In China, start-ups with high-profile leaders are at risk of becoming victims of government expropriation, HKUST’s Jiatao Li and colleagues have found. This effect is particularly pronounced in areas where income inequality is high, and the legal system is underdeveloped. However, the authors find that entrepreneurs can protect themselves by establishing political connections.
Entrepreneurs in developed economies enjoy strong legal protection, but emerging economies such as China are “fraught with institutional voids, typically deficient market intermediaries, and a weak legal system,” say the authors. Local governments in China are free to expropriate rents from businesses illegally to increase their revenue or provide public goods. Start-ups are at especial risk of such expropriation, the authors warn, because they typically operate “at the bottom of the political hierarchy.”
How do governments decide which start-ups to target and which to leave alone? The researchers theorized that entrepreneurs’ socioeconomic status (SES) has an “important bearing on government expropriation.” SES is measured in terms of income, wealth, and educational attainment. The researchers posit that “high SES reflects an owner’s control over valuable resources.” Put simply, high-SES entrepreneurs find it easier to access money, making their start-ups more attractive as targets of expropriation. “The government needs some observable signals,” the authors tell us, “and an entrepreneur’s SES is one such signal.”
To test their theory, the team analyzed data from nationwide surveys of Chinese private firms conducted by the Privately Owned Enterprises Research Project Team. Their results were illuminating. “As an owner’s SES increases by 1 standard deviation (SD),” the authors found, “the unauthorized levies imposed on her start-up increase by 14%.” They report that “in regions with very unequal incomes, the positive relationship between an owner’s SES and government expropriation hazard is strong.”
The researchers also discovered that the risk of expropriation depended on the legal environment. “A well-developed legal system weakened the positive relationship between SES and government expropriation,” they state. Entrepreneurs were more than twice as likely to experience government appropriation in areas where the legal system was less developed.
Although all entrepreneurs in China face the risk of expropriation, they can avoid falling victim by forming connections with politicians. “Start-ups with political connections suffer hardly any increase in unauthorized levies,” the researchers report. In contrast, those without political representation face significant risks.
“Using survey data on start-ups in China,” the researchers conclude, “this study shows that power inequality has implications for the government expropriation that entrepreneurs encounter in emerging economies.” Their findings provide valuable insights into the challenges entrepreneurs face in developing economies, as well as some practical lessons for investors. In China, wealth and status make entrepreneurs targets for government expropriation, due to the political power enjoyed by the government over entrepreneurs and a lack of legal protection. However, there may be a way out. To avoid being targeted for expropriation, the authors explain, “most entrepreneurs build political connections to reduce expropriation risk.”