The Aggregate Costs of Political Connections

This paper quantifies the aggregate costs of political connections using a general equilibrium model in which politically connected firms benefit from output subsidies and endogenously spend resources on rent-seeking activities. The model is structurally estimated using rich firm-level data for the Indonesian manufacturing sector and a firm-level measure of political connectedness based on a natural experiment from the authoritarian rule of Suharto at the end of the 1990s. A major innovation is to non-parametrically identify the output subsidy from differences in distributions of revenue-based total factor productivity (TFP) across connected and non-connected firms. In general equilibrium, both the distribution and the level of subsidies to connected firms matter. I find that subsidies to connected firms are too high and dispersed, costing the economy between 1.0-4.7% of aggregate output. At most, 45% of these output costs are due to the misallocation of factors of production towards connected firms. The large remainder is explained by the costs of subsidizing connected firms instead of putting saved subsidies to more productive use.