The Externalities of Corruption: Evidence from Entrepreneurial Activity in China

We show that corruption affects negatively the performance of small and young firms, which compete with corrupted industry peers in the product market or with corrupted firms in the same province for resources. We exploit the Chinese anti-corruption movement to establish causality and identify the channels through which corruption causes negative externalities. Small and young firms have lower sales growth in industries and provinces with high corruption, arguably because demand is diverted to the largest firms in their industries, which spend more in corrupting officials. Small and young firms also have higher financing costs in industries and provinces with high corruption and therefore invest less. Furthermore, corruption decreases the efficiency of labor and capital allocation and deters entry of small and young firms.