Politically motivated corporate decisions as tournament participation/inclusion games (2022)

Table of Contents
Journal of Corporate Finance Abstract Introduction Section snippets Influence of political forces on corporate decisions A promotion tournament game Testing hypotheses and data Results Conclusion References (44) J. Financ. Econ. J. Public Econ. Econ. Lett. J. Corp. Finan. European Economic Review Policy Uncertainty, Political Capital, and Firm Risk-Taking Opportunistic political cycles: test in a young democracy setting Q. J. Econ. Political cycles in OECD economies Rev. Econ. Stud. Financial constraints, asset tangibility, and corporate investment Rev. Financ. Stud. Politics, state ownership, and corporate investments Rev. Financ. Stud. Economic growth in a cross section of countries Quarterly Journal of Economics Irreversibility, uncertainty, and cyclical investment Q. J. Econ. Politicians, Firms and the Political Business Cycle: Evidence from France What affects innovation more: policy or policy uncertainty? J. Financ. Quant. Anal. Economic performance and political mobility: Chinese provincial leaders J. Contemp. China Precarious politics and return volatility Rev. Financ. Stud. Ownership Structure and Tax Avoidance: Evidence from Agency Costs of State Ownership in China Political Turnover, Ownership, and Corporate Investment Financial constraints, investment, and the value of cash holdings Rev. Financ. Stud. The Real Effects of Political Uncertainty: Elections, Capital Allocation, and Performance Financing constraints and corporate investment Brook. Pap. Econ. Act. Investment-cash flow sensitivities are not useful: a comment on Kaplan and Zingales Q. J. Econ. Cited by (0) Recommended articles (6) Videos
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Journal of Corporate Finance

Volume 67,

April 2021

, 101883

Abstract

We introduce political tournament “participation/inclusion” games. Dominant strategies determine whether players choose to compete by enhancing economic performance. Unique Nash equilibria competitors win (only) inclusion as promotion candidates. We find empirical justification for such equilibria in Chinese province heads' periodic political tournaments/elections for promotion to the Communist Party politburo and government positions. We document pervasive tournament-synchronized corporate decision-making cyclicality. Firms enhance economic performance by increasing investments, taxes, and employment before elections. Cyclicality is dominantly driven by privately-owned enterprises, is weaker in economically/politically weak(strong) provinces. Political promotions, however, are not sensitive to corporate investments enhanced before tournaments but to long-run investments.

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Introduction

Are times of political tournaments favorable for economic activity? The answer depends on which of two forces dominates an economy. On one hand, political uncertainty, arising from possible changes in political leadership, reduces economic activity (Bernanke, 1983).2 On the other hand, the incentives of politicians to maximize the probability of winning an election by demonstrating performance motivate them to use political power to improve economic indicators before an election (Rogoff, 1990). While these forces are not mutually exclusive, and both forces can be at work in any political economy, it is reasonable to expect that under democratic elections (in which outcomes are relatively more uncertain and could lead to change in political party), the forces of political uncertainty dominate. Under autocratic promotions, (where outcomes are relatively less uncertain and do not lead to change in political party), it is reasonable to expect that the forces of political incentives dominate.

China is an interesting laboratory for understanding how incentives of politicians influence economic activity: while firms generally operate in a market economy, their economic behavior depends on the good will of their provincial politicians and, thereby, the political incentives built into the promotion system.3 Also, political uncertainty is limited in the Communist Party system, where popular elections are substituted with tightly controlled promotions of party members.

We first theoretically characterize key features of political promotion tournaments of province heads. In China, these correspond to the national political promotion tournaments, every five years, of the Province (Communist) Party Secretaries (PPS), who are the defacto province heads, to the Communist Party politburo, its standing committee, and government positions.4 We model promotion tournaments where province heads can increase their promotion probabilities by using their political power to enhance their province's economic performance in time for promotion decisions (for example, by influencing firms in their province to improve economic indicators). Not all province heads “participate” in the game of enhancing economic performance before political promotions; those who assess their endowed promotion probabilities as extreme (relatively high or low) have reduced incentives to enhance economic performance prior to promotion decisions and decide not to do so. This participation game has a dominant strategy equilibrium.

In a (unique) Nash equilibrium, the remaining province heads must enhance their economic performance so they do not fall behind. Nevertheless, the incremental promotion probability gained by economic indicators enhancement, over “enhancing” competitors, is driven to zero because of competition. We call this game an “inclusion game,” in which all “included” PPS must enhance economic performance to be considered for promotion. But, in equilibrium, as all competitors are doing the same, none gets a relative advantage over other “included” competitors.

We then test three hypotheses based on our model: 1) Firm activities to enhance economic performance increase before national political promotion tournaments of PPS. These activities can be in various forms such as corporate investments, employment, wage growth, and taxes to the party. 2) Cyclicality of these activities is less pronounced in politically extreme provinces, strong or weak, where PPS are often or rarely promoted. 3) Opportunistic activities before tournaments do not predict promotion outcomes. However, long-run provincial economic performance or corporate investments during the entire term of PPS do predict promotions.

We use three National Communist Party Congress (NCPC) elections from 2000 to 2013 for our empirical analysis.5 Hereafter, we refer to these election years as “tournament years.”

Our first empirical analysis tests whether firms increase investments, which are crucial to enhance the regional economic performance, before the national congress elections. We document a tendency for Chinese firms to increase investment expenditures by an average of 6% one year before PPS tournaments. Notably, this investment cyclicality is pronounced only in privately owned enterprises (POE). State-owned enterprises (SOE), rather, increase investments one year and two years after the tournament year, which suggests that political leaders tend to boost investments of SOE from the early periods of their term (An et al., 2016; Cao et al., 2015; Ru, 2018). While PPS can influence SOE to increase investments from the outset of political tournaments, they may optimally wait to become contenders of tournaments before motivating POE investments.

We further examine how the investment cyclicality of local firms is associated with the promotion probabilities of PPS in upcoming elections. As theoretically predicted, cyclicality is weaker in economically and politically extremely weak (strong) provinces, where PPS are rarely (often) promoted in the political tournaments. The cross-provincial variations in investment cyclicality are robust to controlling for year fixed effects, suggesting that investment cyclicality in the average province is not driven by an unobservable macroeconomic business cycle unrelated to political incentives.

Next, we test whether politically motivated corporate investments support the promotion of PPS. Consistent with our tournament game equilibrium, we find that temporary increases in corporate investments one year before tournaments do not enhance probabilities of PPS being promoted to the Communist Party politburo or its standing committee, both of which represent the party's highest authority.6 Rather, promotion outcomes depend on the long-term economic performance or corporate decisions since previous elections.

Beyond corporate investments, we observe cyclicality synchronized with political tournaments in a broad set of corporate decisions. First, firms tend to increase tax payments, a key economic performance indicator directly benefiting the party, at the tournament year. Specifically, firms pay, on average, 13.6% more taxes (scaled by the earnings before interest and taxes, EBIT) than they pay in other years. We also find associated changes in other corporate decisions that influence the provinces' economic performance. In the tournament year, firms tend to hire more workers and spend more on wages than in other years. Consistent with our equilibrium, we expect to see increases in tax payments or employment later than the increase in investments because it takes time for corporate investment inputs to become productive. Regarding financing decisions, POE tend to reduce cash holdings one year before tournaments, when these firms increase investments. This suggests that their investments are often cash financed. As in investment cyclicality, SOE exhibit weaker cyclicality for cash holdings (i.e., they reduce cash holdings less before the tournaments).

Our paper contributes to the literature in several ways. First, we introduce a participation/inclusion game and provide a theoretical foundation for how political/promotion tournaments induce cyclicality in firm and aggregate economic behavior. While this framework naturally applies to the Chinese PPS promotion cycle, the insights from our participation and inclusion games can also be extended to other autocratic countries where political leaders compete over economic performance and can influence firms' decisions. (In democratic countries, modeling interactions of these games with political uncertainty will likely be important.). Our participation/inclusion game describes equilibria in other tournaments, such as employment tournaments.

Second, in support of our theoretical characterization of the above equilibria, we find empirical evidence that

1.

a broad set of cyclical corporate activities are synchronized with the deterministic PPS promotion calendar. This contrasts with previous studies, such as Cao et al. (2015) and An et al. (2016), that focus on corporate investments around turnovers of other local politicians (governors, city secretaries, or mayors), which are fairly dispersed across years;

2.

promotion outcomes are influenced by the provincial economic performance during the entire term of PPS rather than the opportunistic corporate activities;

3.

province heads of “strong and weak provinces” engage in enhancing economic performance to a lesser extent.

Finally, while most previous studies, except for Liu et al. (2016), focus on the effect of political incentives on SOE, we find heterogeneous cyclicality between SOE and POE, particularly in their investment decisions.

The paper is organized as follows. Section 2 reviews the literature. Section 3 introduces a promotion tournament game, solves for its equilibrium, and discusses implications. Section 4 describes testing hypotheses that the promotion tournament game equilibrium induces and summarizes our data. Section 5 presents empirical analysis results, and Section 6 concludes.

Section snippets

Influence of political forces on corporate decisions

Nordhaus's (1975) model of political business cycles started a debate over whether politicians aim to maximize chances of winning elections through manipulations of fiscal and monetary policies. Rogoff (1990) proposes a rational equilibrium model of political budget cycles in which incumbent political leaders distort the fiscal policy before elections to give voters a signal about their competence in administering public goods. Empirically, previous studies provide ample evidence about the

A promotion tournament game

We present a promotion tournament which consists of a sequence of two games. In the first game, PPS decide whether to actively participate in the competition for promotion. In the second game, participating PPS maximize promotion probabilities by choosing by how much to enhance economic performance.

We demonstrate dominant strategy equilibria in the first game, which we call a “participation game.” We demonstrate a unique Nash equilibrium in the second game, which we call an “inclusion game.”

In

Testing hypotheses and data

We now test the empirical predictions of the participation/inclusion games, using Chinese political events where PPS compete for promotion. In this section, we first develop testing hypotheses implied by the political promotion tournament game equilibrium that we analyze above. We then describe Chinese political, economic and corporate data that we use in empirical tests.

Results

In this section, we present the hypotheses testing results. We first examine the corporate investment cyclicality synchronized with the promotion tournaments of PPS and its variations across provinces and firms. Then, we examine whether the corporate investments opportunistically made before the tournament contributes to the promotion outcomes. Finally, we test the cyclicality of other corporate activities.

Conclusion

This paper investigates how national political promotion tournaments in China influence corporate decisions. By introducing a game, which we call an inclusion game, we provide a theoretical justification for a promotion tournament unique Nash equilibrium in which candidates must enhance economic performance to be considered for promotion but in which the incremental promotion probability gains, due to economic performance enhancements, are driven by competition to zero. Furthermore, politicians

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