# **1. Introduction**

A wealth of research has documented the value of political connections, giving rise to two important questions. To what degree is the value of connections related to regulatory privilege? And what is the effect of privilege on aggregate economic growth? Using novel data from Egypt, we document that connected firms are more profitable and larger; and they enjoy special regulatory treatment across a wide range of policy and regulatory domains. We then go beyond previous research and show that the profit advantage that they enjoy is entirely explained by their regulatory privileges; and the entry of connected firms into sectors where they were previously absent reduces aggregate growth and leads to a more skewed distribution of employment towards less productive smaller firms.

Past research has found that politically connected firms benefit from privileged access to credit. We document benefits across a numerous other regulatory domains: they are more likely to benefit from subsidies, trade protection, access to land, and biased regulatory enforcement. Prior research has also left open the possibility that connected firms could be more profitable because they are better protected from government predation, not because they receive regulatory privileges. We show that privileged access to energy subsidies and trade protection accounts for the higher profits of politically connected firms.

Finally, and most importantly, past research has raised the question of whether the high value of connected firms comes at the expense of aggregate economic growth in the sectors where connected firms operate. Our data allow us to examine the impact of political connections on the growth of the detailed 4-digit sectors that politically connected firms entered compared to the sectors that they did not enter. We observe the variation in market entry of politically connected firms between 1996 and 2006, a period that coincides with the extension of close state-business relations into several more modern, younger industries – those that one would expect should grow fastest. Instead, the entry of politically connected firms into these new, previously unconnected sectors slows their aggregate employment growth relative to sectors that remained unconnected. The data also point to a mechanism that is consistent with theory: slower employment growth after the entry of connected firms stems from an increase in the skewness of the employment distribution towards small and micro firms; these firms are less productive in Egypt, suggesting that the entry of connected firms in a sector increases the misallocation of resources across firms in the sector.

The paper is organized as follows. Section 2 reviews our contributions to the literature on state-business relations. Section 3 reviews the modalities and evolution of political connections in Egypt. Section 4 details our sample of _connected firms_ and describes their characteristics. Section 5 discusses endogeneity concerns and the empirical identification strategy. Section 6 compares the efficiency between politically connected and unconnected firms. Section 7 asks whether the connected firms profited disproportionately from policy protection and subsidies. Section 8 examines whether the presence of connected firms reduced the dynamism and growth opportunities of the rest of the economy. Section 9 provides direct evidence that political connections reduce aggregate sector economic growth. The final section concludes with a discussion of the broader implications of the results.

# **2. What do we know about state-business relations?**

The literature on political connections addresses three concerns: the extent to which political connections are valuable; the ways in which politically connected firms receive policy favors; and the 2