CLS Blue Sky Blog

The Politics of Mandatory Corporate Philanthropy

How do firms allocate their spending on philanthropic causes or other socially beneficial activities? With 94 percent of large U.S. companies committed to charitable giving and some investors increasingly willing to forego financial returns to advance such activities, this is an important question about which we have little insight. In a new paper, I demonstrate that there is a political cycle in the level of corporate philanthropic expenditures, mediated by the quality of firm corporate governance and the level of political corruption. Analyzing mandatory corporate social responsibility (CSR) disclosures from Indian public firms, I find that companies belonging to business groups (which are generally controlled by founding families with cross-holdings in member firms, and have more opaque corporate governance) and headquartered in high-corruption areas decrease their compliance with CSR targets during election years. The exogenous and staggered timing of provincial elections supports a causal interpretation of the political cycle’s effect on CSR compliance.

Studying the unique Indian CSR data is helpful in understanding the role of firm-state relations in corporate philanthropic spending, even in countries with different political and economic conditions such as the United States. The existence of a political CSR cycle implicates concerns regarding corporate governance and agency costs that transcend the confines of the Indian economy.

Consistent with the thesis that business groups substitute between CSR compliance and political giving, I find that these firms increase both officially reported political donations as well as their cash ratios (which the literature has used as a proxy for “unofficial” payments to politicians) at election time, while simultaneously reducing CSR compliance. Finally, I find some evidence that institutional ownership partly mitigates the political CSR cycle, possibly due to institutional investors’ pro-CSR preferences.

I present a simple model to argue that this cycle is driven by bargaining between politicians and firms. Firms first determine the amount of resources they should expend on all non-profitmaking activities, whether political donations or philanthropic spending (such as donating to charity or sponsoring community amenities). However, politicians are more likely to prefer political donations rather than generalized CSR spending in their constituencies if an election is approaching and their political organization urgently needs campaign financing. Therefore, politicians will bargain for firms operating in their constituencies to divert more of their CSR spending to political donations during election years. This political cycle can be expected to be concentrated in companies that have worse corporate governance or are located in states with high levels of political corruption. There are higher agency costs at these firms, leaving managers with more discretion over where to expend resources.

This paper adds to the literature on the political business cycle by extending it to CSR spending by publicly held companies. For several decades, social scientists have studied the effect of elections on economic variables such as unemployment. More specifically, since the electorate is likely to be influenced by more recent events, voters reward or punish politicians for economic conditions that prevail just before the time of the election. Accordingly, politicians who seek reelection will increase government spending immediately before an election to curry favor with voters. However, public funds are not the only types of expenditures affected by electoral cycles. Corporations operating within a jurisdiction can make campaign contributions to bolster the election prospects of favored politicians. Companies can also spend on philanthropic activities in the politician’s electoral constituency, raising the general standard of living and increasing voters’ satisfaction with their elected representatives. My paper extends the literature on the political business cycle to the CSR arena and evaluates how corporate governance and corruption affect tradeoffs between philanthropic spending and political donations.

The paper also contributes to the literature on agency costs and political considerations in corporate charitable giving by using the unique setting of the Indian legislation. Prior scholarship has noted that agency costs in for-profit firms can undermine the goals of corporate philanthropy. These agency problems are particularly pronounced in poorly governed firms with dominant controllers, since managers can use philanthropy as a means to bolster their own reputation or social influence rather than to benefit the firm or society. I am able to empirically validate these claims by demonstrating the difference in compliance with CSR targets by a subset of firms – business groups – shown in the literature to have weaker governance and higher agency costs. The economically significant rise in both official and indirect measures of political giving by business group members at election-time illustrates the substitutability of CSR compliance and campaign donations. Money that could have been spent on CSR compliance is instead donated to political parties, or is kept as part of cash holdings, which can potentially be deployed for illicit payments to local politicians.

The Indian setting is also advantageous because it provides access to the entirety of corporate CSR spending. Previous work shows that 6.3 percent of corporate giving by foundations associated with U.S. S&P 500 and Fortune 500 firms is politically motivated. However, they can only measure corporate philanthropy using foundation data, since it must be reported to the Internal Revenue Service, and do not have information about other significant channels for corporate giving such as donor-assisted funds. The Indian legislation allows me to access information about the totalsum of corporate CSR. Furthermore, I have this information for all reporting public companies, not just the largest firms. A final contribution of this paper’s empirical approach using the Indian setting is that it depends on geographically staggered state elections for identification. The constitutionally predetermined timing of state elections and the different electoral cycles of Indian provinces allow us to draw credibly causal connections between CSR and the political cycle.

Depending on one’s perspective, the normative conclusions from the result should either be increased regulation of firms’ political donations or doubts about the feasibility of mandatory CSR donations. However, more straightforward implications of the study include the importance of corporate governance and political economy considerations in CSR and the potential advantages of transparent disclosure of corporate campaign finance contributions.

This post comes to us from Dhruv Aggarwal, an incoming assistant professor at Northwestern Pritzker School of Law and a PhD candidate in financial economics at Yale School of Management. It is based on his recent paper, “The Politics of Mandatory Corporate Philanthropy,” available here.

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