The Hidden Tax of Cronyism

I don’t like it when poor people receive handouts from government, though not because I think they’re 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’s the moral argument for separation of business and state. But there’s also an economic argument 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, as illustrated by this chart, 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 isn’t 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.

Here’s a recent example of how Obamacare is a vehicle for cronyism, as explained by the Wall Street Journal.

Big business feasts on big government, and ObamaCare has been a bonanza for companies that have figured out how to exploit it. …Ohio contracts with five managed-care organizations (MCOs) to administer Medicaid benefits, four of which outsource their drug benefits management to CVS Caremark… CVS appears to be billing the state for far more than what it is paying pharmacies, driving up taxpayer costs. …CVS is also attempting to drive independent pharmacists out of business and expand its retail market share. …Ohio’s Medicaid enrollment has swelled by more than half to 21.4% of the state population, driven in large part by ObamaCare’s expansion to people earning up to 133% of the poverty line. …In the last three years, Ohio has lost 164 independent pharmacies while CVS has added 68. …States ostensibly have an incentive to curb their Medicaid spending… Yet many may be turning a blind eye because they can pass on the bills to the federal government, which picks up 63% of the costs for Ohio’s pre-ObamaCare population and 94% for the expansion population.

But cronyism isn’t just enabled by bad policies from Washington.

State governments also are guilty of favoritism, even when the feds aren’t involved. Consider the oleaginous handouts for Foxconn in Wisconsin.

…the Foxconn deal is a condemnable example of corporate welfare in its most egregious form. …Wisconsin could end up delivering $3 billion in tax credits to Foxconn. …If the jobs target of 13,000 is met, Wisconsin taxpayers will pay $219,000 per job. If only 3,000 jobs are created, they will pay $587,000 per job in the form of a $1.7 billion tax credit. …Who wins? The politicians. Who loses? Fiscal sanity and those footing the bill for political pet projects.

And the goodies for Foxconn are just the tip of the iceberg.

States and cities dole out billions of dollars every year to attract businesses through cash grants, tax breaks, and new infrastructure. …The search for Amazon’s second headquarters (HQ2), for instance, has left around 230 state and local governments genuflecting before the altar of the Seattle-based tech deity, offering tributes amounting, in several cases, to billions of dollars. …The cost of these kind of incentives is astoundingly high — there is little research that points to their success.

As I’ve previously argued, the pro-growth way for governments to compete is having low tax rates for everyone.

…the most effective solution is the simplest. New Hampshire is a dark horse candidate to receive HQ2, and its pitch is entirely reasonable: Low tax rates for every business, across the board. That approach removes the incentive to attract businesses through what amounts to legal, nonsensical bribery.

Let’s close with this visual from libertarian Reddit. It’s simple, but a very accurate summary of how the real world operates.

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

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