Why do Chinese SMEs avoid formal employment? Political connections and unequal access to formalization benefits11Corresponding author is Ketong Zhu. We are grateful to the editors of this special issue and the anonymous referees for their insightful suggestions. We thank Zijun Cheng, Bing Lu, Shuanghe Shang, Wenkai Sun, Zhongwen Zhang, Xiaobo Zhang and participants in 24th China Economics Annual Conference for their valuable feedback. We gratefully acknowledge the financial support from the National Natural Science Foundation of China (#72203252, #72342031, and #42293273), the Science Foundation of China University of Petroleum, Beijing (No. 2462025YJRC029), and the Program for Innovation Research at the Central University of Finance and Economics. We thank the data support from the Center for Enterprise Research of Peking University. The authors are listed alphabetically according to the last names. Authors equally share the first authorship. All errors are ours

Employment formalization among small and medium-sized enterprises (SMEs) remains low in developing countries, which weakens job security and social protection. Despite policy efforts, many SMEs evade social insurance obligations, raising concerns about labor rights and economic stability. Using data on 2664 SMEs in the 2018 Enterprise Survey for Innovation and Entrepreneurship in China (ESIEC), we document that 48.4 % of SMEs provide no social insurance, while 74.6 % cover only some employees. After controlling for firm characteristics as well as city and industry fixed effects, SMEs led by politically connected entrepreneurs have a 7.1-percentage-point higher probability of providing social insurance than those without such connections. This correlation likely stems from connected entrepreneurs' preferential access to formalization benefits—including formal credit and government procurement contracts—which collectively generate a political-connection premium that incentivizes compliance with labor regulations. These findings suggest that the uneven distribution of such benefits (concentrated among politically connected firms) contributes to the overall low formalization rates in China's SME sector, as most entrepreneurs lack access to these incentives. Moreover, the political-connection premium diminishes in regions with stronger financial inclusion and lower government intervention, suggesting that an improved business environment encourages broader formalization. These findings underscore the importance of policies that decouple formalization benefits from political connections to foster more inclusive labor protection and economic stability.