Paying taxes for favor: the deterring effects of industrial policies on innovation in South Korea

Abstract The developmental state model indicates that targeted industrial policies promote technological advancement among incumbent firms. However, the long-term repercussions for nonincumbent firms remain under-explored. We argue that targeted state support may unintentionally reduce innovation in nonincumbent firms. Using innovation data on South Korean firms and novel data on the political profiles of 4,936 corporate board members, we find that firms with political connections to the president tend to engage in less innovation. Interestingly, this reduced innovation among politically connected firms is linked to their ability to secure contracts with incumbents. These findings reveal unintended consequences of South Korean industrial policies. Non-incumbent firms that recognize the strategic value of political connections focus on maximizing short-term profits, thereby diminishing their focus on innovation. Concurrently, incumbent firms that rely on government support effectively pay a “tax” for this favor by granting contracts to non-incumbent firms.