For the Common Good? The Effects of Private Entrepreneurs Political Participation in China

Transcription

1 Preliminary draft, please do not quote For the Common Good? The Effects of Private Entrepreneurs Political Participation in China Xunan Feng City University of Hong Kong Anders C. Johansson * Harvard University Stockholm School of Economics Tianyu Zhang City University of Hong Kong November 2010 * Corresponding author, Stockholm School of Economics, P.O. Box 6501, SE Stockholm, Sweden. Phone: Fax: anders.johansson@hhs.se. Johansson acknowledges financial support from the Bank of Sweden Tercentenary Foundation (RJ), the Swedish Foundation for International Cooperation in Research and Higher Education (STINT), and the Swedish School of Advanced Asia-Pacific Studies (SSAAPS).

2 For the Common Good? The Effects of Private Entrepreneurs Political Participation in China Abstract We study the benefits of private entrepreneurs entering into politics in China. Using original hand-collected data on political participation of entrepreneurs that control listed firms, we document evidence of rent seeking through their political networks and several potential channels through which rent seeking is realized. It is shown that political participation results in increased stock performance and operating performance, consistent with the rent-seeking argument. As rent-seeking channels, firms controlled by politically active private entrepreneurs are able to access debt financing better, lessen their tax burden, and engage in favorable M&A activities, at least partly explained by better access to regulated industries. This study thus sheds light on the benefits of political participation for private entrepreneurs in China and, more importantly, document several channels used to exploit political networks built up through active participation in politics. JEL Classification: G30; G32; G34; H20; P26 Keywords: Political participation; Entrepreneurial firms; Corporate governance; Rent seeking; Capital structure; Tax burden; Mergers and acquisitions; Regulated industry; China 1

3 1 Introduction Do private entrepreneurs become politically active for the good of society? Or do they enter into politics looking for preferential treatment and access to rent-seeking opportunities? A small but growing literature has studied private entrepreneurs that participate in politics in transition economies. The focus in most such studies is mainly on the potential effects on firm value and operating performance. There are only a few studies that identify and test the significance of different potential rentseeking channels that politically active private entrepreneurs may exploit through their political connections. This paper examines the valuation effect of political participation by private entrepreneurs in China and analyzes several rent-seeking channels that lead to such an effect. By identifying when a private entrepreneur enters into politics, we are able to explore the potential benefits of doing so, and the channels through which the entrepreneur may exploit his or her new political position. Such potential rent-seeking channels include better access to capital, preferential tax treatment, and superior access to regulated industries through corporate deals. China is perhaps especially well suited for our study. Chinese private entrepreneurs have been politically active for a long time, especially so after the then President Jiang Zemin welcomed them into the Chinese Communist Party (CCP) in In a business environment marked by poor legal protection, ambiguous property rights, and rent seeking, many Chinese private entrepreneurs have tried to develop close ties to local and national politicians. 2

4 It is therefore valid to raise the question whether they enter into politics for the common good or mainly to exploit rent-seeking opportunities otherwise not available to them. To understand the workings and effects of entrepreneurs political participation we thus (1) examine the effect of political participation on a firm s longterm stock performance and operating performance; and (2) study different potential rent-seeking channels made available through political participation. To analyze political participation, we identify when an entrepreneur (or one of his or her family members) becomes a member of the Congress of the Chinese Communist Party (CCCP), the National People s Congress (NPC), the Chinese People s Political Consultative Conference (CPPCC), or any of their provincial counterparts. Our hand-collected data set covers all listed entrepreneurial firms during the period For this period, we find 73 cases of private entrepreneurs controlling listed firms that have entered into politics. We then perform an event study based on the point in time when a private entrepreneurs becomes a member of any of the political state entities mentioned above. We find that political participation has a significant positive effect on long-run stock performance and that this effect increases over time during an extended period after the event. We also document that political participation has a significant positive effect on several accounting measures of operating performance. Having identified the positive effects of political participation on firm performance and firm value, we then explore several potential channels through which political participation enables such effects. Political participation facilitates 3

5 debt financing as indicated by higher leverage and longer maturity in debt for firms controlled by politically active private entrepreneurs. Political participation also improves the access to regulated industries through merger and acquisitions (M&As). Finally, political participation reduce firms tax burden measured as the effective tax rate. Overall, our empirical findings provide a picture of the significant benefits that stems from political participation by private entrepreneurs becoming in China. In addition to documenting the effects on firm value and operating performance, we are able to identify several channels through which politically active entrepreneurs are able to exploit their rent-seeking opportunities. These results have important implications for the literature on the relationship between entrepreneurs and the political sphere and rent seeking in transition economies. The remainder of this paper proceeds as follows. Section 2 provides a review of the related literature on rent seeking and how entrepreneurs use political affiliations to improve their business. Section 3 discusses the institutional background and the relationship between private entrepreneurs and politicians in China. This section also develops the hypotheses for the empirical analysis. Section 4 describes the data sample and presents the initial empirical results of the effects on firm value and operating performance. Building on these results, Section 5 then analyzes the different rent-seeking channels. Finally, Section 6 concludes the paper. 4

6 2 Literature Review This paper relates to research that focuses on rent seeking and how entrepreneurs use their political ties to benefit their businesses. In her seminal article, Krueger (1974) argues that it is natural for firms to devote economic resources toward rent seeking in order to compete for favorable policy decisions. In general, politicians are able to influence firms through a variety of policy decisions. Politicians may do this for political as well as personal objectives (e.g., La Porta et al., 2002; Rajan and Zingales, 2003). Government decisions can have a significant effect on firm performance and firm value through various channels, such as preferential access to finance, better access to different forms of government subsidies, tax benefits, and reduced regulatory constraints. Numerous studies have analyzed how political connections play an important role for U.S. firms, including Roberts (1990), Kroszner and Stratmann (1998), Jayachandran (2006), Knight (2006), Benmelech and Moskowitz (2007), Goldman et al. (2009), and Cooper et al. (2010). Besides research on the U.S., there is a small but growing literature on the importance of political relationships in other countries. Faccio (2006) performs a cross-country analysis on firms with political connections. She finds that such firms are more likely to be listed in countries with higher levels of corruption and weaker legal systems. Fisman (2001) documents the effects of announcements about the health condition of the former President of Indonesia, Suharto. He shows that companies with close ties to the Suharto family experienced abnormal losses in market value after news of Suharto s deteriorating health was 5

7 published. Johnson and Mitton (2003) study the decision by Malaysia s Prime Minister Mahathir to fire the Deputy Prime Minister Anwar Ibrahim and impose capital controls after the outbreak of the Asian financial crisis. They find that firms with close ties to Mahathir benefitted greatly as a result of the capital controls. Faccio et al. (2006) show that politically connected firms are more likely to be bailed out by the government during times of distress. Fan et al. (2007) analyze how political connections affect firm performance after partial privatizations and public offerings of Chinese state-controlled firms. They find that political connections affect firm performance and market value negatively, indicating that politicians continue to extract resources from state-controlled companies after they have been partially privatized. Finally, Claessens et al. (2008) analyze the Brazilian 1998 and 2002 elections. They document that higher campaign contributions result in higher stock returns around announcements of election results. Even though most research on political relationships and rent seeking has focused on finding evidence for firm effects, a limited number of recent studies have tried to identify potential rent-seeking channels. The channel that has been analyzed most thoroughly is that of preferential access to financing. Faccio et al. (2006), analyzing firms in 35 different countries, find that politically connected firms tend to have higher leverage ratios. Johnson and Mitton (2003) show that politically connected firms in Malaysia had significantly higher debt-asset ratios before the Asian financial crisis and that they had less short-term debt, indicating that politically connected firms have better access to long-term debt financing. Dinc (2005) looks at 6

8 the behavior of banks in developing countries. By focusing on political elections, he finds that political motivations are a part of government-owned banks decisionmaking process. Khwaja and Mian (2005) analyze politically connected firms in Pakistan. They find that such firms have preferential access to loans and that they borrow twice as much as other firms. As a result, politically connected firms in their sample exhibit much higher default rates. Charumilind et al. (2006) analyze firms with strong connections to politicians and banks in Thailand. They find that such firms had significantly better access to long-term debt before the financial crisis erupted in While these initial studies on rent-seeking channels made available through political connections are important, our study provides a more comprehensive picture. In addition to analyzing capital structure changes due to political participation, we are able to identify other channels that politically active entrepreneurs in China are able to exploit, such as increased tax benefits and access to beneficial corporate deals. 3 Institutional Background and Hypotheses 3.1 Private Entrepreneurs and Politics in China Private entrepreneurs did not constitute a major part of early economic reforms in China. From 1978 up to 1988, the first form of private enterprises that was allowed, so-called getihu, was restricted to have no more than eight employees. During this period, private entrepreneurs basically played a somewhat limited role in 7

9 an experiment in which the Chinese government tried to come to grips with how private businesses could function besides state-owned enterprises (SOEs). As a result, early private entrepreneurs were only allowed to do business in sectors previously ignored by larger SOEs. As they became increasingly important, private firms with more than eight employees (siying qiye) were allowed in During the second half of the 1980s, things seemed to progress fast. However, after the Tiananmen demonstrations in 1989, private entrepreneurs experienced a negative setback in the treatment they received from the government, after an event that most of them did not take part in. The CCP imposed a formal ban stating that private entrepreneurs were not allowed to be members in the party. Private entrepreneurs had been discriminated against by the state and its different entities before, but after Tiananmen Incident, they had to function in a more difficult business environment. Albeit discriminatory practices were more or less the norm when dealing with private enterprises, the private sector boomed during the 1990s. Deng Xiaoping s southern tour (nanxun) in 1992 also marked a change in the treatment of private entrepreneurs. A wave of new economic reforms came to change the role entrepreneurs played in the domestic economy. For example, the Chinese Company Law was established in 1994, a first serious attempt to clarify the functions of both state-owned and private enterprises. In the mid-1990s, the restructuring (gaizhi) of the previously so important township and village enterprises (TVEs) had begun, a process that soon increased in speed. Also, a major change in how the Chinese regime sees the private sector was introduced in 1999, when it was stated that individual, private and 8

10 other non-public economies that exist within the limits prescribed by law are major components of the socialist market economy (Tsai, 2006). In 2001, the former Chinese leader Jiang Zemin declared that private entrepreneurs should be allowed to join the CCP. This was reiterated formally during the 16th Party Congress the following year, showing how important the private sector had become for the country. In 2005, there were approximately 30 million registered private companies in China. The same year, they accounted for approximately half of China s total GDP (Tsai, 2007). Dougherty et al. (2007) find that the private sector increased in importance at the turn of the century. In their study based on a data sample comprised by approximately 250,000 companies, it is shown that private firms share of total industrial product increased from 25% in 1998 to over 50% in It was this change that Jiang Zemin acknowledged: private firms with their much higher average productivity compared to SOEs continued to fuel the Chinese economy. Regardless of the increasing acceptance of private entrepreneurs, they have been significantly discriminated against for a long period of time. Entrepreneurs that tried to build up their business during the early period of the economic reforms had to rely on creative solutions to overcome such discrimination. For example, a large number of private enterprises called red-hat (dai hongmaozi) firms registered as publicly-owned firms as a way to disguise their true ownership (Tsai, 2007). It comes as no surprise then that many private entrepreneurs have chosen to become politically active at least partly to ensure better treatment by local and state officials. Entrepreneurs that become members of the CCP are often called red capitalists 9

11 (Dickson, 2003). In this study, however, we focus on entrepreneurs that not only become passive members of the CCP, but also choose to participate in politics at the local or national level. It should be noted that while the number of politically active private entrepreneurs is growing fast, it does not necessarily mean that all of them constitute private entrepreneurs that decide to become members of the CCP or become more politically active. For example, if we were to define a politically active private entrepreneur as a person that is also a member of the CCP, then most such individuals were members of the party before they became entrepreneurs (Dickson, 2008). After the decision to formally accept private entrepreneurs to become party members in 2002, people inside the CCP quickly became active in a plethora of private business ventures. This move, often called to jump into the sea (xia hai), has spurred the private sector to grow even faster. While members of this group of private entrepreneurs are interesting in their own right, this study focuses exclusively on the private entrepreneurs that choose to become politically active after having gained control of a company. 3.2 Defining Political Participation As mentioned earlier, this study focuses on entrepreneurs that enter into politics while already controlling a publically traded company. Political participation is identified for either the private entrepreneur or one of his or her family members. Following the related literature (e.g. La Porta et al., 1999), we identify shareholders who control more than 10% of the outstanding shares. Thus, for a company to be 10

12 defined as a firm controlled by a private entrepreneur, the entrepreneur or his or her family control at least 10% of the its outstanding shares. We then use representation at one of three key state entities as a proxy for political participation. The three entities are: the Congress of the Chinese Communist Party (CCCP), the National People s Congress (NPC), and the Chinese People s Political Consultative Conference (CPPCC). We also include participation at the provincial level of any of the three entities. Wright (2010) states that private entrepreneurs have shown considerable interest in joining these state entities and we therefore believe that a position in one of them constitutes a strong indication of political participation. 1 The CCCP functions as the highest body within the Communist Party of China (CCP). The congress is held only once every five years. The NPC functions as the country s legislative body and is formally the highest organ of the state. Finally, the CPPCC functions as a political advisory body and it consists of members from different parties and organizations as well as individuals. While the CCCP is the only entity that is directly organized by the CCP, both the NPC and the CPPCC are close to the party. The CPPCC has been used as a way for the CCP to attract non-ccp members and increase the support of the party. Shambaugh (2009) also argues that the CPPCC is becoming more systematically involved in the party s policymaking process. Members of both the NPC and the 1 See also Chen and Dickson (2010) for a detailed discussion on entrepreneurs participation in these state entities. 11

13 CPPCC on different levels are approved by the CCP, which indicates the party s influence on these entities. It is widely recognized that the inclusion of private entrepreneurs into the NPC and CPPCC is a way for the CCP to co-opt this increasingly important class. At the same time, an entrepreneur s decision to join one of the state entities in question is more than likely at least partially based on the fact that he or she gets access to a powerful political network. It is thus logical to assume that political participation could be used for the benefit of privately controlled firms. 3.3 Hypotheses The literature on political connections shows that connected firms often are able to exploit their rent-seeking opportunities. The final outcome of such behavior depends on whether the effects of political ties are dominated by rent-seeking or the grabbing hand phenomenon. For example, Fan et al. (2007) show that listed SOEs in China tend to be negatively affected by political connections, indicating that the presence of politically connected people in management and on the board can be detrimental to firm value. However, we are focusing on private entrepreneurs whom have not been rewarded the position in their firm as a result of political connections. We thus expect that the controlling entrepreneur s decision to enter into politics has a positive effect on firm value as well as operating performance. The following hypotheses focus on the effects of political participation: Hypothesis 1a: A privately controlled firm experiences a positive effect on operating performance when the controlling entrepreneur becomes politically active 12

14 Hypothesis 1b: A privately controlled firm experiences a positive effect on firm value when the controlling entrepreneur becomes politically active While the effects of political ties is analyzed in the research literature, less effort has gone into identifying and analyzing channels through which entrepreneurs are able to exploit rent-seeking opportunities. We identify and test several such channels. First, previous studies have shown that political networks can improve firms access to capital. In China, most capital is channeled through the banking system, controlled by the state. For example, Fan et al. (2008) find a significant decline in leverage and debt maturity ratios for firms connected to corrupted bureaucrats after corruption scandals involving the bureaucrats become published. Political participation can thus result in preferential access to debt financing. Hypothesis 2a: A privately controlled firm experiences a positive effect on debt financing when the controlling entrepreneur becomes politically active Hypothesis 2b: A privately controlled firm experiences a positive effect on debt maturity when the controlling entrepreneur becomes politically active Second, close ties to politicians may facilitate preferential tax treatments. If this is the case, we can expect the tax level to be negatively affected when the entrepreneur that controls the company participates in politics. Hypothesis 3: A privately controlled firm experiences a decrease in its tax burden when the controlling entrepreneur becomes politically active 13

15 Third, political participation may result in political ties that provide better access to corporate deals in the form of M&As. One potential effect of political participation is thus that politically active entrepreneurs may obtain better access to certain regulated industries. There are a number of industries that are heavily regulated in China, including the energy, natural resources, and finance sectors. We can thus raise the following hypothesis: Hypothesis 4: Political participation by a the controlling entrepreneur has a positive effect on a firm s ability to enter regulated industries through M&A deals 4 Data and Initial Empirical Analysis 4.1 Data and Sample Description Our data set is comprised of all privately controlled listed firms on the Shanghai and Shenzhen stock exchanges from 1993 to Firms with a private citizen controlling at least 10% of the company are defined as privately controlled firms. Panel A in Table 1 shows the total number of listed firms and the number of privately controlled firms for each year during the sample period. The number of firms controlled by private entrepreneurs is very modest during the 1990s, never reaching above 10% of the total number of listed firms. During the following decade, however, the ratio of privately controlled firms to the total number of listed firms increases fast. In 1993, the total number of listed firms was 183, of which only six 14

16 were controlled by private entrepreneurs. In 2009, the total of listed firms had increased to 1714, with no less than 659 firms that can be defined as firms controlled by private entrepreneurs. This means that the ratio of firms controlled by private entrepreneurs to the total number of listed firms increased from a mere 3.28% to an impressive 38.4% over the sample period. This change mirrors the overall development in the Chinese economy, in which privately controlled firms constitute an increasingly important part, especially during the last decade. Next, we look at political participation by identifying when the controlling private entrepreneur or one of his or her family members becomes politically active (i.e. a member of the CCCP, the CPPCC, or the NPC). Panel B in Table 1 presents the distribution of private entrepreneurs that become active in any of the main political entities listed above. As expected, none of the private entrepreneurs participated in politics during the most of the 1990s. Four of them became politically active during the last years of that decade comprising no more than approximately 2% of the total number of listed privately controlled firms in China. After the official recognition of the importance of the private sector and the formal acceptance of private entrepreneurs into the CCP in 2001 and 2002, the number of private entrepreneurs that controlled a listed firm increased quickly. In 2009, a total of 73 privately controlled firms had access to a political network through the political participation of the controlling entrepreneur or one of his or her family members. This constituted 11.1% of the total number of privately controlled firms, indicating that not only were private entrepreneurs allowed to enter into politics, they themselves clearly found it 15

17 attractive to do so. While approximately 11% of the number of privately controlled firms is substantial, it is clear that the Chinese government has a process of its own to select which private entrepreneurs that are allowed to take higher-level political positions. This selection procedure can be seen as contributing to the rent-seeking process. 4.2 Political Participation and Firm Value To analyze the effects of political participation, we analyze stock performance around the time when the political participation of private entrepreneurs that control listed firms begins. In order to be compare stock performance of our sample firms with regular firms controlled by private entrepreneurs, we first identify matching firms. Matching firms are selected based on size (in terms of sales) and industry in the year of political participation. Table 2 reports univariate tests for stock performance in both the sample with companies controlled by private entrepreneurs that entered into politics (the research sample) and the matching sample. We use cumulative abnormal market-adjusted stock returns (CARs) to analyze the effects of political participation. The CARs are based on monthly returns and are calculated using returns from three months prior to the controlling private entrepreneur enters into politics up to 12 and 24 months after the event, respectively. Market returns used to calculate the CARs are the equally-weighted monthly returns including dividends of all stocks on the Shanghai and Shenzhen stock exchanges. Panel A in Table 2 presents the mean and median CARs for the two groups. The average 12- and 24-month CARs for the 16

18 matching sample are 6.1% and 8.4%, while the CARs for the sample composed of firms controlled by private entrepreneurs that enter into politics have a much higher average mean of 13.6% and 27.3%, respectively. The difference is significant for both time lengths. These results show that firms controlled by private entrepreneurs that decide to become politically active outperform their peers with an average of 7.5% over a 12-month period and 18.9% over 24 months. The results also indicate that the difference between the two samples seem to increase over time, which means that the advantages of developing an extensive political network through political participation is not a one-time effect, but rather something that benefits the firm over a long period of time. To shed more light on the long-term effects of political participation, we calculate CARs for every month up to two years after the event. Figure 1 shows how CARs for the two sample groups develop over time. It is evident that the benefits of political participation by the controlling private entrepreneur are highly beneficial for the firm and that the positive effects are persistent. To control for other variables that may influence our results, we again estimate OLS regressions, this time using the 12- and 24-month CARs as dependent variables. We include the same variables as when analyzing operating performance, i.e. Tobin s Q, leverage, size, and industry and year dummies. Panel B in Table 2 reports the regression results. Even when taking additional influential factors into account, political participation still has a significant and positive effect on long-run stock performance, especially over longer periods, as indicated by size and significance of political participation when the 24-month CAR is the dependent variable. We can 17

19 therefore conclude that political participation by controlling private entrepreneur has a significant positive effect not only on operating performance, but also firm value. These initial results support those of earlier studies on how firms may benefit from strong connections with leading politicians (e.g. Fisman, 2001; Faccio, 2006; and Ferguson and Voth, 2008). Having established that political participation is closely related to increases in firm performance, next we focus on potential channels firms controlled by entrepreneurs that enter into politics may exploit for additional rent seeking. 4.3 Political Participation and Operating Performance To further analyze the effects of political participation, we compare changes in operating performance based on when the political participation of private entrepreneurs that control listed firms begins. We focus on six different measures of accounting-based operating performance. First, we define growth in assets, sales, and earnings as the growth of average of each measure during three years before the entrepreneur becomes politically active to the average of the year of the entrepreneur entering into politics and the year after. Second, we define change in return on sales (ROS), return on assets (ROA), and return on earnings (ROE) as the difference between the average of each measure during three years before the entrepreneur becomes politically active and the average of the year that the entrepreneur enters into politics and the year after. Before moving on to the regression analysis, we perform tests for differences in the mean and median of the two groups for all six operating 18

20 performance measures. Panel A in Table 3 presents the descriptive statistics and the results of univariate tests for the different operating performance measures. All variables are winsorized at top and bottom 5%. Both the mean and median of all six measures are significantly higher for firms with controlling private entrepreneurs that enter into politics. These initial results show that firms controlled by private entrepreneurs that enter into politics experience a significant positive effect of their new political network. To control for a number of factors that have been shown to influence operating performance in later regressions, we also include three additional variables that are commonly used in the literature on operating performance: Tobin s Q, measured as the sum of total market value of equity and total net liabilities divided by total assets; leverage, measured as the ratio of total liabilities over total assets; and size, measured as the natural logarithm of total assets. We again test for differences in mean and median between the group of politically entrepreneurs and the matching group. Both the mean and median of Tobin s Q is significantly larger for firms with politically active entrepreneurs, indicating their greater growth potential. Similarly, politically active entrepreneurs have significantly higher leverage, even though the difference in the mean is only significant at the 10% level. While we revisit this topic in a later section, it is worth noting that firms controlled by politically private entrepreneurs have higher debt levels than other entrepreneurial firms. Finally, the mean and median of firm size in the two groups are indistinguishable. This shows that the matching 19

21 sample mirrors that of our sample of firms controlled by private entrepreneurs that enter into politics during the sample period. To control for other variables that may influence our results, we estimate ordinary least squares (OLS) regressions using each of the six measures of operating performance as dependent variables. Panel B in Table 3 presents the results of the six OLS regressions with political participation, Tobin s Q, leverage, size, and industry and year dummies as independent variables. The regression results show that firms controlled by private entrepreneurs that enter into politics experience an improved operating performance, regardless of whether or not the change in performance is measured by growth in assets, sales or earnings, or the change in ROS, ROA, or ROE. These results are consistent with the initial univariate results in Panel A and show that political participation by the controlling entrepreneur results in a positive effect on a firm s operating performance. 5 Identifying Rent-Seeking Channels 5.1 Access to Debt Financing and Debt Maturity We begin our analysis of potential rent-seeking channels by looking at debt structure and debt maturity. Our hypothesis is that political participation results in better access to debt financing with resulting changes in debt structure and debt maturity. To do this, we look at two separate variables. For debt financing, we analyze the change in total debt over total assets and the total debt plus accounts payable over 20

22 total assets. To examine how firms use their newly found political networks to change their debt composition, we focus on the change in long-term debt over total debt and the long-term debt over total debt plus accounts payable. Panel A in Table 4 provides a description of the sample based on the debtrelated variables. The changes in debt financing indicate that firms controlled by private entrepreneurs that become politically active experience a significant positive change in the debt ratio. Total debt over total assets as well as total debt plus accounts payable over total assets are larger in both the mean and median for the group of firms with politically active entrepreneurs. This means that after the controlling entrepreneurs enter into politics, their firms are able to increase their leverage more than normal firms controlled by private entrepreneurs. Focusing on the changes in debt maturity, it is evident that political participation increases long-term debt as share of total debt plus accounts payable. These results support earlier studies that find evidence of higher leverage ratios and better access to long-term debt for politically connected firms (e.g. Johnson and Mitton, 2003, and Faccio et al., 2006). Next, we perform regressions to examine whether the financing policies of the firms in the research sample change after the controlling entrepreneur engages in political participation. We control for a number of additional factors that are known to affect financial leverage and debt maturity. In addition to the three controls we used previously, we also include profitability, measured as earnings over total assets, and collateral, measured as the ratio of net fixed assets over total assets. Finally, we again include industry and year dummies. Panel B in Table 4 reports the regression results 21

23 with each of the four debt measures as dependent variable. Column 1 presents the regression results with the leverage variable as the dependent variable. Both total debt over total assets and total debt plus accounts payable over total assets are affected by political participation and the effect is positive and significant, indicating that firms with access to comprehensive political networks as a result of their controlling entrepreneur becoming politically active experience a significant increase in leverage. Looking instead at the changes in debt maturity, political participation has a somewhat weaker effect. However, the effect is still positive and significant at the 10% level for change in long-term debt over total debt plus accounts payable. Longterm debt is thus positively related to political participation, indicating that firms controlled by private entrepreneurs that enter into politics are able to shift to longerterm debt. The results show that the changes in leverage and debt maturity cannot be explained away by changes in other corporate fundamentals or industry and year effects. Overall, the findings in Table 4 demonstrate how debt financing behavior changes as private entrepreneurs that controls listed firms in China decide to enter into politics. 5.2 Tax Burden To analyze the changes in taxes after an entrepreneur engages in political participation, we focus on the effective tax rates (ETR). ETR is defined as the tax expense minus deferred tax expense divided by earnings before interest and tax (EBIT). For completeness, we also use two alternative ETR measures. For the first 22

24 alternative measure (ETR1), we divide tax expenses only with EBIT. For the second alternative measure (ETR2), we divide the difference between tax expenses and deferred tax expenses with total profit. Then, to analyze the effect of political participation, we calculate the change in tax burden as the difference between the average annual ETR during the year of the event and the year after event and the average annual ETR for the three years before the event. We also include several control variables commonly seen in the literature on tax rates: capital intensity, defined as the net fixed assets over total assets, and inventory intensity, defined as inventory over total assets. We also use profitability, defined the same as before. Panel A in Table 5 reports the mean and median values of change in the three different tax burden measures. Initial tests for difference in mean and median show that firms with entrepreneurs that enter into politics exhibit a significant reduction in tax burden. While the mean of ERT is slightly positive for firms controlled by politically active entrepreneurs, its median is negative. The mean and median is negative for both ERT1 and ERT2 for firms controlled by entrepreneurs that become politically active. For the matching sample, only the change in ERT1 is negative. When testing for differences in mean and median, the negative effect is significantly stronger for the research sample, indicating that political participation enables firms to lower their tax burden relative to similar firms in the matching sample. Panel B in Table 5 reports the results of the different regressions with each of the three tax burden measures as dependent variables. The independent variable of interest is again political participation. The coefficient for political participation is 23

25 negative and significant for each of the three tax burden measures. To conclude, even when controlling for various alternative factors that may influence the dependent variables, our results show that political participation by the controlling private entrepreneur eases tax burden. 5.3 Access to Regulated Industries through M&A Deals We have established that political participation has a positive impact on operating performance and firm value and that some of this effect goes through debt and tax burden channels. Next, we study how political participation affects privately controlled firms access to beneficial corporate deals, either through mergers or acquisitions. To analyze the effects of such deals, we identify M&A deals by firms controlled by politically active private entrepreneurs. As before, we match these firms with corresponding firms controlled by private entrepreneurs who have not entered into politics through any of the three state entities we use as proxies for political participation. We then carry out a regression analysis that focuses on access to regulated industries in China. The first two panels in Table 6 present descriptive statistics focusing on M&A deals for both sample groups. Panel A reports the firm characteristics. Approximately 39% of the total number of deals was carried out by firms controlled by entrepreneurs that are politically active. The standard control variables are also included: Tobin s Q, leverage, and size. The characteristics of the M&A transactions are reported in Panel B. We measure type of M&A with a dummy variable that is equal to 1 when the 24

26 transaction is based on equity purchase and 0 otherwise. The variable M&A size is measured as the ratio of the transaction value to the size of the buyer. We also include the dummy variable regulated industry which is equal to 1 if the target firm is active in one of China s regulated industries and 0 otherwise. A majority of the M&A transactions are based on stock purchases. The average size of the target company relative to the buyer is relatively modest at 7.7%. Finally, only a minority of the total number of transactions involves deals in regulated industries, mirroring the fact that it is difficult for privately controlled firms to enter certain sectors of the Chinese economy. To analyze the influence that political participation may have on gaining access to regulated industries, we perform a logistic regression with the dummy variable regulated industry as dependent variable. Besides political participation, we include our standard control variables as well as industry and year dummies. Panel C in Table 6 reports the results of the logistic regression. The coefficient for regulated industry is highly significant and positive. We can therefore conclude that a firm that is controlled by a private entrepreneur that has entered into politics is more likely to carry out an M&A transaction in a regulated industry. This means that political participation by private entrepreneurs in China can be used to gain access into industries that are heavily regulated and often closed to the private sector. 25

27 6 Conclusion This paper examines the effects when Chinese private entrepreneurs enter into politics. We firsts identify all listed firms that are controlled by entrepreneurs and then analyze the effects of the event of initial political participation. The event is thus defined as the controlling private entrepreneur entering into politics through one of three important Chinese state entities. Consistent with the literature on rent seeking and political connections, we find that political participation has a positive effect on operating performance and firm value. This indicates that private entrepreneurs are able to exploit their newly developed political networks for rent seeking. We then examine several potentially important channels for rent seeking. First, we find that firms controlled by private entrepreneurs that enter into politics are able to increase their leverage after the event. We also find that political participation has a positive effect on long-term debt relative to total debt. These results indicate that political participation results in advantages when it comes to access to debt financing and thus affect capital structure choices. Our findings on the effect of political participation on debt financing thus support recent research findings suggesting that financing patterns are affected not only by factors at the firm or industry level, but also on the country level (e.g. Rajan and Zingales, 1995; Demigurc-Kunt and Maksimovic, 1996, 1998, 1999; Booth et al., 2001). Second, we look at several alternative measures of tax burden. Our findings show that political participation results in a negative effect on efficient tax rates (ETRs). This indicates that private entrepreneurs in China are able to exploit the 26

28 networks they build up through political participation to lower the tax burden of their companies. Third, we analyze how firms corporate deals are affected by political participation. We find that political participation significantly increases the likelihood of corporate deals in China s regulated industries. This means that private entrepreneurs are able to access certain industries by entering into politics. Our paper makes important contributions to the literature on political connections and rent seeking. First, we document how China s private entrepreneurs can choose to become a member of any of the major political entities and thereby improve their firms value and performance through rent seeking. Second, and more importantly, we identify several important rent-seeking channels that private entrepreneurs are able to exploit through their political participation, including better access to debt financing, reductions in tax burden, and better access to heavily regulated industries in China. Our results should be useful when trying to understand problems in other emerging markets with similar institutional features. 27

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