Corruption and Innovation in China 

By | June 15, 2022

In the past four decades, China has been demonstrated miraculous growth records as well as rampant corruption, which presents a paradox for scholars: Is corruption is conducive to Chinese economic development? Some argue that corruption is “grease” in the economy and helps firms bypass inefficient regulation and red tape, while others believe that corruption exacerbates distortions in the economy and misallocates resources, leading to a large efficiency loss and thus hindering economic growth. The empirical results and the quantitative analysis in my recent paper support the latter view. However, I also find that the promotion of competition restrains the local government officials from corruption and from acting as a “grabbing hand” into the economy. This result establishes that the meritocratic political selection process is effective in reducing the harmful effects of corruption. 

I provide empirical evidence that corruption deters innovation, thus supporting the view that corruption is harmful for economic growth in China. The results suggest that corruption has negative effects on innovation for both measures of corruption: (1) whether the city’s mayor or Party Secretary is prosecuted for corruption; and (2) the number of cases of corruption prosecuted in a certain province-year cell. In comparison to non-corrupt local leaders, firms under the governance of corrupt leaders are 3.71% less likely to apply for patents. Increasing the number of corruption cases by a standard deviation similarly reduces patent applications by about 12.1%. The results also indicate that corruption increases entry and reduces exit. This can be interpreted as firms and corrupt government officials forming a reciprocal symbiosis: Firms bribe the officials in exchange for lower entry costs and exit hazards.  

I conduct several tests for heterogeneity, i.e., to determine whether the effects of corruption on innovation are stronger for in specific circumstances. First, I examine whether the effects of corruption are larger for leaders with higher capacity. I first measure ability using the residual of growth regressions. The results indicate that the negative effects of corruption on innovation are more pronounced for leaders with higher capacity. For leaders with lower capacity, the effects of corruption on innovation are actually positive. Second, I use the leaders’ educational attainment as a measure of leaders’ capacity, based upon on the argument that political leaders with a higher education level have better economic performance. The results also indicate that the negative effects of corruption on innovation are more salient for leaders with higher capacity. The results suggest that corruption is more damaging to the economy in the case of leaders with higher capacity: They are more capable of mobilizing resources for personal gains and, thus, do more harm to the economy. Such results imply that the anti-corruption agency should target more on more capable leaders to minimize the negative effects of corruption. 

Next, I examine whether the effects of corruption on firm dynamics are associated with promotion incentives. First, I use age to measure promotion incentives. Local government officials face a mandatory retirement age limit of 58. Leaders aged above 58 do not have any chances to be promoted and have to retire.  Therefore, I classify a leader as one without promotion incentives if he or she is aged 58 or above. I estimate the baseline specification for leaders with and without promotion incentives, respectively. The results indicate that the negative effects of corruption on innovation only exist for those without promotion incentives. Second, I test whether the negative effects of corruption on innovation are larger or smaller for leaders who are actually promoted. The results imply that the negative effects are only present for leaders who are not promoted. Third, I explore the pattern of political cycles. As the Party Congress, when there will be a massive reshuffling of government officials, approaches, the promotion incentives for local leaders are more salient. The results suggest that the negative effects of corruption on innovation are smaller if there are stronger promotion incentives, measured by the political cycle. 

The results of the above three empirical tests all support the argument that promotion incentives restrain the local leaders from imposing a “grabbing hand” to the economy because they face a trade-off between promotion (political gains) and bribery (monetary gains)

I next test whether the cost and return of corruption may affect the magnitude of its effects on innovation. First, I test whether the negative effects of corruption on innovation will disappear under the anti-corruption campaign, when the cost of engaging in corruption is much higher than before. The results, which are obtained by running the baseline specification using the post-2012 sample, imply that it is exactly the case: The coefficients of the corruption dummy and the number of corruption cases are no longer negative and statistically significant. Second, I examine whether the negative effects of corruption on innovation are stronger in certain sectors. I classify several sectors as ones more susceptible to corruption, including mining, postal and shipping, and finance. I interact the main independent variables with a dummy indicating whether the sector belong to the above category. The results suggest that the negative effects of corruption on innovation are mainly driven by sectors not susceptible to corruption. A potential interpretation could be that the “competition in corruption” is less severe as that in the other sectors that are susceptible to corruption. Thus, the return in corruption is higher in sectors not susceptible to corruption. 

Finally, I explore size and ownership heterogeneity. First, I test how the magnitude of the effects of corruption varies with firm size. I calculate the number of patent applications for large (paid-in capital at top 10%), medium (10-50%), and small (below 50%) firms. I then use it as the dependent variable. The negative effects are largest for large firms. This is because large firms are easier to become the targets of rent-seeking behavior by the corrupt politicians. This feature is also embedded in the quantitative model. Second, I test how the effects of corruption on innovation vary with three ownership types: state-owned, foreign, and private. The results suggest that the effects on private firms are largest. This is because private firms rely on need the protection of the corrupt politicians more, and thus are more willing to sacrifice its innovation capacity in exchange for preferential political treatment by the corrupt leaders. 

Using a cutting-edge quantitative firm-dynamics model, I quantify the welfare effects of eliminating firms’ political connections. I find that, eliminating firms’ advantageous political connections and thus corruption can improve welfare by 11.3%. 

My findings provide empirical evidence that corruption significantly deters innovation. Such effects are stronger for officials with higher capacity but can be limited mitigated by imposing promotion incentives onto the officials in charge. Future research can focus on the role of corruption in innovation and economic growth in other emerging economies. 

Xiangyu Shi is an economics Ph.D. student at Yale University.  

This post is adapted from the author’s paper, “Corruption and Innovation in China,” available on SSRN.  

The views expressed in this post are those of the author and do not represent the views of the Global Financial Markets Center or Duke Law. 

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