Fraud and Innovation: Is There a Cheater's Discount?

Extremely preliminary draft. Please do not cite or distribute. ABSTRACT Fraudsters seem to possess many of the traits that are associated with innovators – they disrespect the established ways of doing things; they think outside the box to create their own ways of obtaining what they want; and in the process they embrace the risks of failure and of social sanctions. However, there are also good reasons to expect fraudulent firms to be less innovative than their nonfraudulent peers, as cheating buffers firms from external pressures and thus fosters managerial complacency. In this paper, we develop a theory that links resource acquisition with resource allocation. We argue that resources obtained through fraudulent means are less likely to be allocated to productive activities such as technological innovation. To test our theoretical predictions, we built a longitudinal dataset tracking the patenting behavior of 467 Chinese hi-tech firms applying for state grants promoting technological innovation. Because relying on the public-control agent for fraud identification would introduce selection bias, we use an unconventional approach – comparing two sets of financial books (which are assumed to report the same financial data) from the same firm – to identify fraudulent financial reporting among our sampled firms. We find that fraudster firms receiving state grants are less likely to create new knowledge. 1 Are fraudulent firms more innovative than their rule-abiding peers? While this question has rarely been examined directly, the management and organization theory literatures seem to suggest an answer of yes. By definition, innovators are individuals or organizations that are not constrained by the established ways of doing things (Schumpeter 1934; Kirzner 1973). When societal norms or the dominant design of technology prevents the achievement of their goals, innovators think outside the box and create their own ways of obtaining what they want (Merton 1938; Drucker 1985). When their new ways are socially accepted, innovators are labeled as entrepreneurs and are applauded for their heroic act of creative destruction (Schumpeter 1934). However, when the new ways are socially proscribed, the innovators who use them are labeled as deviants and run the risk of being punished as group is generally perceived to be productive and the second group destructive (Baumol 1990), both bear the risks and uncertainties that face catalytic agents who seize new opportunities, shift the choice set, and increase " the probability that a new project will in fact be implemented " (Knight 1921; …