Taxes and Economic Rents: The Role of Political Connection in Chinese Listed Private Firms

In the extensive political economy literature, the most heavily-examined issues related to political connection is whether firms benefit from political connections or suffer from lack of connections. However, the cost side of seeking or maintaining political connections by firms has been largely ignored. Seeking political connections is costly. In this study we will exam the costs (in the form of tax overpayment) firms have to incur in seeking political ties and the resultant benefits (economic rents) they obtain. We first describe why Chinese private firms have incentives to develop stronger political connections and how those incentives compare to U.S. settings. We then examine whether firms seeking political ties pay more taxes to help local governments make up their expenditure shortage. We then study whether, in return, connected firms get preferential access to government-controlled resources (licenses, subsidies and financing opportunities). Finally, we examine the legal institutions in which such a “gift exchange” between the government and the firm most likely exists. The results of the study will highlight the importance of understanding political economy when analyzing corporate operations and tax reporting behaviour.