Public Governance, Corporate Governance, and Firm Innovation: an Examination of State-owned Enterprises

Abstract: Innovation activities create substantial firm value, but they are difficult to manage owing to agency risks which are commonly thought to result in shirking hence underinvestment in innovation. However, agency risks can also create inefficient allocation of resources among innovation activities, on which the literature provided limited understanding. We examine an important type of agency risk-that agents pursue quantity of innovation at the expense of novelty, and how it is influenced by corporate and public governance. We theorize that improved corporate governance tools, including better alignment of agents' private incentives and stronger monitoring, and high-quality public governance reduce such agency risk in state-owned enterprises (SOEs). Furthermore, high-quality public governance enhances the functioning of corporate governance tools in further reducing this agency risk in innovation. We test our theory in the context of Chinese SOEs that responded to state's pro-innovation policies relying disproportionately on quantifiable outcomes (e.g., patent counts) for assessing innovation performance. Our difference-in-differences estimates provide overall support for the hypotheses. These findings provide new insights on how agency risk affects innovation by distinguishing the consequences on quantity and novelty of innovation and on how conventional corporate governance tools shaping innovation is dependent on public governance of institutional environment.