The economics of regulation: 7 insights
November 2, 2022 | By Joseph Kalmenovitz
Anyone who has ever run a business, large or small, is familiar with the burden of regulation. Business owners cite regulation as a major risk factor that affects capital structure, employment, and innovation.
But while regulation is a critically important topic in economics, it is also one of the most neglected. In academia, most empirical work involves a cost-benefit analysis of specific regulations. There is surprisingly little out there that helps us understand how regulation as a whole impacts business decisions. My research is geared toward filling that gap.
Below, I share 7 key insights that shed light on the U.S. regulatory system:
1) More intense regulation leads to persistent, tangible declines in investment and hiring by U.S. corporations.
In “Regulatory Intensity and Firm-Specific Exposure,” I developed a firm-specific measure of regulation. It captures the cost of compliance with all federal paperwork regulations. The result was unambiguous: The higher the regulatory intensity, the higher the SGA (Selling, General and Administrative Expenses) spending on the part of corporations. Companies are incentivized to reduce capital investment, invest more resources into lobbying the federal government, and cut down on hiring. This effect is particularly strong among firms with significant financial constraints and irreversible investment opportunities, demonstrating the extent to which intense regulation creates budgetary pressures and uncertainty.
2) The more federal agencies a company must answer to, the more adverse the impact of regulation.
Following the financial crisis, banking regulation became highly fragmented as multiple federal agencies took part in overseeing financial activities. In “Regulatory Fragmentation,” I took a closer look at companies that are regulated by multiple federal agencies. I used a machine learning algorithm that combs through the entire text of the Federal Register, the government’s official daily publication. The algorithm identifies regulatory topics and calculates how each topic is fragmented across multiple agencies. With this new data in hand, I gained a clearer picture of how regulatory fragmentation impacts companies: High fragmentation negatively impacts companies by slowing down growth rates, reducing operating profitability, and increasing administrative costs.
3) Companies that appear to have little in common often share a deep similarity because of their regulatory burden. This regulatory similarity has a significant impact on a company’s operations.
In “Regulatory Similarity,” I introduced a new measure that quantifies the regulatory similarity between each pair of companies. I found that regulatory similarity has little to do with traditional industry boundaries. For example, Boeing (aerospace manufacturer) and Chevron (energy company) have a high similarity score because they are both under the regulatory spotlight when it comes to antitrust concerns and violations of environmental laws. I also find that companies which are generally quite different but have similar regulatory problems make similar economic decisions. For example, they have similar profit margins and similar lobbying efforts.
4) Regulation creates synergy opportunities and makes M&A transactions more attractive.
In “Does Regulatory Exposure Create M&A Synergies,” I uncover a new link between mergers and acquisitions (M&A) and regulation. Intuitively, if company A is facing high regulatory costs which are similar to company B’s regulatory costs, then a merger between the two companies will reduce the overall regulatory cost. This hypothesis turned out to be true. I found that highly regulated companies issue more acquisition bids, invest more in those bids, and earn higher M&A announcement returns. We also see that highly regulated acquirers achieve better long-term performance and a major reduction in regulatory exposure after completing a merger.
5) The activities of regulators at the Securities and Exchange Commission (SEC) are directly affected by promotion incentives.
In “Incentivizing Financial Regulators,” I demonstrate that promotion incentives at the SEC matter more than the public may realize. If you’re a junior attorney at the SEC, you know that if you work hard enough you will earn a promotion to the next pay grade. But if your starting salary was quite high to begin with, the promotion won’t change your salary band much, reducing the incentive to advance. Indeed, I find that better promotion opportunities inside the SEC increase the quantity of enforcement of capital markets, especially the prosecution of severe financial misconduct. When those promotion opportunities are weak, the quantity of enforcement goes down.
6) High pay gaps between EPA attorneys lead to more enforcement actions, which incentivizes companies to cut down on pollution near offices with higher pay gaps.
What is true at the SEC is also true at the Environmental Protection Agency (EPA). In “The Environmental Consequences of Pay Inequality,” I find that local EPA offices with significant pay gaps between attorneys are more proactive, because the attorneys have a greater desire to earn a promotion. As a result, offices with high pay gaps pursue more enforcement actions against polluting companies. Companies internalize this enforcement risk and reduce pollution near EPA offices with high internal pay gaps in order to avoid detection and prosecution.
7) In making decisions about small business loans, officers at the Small Business Administration (SBA) show a bias against the businesses who need help most.
At the SBA, the role of a loan officer is to provide access to capital for small businesses. In “Regulatory Risk Perception and Small Business Lending,” I find that loan officers favor businesses they view as less risky, because they are afraid of supporting a business that will ultimately default. Instead of directing funds toward risky businesses, who need the most government support, they direct it to businesses who need it less. As a result, they inadvertently reduce available credit and hinder job creation.
Joseph Kalmenovitz is an assistant professor of finance at Simon Business School and a former senior law clerk at the Supreme Court of Israel. His research focuses on developing novel data sets to study how regulation affects economic decisions. To learn more about past and ongoing research, visit: https://sites.google.com/view/jkalmenovitz/home.
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