I present a study of ownership of firms under government rent seeking. Using its control of regulated inputs, a government agency extracts rents from a manager who undertakes an investment. Such a government rent seeking activity leads to a typical hold-up problem. Government ownership is shown to serve as a second best commitment mechanism through which the government agency will restrain itself from the rent seeking activity and even offer the manager support and favor such as tax breaks and subsidies. This mechanism works at a cost as government ownership compromises ex post managerial incentives and creates distortion in resource allocation. Nevertheless, under some fairly general conditions, government ownership Pareto dominates private ownership. The analysis corresponds to a host of stylized empirical observations concerning local government-owned firms during China's transition to a market economy. Based on this analysis, I suggest that local government owned firms will be transformed to private ownership as China's input markets become more liberalized.
