Working Papers
Misallocation of Resources, Political Connections and External Flows (Submitted and Under Review) (Latest version)
This paper examines how the design of foreign aid and external loans can hinder economic growth in developing countries with weak political institutions. Using firm-level data from Pakistan, I provide empirical evidence that politically connected firms pay lower effective taxes, and this tax advantage increases with the public external debt-to-GDP ratio. To explain these findings, I develop a political economy model where connected firms receive lower tax rates and face lower barriers to entry in exchange for political support, leading to resource misallocation. Greater external inflows allow the government to further reduce taxes for connected firms, sustaining the presence of low productivity connected firms. Calibrating the model to Pakistan, I find that reducing external flows by 30% decreases inequality and increases output by 12%. I also show that similar economic gains can be achieved by conditioning external funding on higher domestic fiscal revenues or reduced barriers to entrepreneurship.
Modelling corporate tax rates in the presence of political connections and external assistance
This paper develops a static political economy model to show that in an environment of weak political structures that provide an economic advantage to politically connected, external assistance (aid and loans) may not encourage economic growth. In the model, endogenous tax differential arises between the agents which are connected and non connected with the Elite, due to the Elite’s dependence on the political patronage to stay in power, causing resource misallocation. I show that if the tax differential is large enough, then depending on the parameters of the economy, it is possible to get an equilibrium with misallocation: a situation where low skill entrepreneurs remain or enter in the market. I calibrate the model to Pakistan and get an equilibrium with resource misallocation. I show that decreasing non-tax government revenue such as external debt and aid by 71%, increases tax differentials, eliminates resource misallocation, and increases output by 11%.
External Debt, Political Connections and Effective tax rates: Evidence from Pakistani firms (Working Paper)
Preferential treatment received by the politically connected firms in an economy has been identified as one of the potential causes of the misallocation of resources in developing economies restricting growth. Pakistani politics suffers with corruption and rent-seeking and in the last few years is dependent on external debt, loans and bailouts. Using data from 268 publicly listed Pakistani firms and elections data for the period of 2013-2019, this paper identifies the politically connected firms as those with key board members taking part in an election. The paper finds that politically connected firms pay 8.32 percentage points lower effective taxes. It shows that taking part in the election is enough to receive the preferential treatment and politically connected firms with winning candidates do not pay lower effective tax rates than candidates who do not win. It also finds that a 0.1 increase in the external debt to GDP ratio decreases the tax rates for politically connected firms by 6.81 percentage points. The decrease in the tax rates for the connected is higher when the public external debt to GDP ratio is used.