between 2004 and 2008 in order to maximize the representativeness of the perceived policy data at the sector level. Overall, the WBES data identify the regulatory environment perceived by more than 4,200 firms that were active in 90 (ISIC Rev. 3.1) 4-digit sectors.<sup>9</sup> We then examine whether WBES respondents from sectors with more connected firms experienced softer or harsher regulations than those from other sectors.

# **5. Identification issues**

The overarching question in the literature on state-business relations is whether politically connected firms extract policy advantages from government that allow them to earn higher rents at the expense of other firms, potentially reducing competitive pressures to increase productivity and, therefore, suppressing growth. Prior research has occasionally used exogenous variations in political connectedness, such as announcements of leader illness, to make inferences about the causal effects of political connectedness on firm value.<sup>10</sup> In general, though, the research has relied on simple correlations between political connections and some subset of various possible consequences of connectedness.

In the first part of the paper, we lack, like most of the literature, an exogenous change in political connections with which to identify the causal effects of political connections on firm profits, firm size, or on various government regulations ranging from energy subsidies and trade protection to access to land and industrial zones. However, for the first time we are able to document such correlations across all of these. Moreover, we are able to show the robustness of these correlations to controls for firm characteristics, such as firm size or age, and fixed sector characteristics. These correlations do not establish a causal effect: we cannot observe the counterfactual of what regulatory benefits might have flowed to these firms had they not enjoyed political connections.

Two arguments suggest a causal relationship, however. First, qualitative evidence indicates an increase in privileges for politically connected firms after the entry of connected businessmen into government (e.g., the establishment of non-tariff trade barriers after a prominent businessman became Minister of Industry and Trade in 2005). Second, it is unlikely that businessmen developed political connections as a consequence of increased contact with governments following independent policy shifts that favored their sectors.

In the second part of the paper, however, the data allow us to make stronger causal inferences. Many sectors exhibited no politically connected firms in 1996 (i.e., 145 4-digit sectors non-agriculture sectors). Between 1996 and 2006, however, politically connected firms entered into some of these sectors, but not others. We estimate the impact of political connections on aggregate sector growth by comparing previously unconnected sectors that experienced entry by connected firms with those that did not experience entry. Our identifying assumption is that politically connected firms did not enter new sectors with an (unobservable) lower growth potential.<sup>11</sup> Such an unobservable correlation

> 9 We exclude sectors for which we observe less than 4 firms leading to, on average, 38 firms per 4-digit sector.

> 10 Event studies estimate the impact on firm value, thus discounted future profits, but they have to rely on small samples due the small number of traded firms on local stock markets.

> 11 We do control for observable differences in observable sector characteristics such as the average firm size, firm age, and broad sector dummies in the corresponding estimations.

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