The Value of Local Political Connections in a Low-Corruption Environment

The following post comes to us from Mario Daniele Amore of the Department of Management and Technology at Bocconi University and Morten Bennedsen, Professor of Economics and Political Science at INSEAD.

Connections between firms and politicians are widespread around the world. Faccio (2006) documents the existence of publicly traded firms with national political connections in 35 of 45 countries; these firms account for nearly 8% of the world’s stock market capitalization. She also documents that national political connections are valuable, especially in countries with weak political institutions.

In our paper, The Value of Local Political Connections in a Low-Corruption Environment, forthcoming in the Journal of Financial Economics, we explore the value of local political connections in a low-corruption environment. We use an administrative reform that generates exogenous variations in the size of local municipalities in Denmark to establish the effect of changes in political power on the profitability of firms that have family ties with local politicians. On average, we find that (1) doubling the political power (as measured by population per elected politician) doubles the performance of politically connected firms, and (2) the effect is larger in industries delivering goods and services to the public sector.

Our study makes two contributions to the literature. First, we explore the value of family connections with local politicians in a country with strong political institutions: according to the well-respected Corruption Perceptions Index (CPI), Denmark is the world’s least corrupt country in four out of the last six years. Previous studies have identified the value of political connections in corrupt countries (e.g., Fisman, 2001; Johnson and Mitton, 2003; Li et al., 2008; Bunkanwanicha and Wiwattanakantang, 2009; Cingano and Pinotti, 2011), for powerful national politicians (Jayachandran, 2006; Goldman et al., 2009, 2012), and in times of severe financial crisis (Acemoglu et al., 2010). Yet research has failed to establish the general effect of political connections in countries with strong political institutions. For instance, Faccio (2006) finds that political ties in countries with high levels of corruption generate a statistically significant cumulative abnormal return (CAR) of 4.32%, versus an insignificant CAR of -0.02% in countries with low levels of corruption. We contribute to this field by establishing—in a highly accountable institutional environment—the corporate value of family connections with local governments, which account for almost half of total public expenditures.

Second, we provide a novel identification strategy for estimating the effect of political ties on operating performance. Event studies have been used to estimate the market value of political connections (Fisman, 2001; Faccio, 2006; Faccio and Parsley, 2009), but identifying the effect on operating profits is difficult in such studies owing to the challenge of finding appropriate counterfactuals. Our identification strategy exploits exogenous variations in political power for a given firm–politician match. These variations result from an administrative reform, implemented in 2005, whereby 238 Danish municipalities merged into 65 new ones and 33 municipalities were left unchanged. Our difference-in-differences framework establishes how the increase in political power due to the enlargement of local governments increased the profitability of firms connected with local politicians before and after the reform; for counterfactuals, we use similarly connected firms in municipalities unchanged by the reform.

Our approach presents two empirical advantages. First, we can study how exogenous changes in political power affect corporate performance within a given firm–politician match. Second, by focusing solely on connections with winning candidates, we avoid potential endogeneity problems in the formation and disruption of connections. For example, we do not use nonconnected firms or firms connected with unelected candidates, which represent poor counterfactuals because the electoral fates of connected politicians can be affected by corporate outcomes.

A premise for our identification is that the merging of local municipalities creates a positive shock to politicians’ power. To support this argument, we show that the ratios of population, governmental budget, and outsourced expenses to elected politicians increased significantly in merging municipalities as compared with unchanged municipalities. We remark that the reform itself was backed up by DKK 1.2 billion to cover transitory expenses in merging municipalities only.

Our estimates indicate that an increase in political power significantly improves the performance of connected firms. The average effect is consistent with an elasticity of firm performance to political power close to unity; thus, a 100% increase in population per politician nearly doubles connected firms’ operating returns. This performance increase is also associated with larger firm revenues, and it is greater for firms operating in industries that depend more on public demand. Taken together, these findings support the notion that family ties with the political sector help a firm secure more business with local governments.

We provide additional tests to support the causal interpretation of our findings. First, we show that the municipality mergers did not affect the profitability of nonconnected firms or of firms connected with politicians who ran for local offices but were not elected. Second, we confirm that there were no significantly diverging firm-level trends—as regards merging versus nonmerging municipalities—prior to the reform. Third, we control for selection bias due to increased electoral competition in merging municipalities. For this, we use two exclusion restrictions: the aggregate party vote; and the share of politicians older than 65 in the pre-reform municipalities. Fourth, we employ alternative specifications. We use a matching strategy to address the possibility that the impact of the reform is heterogeneous with respect to observable firm and political characteristics that are unbalanced across merging and unchanged municipalities. In addition, we exploit the sharp discontinuity adopted for selecting which municipalities to merge. Comparing connected firms in municipalities barely above and below the qualifying threshold allows us to mitigate concerns that the merging municipalities are characterized by, for example, declining economic or demographic trends.

We also exploit variation in politician, firm, and municipality characteristics in order to gain further insight concerning the relationship between family connections and corporate rent seeking. Sample split results are consistent with our hypothesis that firms connected to stronger politicians benefit more from that greater political power. Also, these benefits are primarily present among small firms and firms making little profit before the reform, thus indicating that this rent extraction may not be welfare improving. Finally, we show that the strength and persistence of political institutions matter. First, revising municipality borders had a larger connected firm effect in municipalities where the reform increased electoral competition more. Second, the effect is smaller for firms connected to politicians in municipalities that developed “persistent” social capital by virtue of having received, centuries ago, special city rights.

The full paper is available for download here.

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