Quid pro quo? Government-firm relationships in China

Abstract

This paper studies favor exchange between governments and firms in China by exploiting a quasi-experiment tax reform. A tax revenue-sharing rule between central and local governments was announced in October 2001: the higher the local tax revenue in 2001, the higher the share of the tax revenue that stays at local afterward. I find that local governments that granted more favors to firms before the reform received more assistance from firms to raise the tax revenue in 2001; in turn, an abnormally high government subsidy was returned to firms that offered assistance. This paper demonstrates that a reciprocal relationship between governments and firms beyond the simple trading of personal favors could arise in non-democratic societies where politicians face no electoral incentives. The fact that firms and governments could mutually benefit from this reciprocal relationship helps explain the exceptional economic growth in China despite its unfavorable business environment.