It is well-known that businesses in China maintain a mutualistic relationship with the state, but what is the price of political connection, and how does the state meet its revenue goals through such partnerships? In a new article in The China Quarterly, researchers including APARC China Program Director Jean Oi present the first study to empirically document the costs of political connection for state-owned enterprises and the reciprocal benefits for the state.

By showing how interests are aligned between firms and local authorities, the authors explain why China, unlike Russia, has been able to collect more taxes from restructured firms and why politically connected firms are more likely to pay even more.

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Overpaying Taxes for Preferential Access

Comparative studies have shown how firms with political connections in different economic and political contexts receive preferential access. The co-authors, including Chaohua Han of the Chinese Academy of Social Sciences and Xiaojun Li of the University of British Columbia, analyze special political connections as repeated patron-client exchanges in which politically connected firms can help the state fulfill its revenue imperative. They show that firms, particularly state-owned enterprises (SOEs), often serve as a failsafe for local authorities to ensure that upper-level tax quotas are met. 

The researchers examine survey data of Chinese firms over an 11-year period and the variations in their post-restructuring board composition. They find that restructured SOEs with political connections repeatedly pay more tax than their assessed amount, independent of profits, in exchange for more preferential access to key inputs and policy opportunities controlled by the state. 

The longitudinal nature of the surveys allosa the authors to exploit variation within the same firm over time, thus accounting for unobserved firm-specific factors that confound cross-sectional analyses.

The restructured firms with political connections, measured as firms with current or former government officials on the executive board, are more likely to pay more taxes, even when the profits of these firms remain flat. These findings support the authors’ argument that the “helping hand” relationship is part of a reciprocal exchange between the state and its politically connected firms, rather than just a one-sided provision of goods or opportunities to the firms by the state.

For SOEs, it is tax payments, especially overpayment above the amount set by the statutory rate, that are the premiums that must be paid in order to maintain their clientelistic relationship, thereby ensuring continued preferential access to benefits from the government, including loans from state banks and help with debt financing.

A Two-Way Street to Common Prosperity

While many SOEs remain unprofitable, the authors show that the relationship between the state and its politically connected firms is a complex and nuanced patron-client reciprocal exchange, where political connections yield benefits but also entail costs for firms, including helping the state meet its revenue imperative.

While existing research, including that on China, already shows that firms with political connections can maintain a patron-client relationship by providing individual officials rents, i.e. bribes, in exchange for preferential access to limited opportunities and resources, the authors show that the patron-client relationship between SOEs and the state is different. 

Oi and her co-authors argue that the key difference is that “the extra payment is going not into private pockets but into local coffers to meet the local tax collection quotas, which have more diffuse benefits for the populace at large.” Examining taxes rather than profits also offers a new interpretation for why China continues to favor its remaining SOEs even when they are less profitable.

Patron Turnover, Client Turnover, and their Enduring Relationship

The logistics behind the patron-client reciprocal relationship can be fraught with uncertainty. Firms know that key local officials, at the top of local government as well as within bureaus, get transferred, but personnel changes do not necessarily make paying additional tax ineffective and costly, the authors contend. 

For politically connected firms, there is continuing certainty that agreeing to pay higher taxes when needed will still be effective regardless of personnel changes. It matters not whether there is a new official, as they will likely run into periods of economic difficulty and need help meeting the tax collection quotas. This is one more reason why firms continue to “help” the state, especially when new officials take office. 

Sustained overpayment of tax is a clear reaffirmation by a client to the local state, note Oi and her colleagues. The relationship that politically connected firms have with the state is more than simply having “personal ties” (guanxi 关系) with a single individual. Rather, it is a long-term relationship between a firm and the local state based on trust as well as exchange, where payback is not predetermined in time or amount.

The government revenue incentive is the core of the nuanced patron-client relationship, and drives the government to favor SOEs as opposed to entirely private firms. The authors suggest that “A question that needs asking is what economic returns does the state get from allowing selected firms to use political connections to get ahead?” 

Their findings that the state pursues its interests through tax collection rather than increased firm profits offers an explanation as to why the Chinese leadership continues to embrace state-owned or state-controlled firms as a necessary and crucial part of the economy, despite their flagging profits.