician. At the more aggregate level, political connections tend to be associated with worse industry dynamics — a lower rate of firms entering the market, less reallocation of resources from less- to more-productive firms, less growth, and lower productivity. This indicates that the effects of firm-level political connections go beyond the effects on connected firms and may imply significant social costs. In an environment where a firm’s route to success often runs through the political system, political connections may impede growth by lowering innovation and reallocation. What is clear from our study is that effect of political connections go well beyond the private benefits to connected firms. While these connections might alleviate certain market frictions, such as regulatory barriers or bureaucratic burden, and provide some benefits to connected firms, on the other hand — by giving incumbents a powerful advantage over entrants — their detrimental impact on market competition and creative destruction might outweigh the firm-specific benefits. While one may find it less surprising that we uncover these results strongly in the data on Italy — a country with a history of corruption, including the famous “mani pulite” investigation — our results could also shed some light on the declining business dynamism in the U.S. and in Europe, where market concentration has increased and spending on lobbying has grown to record levels. When companies gain advantage through political connections, our research suggests, other companies and the broader economy suffer.

Research: When Companies Cozy Up to Politicians, the Economy Suffers

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