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Political Connections, Government Subsidies, and Capital Misallocation: Evidence from China

We show that the political connections of Chinese firms have a substantial influence on the allocation of government subsidies, which exacerbates the economy’s capital misallocation. Our identification strategy exploits a regulation that forces politically connected independent directors – independent directors who are current and former government officials or members of the Communist Party in China – to resign from the company. Treated firms experience a substantial decline in subsidies after the regulation, especially so for low-efficiency firms. Further, treated firms’ investment efficiency improves after the regulation. Finally, we find that the degree of capital misallocation in industries that are most affected by the regulation declines. Our findings provide supporting evidence for the effectiveness of China’s anti-corruption campaign.