Mitchell: The hidden tax of political cronyism

Daniel J. Mitchell


I do not like it when poor people receive handouts from government, though not because I think they are being grifters. I mostly view them as victims who are vulnerable to getting trapped in the quicksand of government dependency.

The people I despise are the rich people who manipulate the levers of power to get undeserved goodies. These well-heeled sleazeballs generally have the brains and ability to earn money honestly, but they decide it’s more lucrative to steal money from ordinary people, using government as the middleman.

That is the moral argument for separation of business and state. But there’s also an economic argument to be made against government cronyism.

There’s a very interesting new study from the World Bank that estimates the impact of government favoritism in Ukraine. Here’s how the authors define the problem.

“Rent seeking is the manipulation of public institutions to obtain … income … without the creation of new wealth …. Rent seeking is sometimes legal …. In Ukraine, rent seeking includes the award of public resources to companies through tax exemptions, direct subsidies and procurement contracts to connected companies that cannot be justified in terms of the economic benefits to society as a whole. The rent seeking activities provide a basis for the existence of so-called “crony capitalism” …. Crony capitalism allows politically connected businesses to enjoy benefits that other companies cannot access. It allows politically connected businesses to create barriers to entry in those sectors where they operate. As a result, crony capitalism allocates resources inefficiently, restricts competition, increases economic costs and limits economic opportunity …. This paper estimates the economic cost of crony capitalism in Ukraine.”

They start with the challenge of trying to measure cronyism.

“If we are to assess the impact of crony capitalism in Ukraine, we must first define political connection and distinguish politically connected firms from non-connected firms …. We use two approaches to identify politically connected firms. The first approach is based on publicly available information on the ownership and control of businesses by politically exposed persons …. A PEP is a person who has been entrusted with prominent public functions, including senior politicians and party officials, senior government, judicial or military officials, and senior executives of state-owned corporations …. The second approach is … to include companies that are not formally controlled by PEPs, but enjoy a political connection through an oligarch or a business group they belong to …. Between half a percent and 2 percent of the total number of firms in Ukraine are politically connected. However, politically connected firms controlled over 20 percent of the total turnover of all Ukrainian companies.”

Here are some of their empirical results.

“The economic performance of politically connected firms in Ukraine is significantly different from that of their non-connected peers …. Politically-connected firms are larger than their non-connected peers …. Politically-connected firms pay a lower effective tax rate …. Politically-connected firms are less productive. Politically-connected firms have a negative Total Factor Productivity (TFP) gap compared to non-connected firms …. This indicates that there could be a potentially large pay-off from policies that promote competition …. Politically-connected firms grow slower than non-connected firms …. Such firms tend to have better access to rents and less incentives to compete …. The politically connected firms reap the benefits from preferential treatment when interacting with the state and limiting market competition.”

The bottom line is that cronyism promotes and protects inefficiency. And when an economy is less productive, that results in lower incomes and diminished living standards.

Sadly, this is not just a problem in developing and transition nations.

Cronyism exists wherever governments have a lot of power, and that includes the United States.

The federal government has myriad policies that tilt the playing field in favor of connected companies. The purpose of policies such as ethanol handouts, the Export-Import Bank, protectionism, tax favoritism, bailouts, subsidies, and green energy is to provide unearned wealth to the friends of politicians.

But cronyism is not just enabled by bad policies from Washington. State governments also are guilty of favoritism, even when the feds aren’t involved. As I’ve previously argued, the pro-growth way for governments to compete is having low tax rates for everyone.

P.S. Elizabeth Warren wants to turn all big companies into cronyist entities.

P.P.S. American taxpayers are subsidizing cronyism in Ukraine.

Daniel J. Mitchell, chairman of the Center for Freedom and Prosperity, is on the Editorial Board of the Cayman Financial Review.


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