How Political Corruption Impedes Corporate Innovation

By Stephanie Policastro

If “always be closing” is the mantra of the salesforce, “always be innovating” might be the new catchphrase for those in the C-suite. Whether it’s bringing new products and services to market or introducing ideas that boost productivity and increase revenue, innovation is essential for growing a successful business in any industry. But what happens when external factors – like political corruption – impede that innovation? 

That’s the question that Jesse Ellis, Poole College professor of finance, Jared Smith, Poole College associate professor of finance, and Roger White, associate professor at Arizona State University, have explored in-depth. A paper of their findings, titled “Corruption and Corporate Innovation,” was published in the Journal of Financial and Quantitative Analysis, and examined how political corruption in the United States affects firm innovation.

Previous theory suggests that entrepreneurial and innovative firms are the most susceptible to rent-seeking – manipulation of public policy as a strategy for increasing profits, and corruption – use of public office for private gain, due in part to the fact that they create new products and are likely to interact with government officials more often than other types of businesses. 

“Any interaction with a powerful, corrupt government official presents an opportunity for bribery or extortion, and because entrepreneurial firms often require operating licenses, building permits or approval by regulatory agencies – their interactions with these officials are more frequent,” says Smith. “Unfortunately, this can really impede a firm’s innovation activities and cause other costly risks long after the innovation is completed.”

Using these arguments, Ellis, Smith and White hypothesize that political corruption will reduce the quantity and quality of firm innovation, which they term “the costly corruption hypothesis.” 

To test the hypothesis, they developed a proxy for political corruption at the local level within the U.S. using data on public corruption convictions in the U.S. federal judicial court districts. Through a series of tests using different fixed effects, proxies for local political corruption, instrumental variables, and subsamples, they find a negative relation between the level of political corruption surrounding a firm’s headquarters and the quantity and quality of patents generated by the firm. 

We found that corruption reduced innovative output on average, but perhaps more significantly, that it reduced output for the firms that innovate most… meaning that increased corruption seems to negatively shift the entire distribution of innovation.

“We found that corruption reduced innovative output on average, but perhaps more significantly, that it reduced output for the firms that innovate most… meaning that increased corruption seems to negatively shift the entire distribution of innovation,” says Smith. 

Their findings show that in addition to incentives like tax credits and direct grants, simply investing in better quality government and rooting out corruption can lead to more innovation.

The study abstract follows.

“Corruption and Corporate Innovation”

Authors: Jesse Ellis, Ph.D., North Carolina State University; Jared Smith, Ph.D., North Carolina State University; and Roger White, Ph.D., Arizona State University

Published: Journal of Financial and Quantitative Analysis, Vol. 55, Issue 7, November 2020. 

Abstract:

We examine whether political corruption impedes innovation. Using a comprehensive sample of

U.S. firms, we find that corruption has a substantial, negative relation with the quantity and quality of innovation. These results are robust to using various fixed effects, proxies for corruption and innovation, and subsamples. To establish causality, we employ two instruments for corruption: local ethnic diversity and the corruption of the state a firm’s founder grew up in. Corruption appears to reduce innovation output both on average and for the most innovative firms. Overall, this evidence is consistent with the notion that corruption reduces social welfare by impeding innovation.