Regulators and Gatekeepers
Michelle Lowry, PhD, TD Bank Endowed Professor of Finance at Drexel University’s LeBow College of Business, and coauthors show that, when regulatory oversight is fragmented across multiple government agencies, firms incur higher costs and experience lower productivity, lower profitability and lower growth.
Key Insights
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Regulatory fragmentation, which occurs when multiple federal agencies oversee a single issue, has decreased for most firms between 1994 and 2019, consistent with efforts by policy makers to reduce it. However, this trend is uneven across issues and sectors. For example, financial companies focus their attention on a relatively small number of issues, but these issues tend to be regulated by multiple agencies. As a result, the financial sector operates under higher regulatory fragmentation than other industries.
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Firms facing higher regulatory fragmentation spend a higher fraction of their revenues on sales, general and administrative costs compared to firms with lower regulatory fragmentation. They also hire more employees, have lower productivity, achieve lower profitability, and experience slower growth in both assets and sales.
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The burden to firms of regulatory fragmentation is evidenced across all stages of government regulatory activities, from early notices to the final rulemaking. Interestingly, regulatory fragmentation is also associated to a decrease in firm lobbying, as firms are less clear as to where to direct their lobbying efforts.
Summary of Complete Findings
The government’s activities have a tremendous impact on companies. This study uses data from the Federal Register (FR) from 1994 to 2019 to assess the burden of regulatory fragmentation on firms. The FR publishes comprehensive summaries of the activities of all federal agencies. The researchers use textual analysis to classify the government’s activities into 100 topics. They then calculate the fragmentation of each topic across federal agencies as 1 minus the sum of squares of the fraction of words in the topic-year observation written by each agency. A score closer to 0 indicates that regulation is concentrated in the hands of fewer agencies; a score closer to 1 indicates that regulation is spread across many agencies.
The study observes a downward trend in the regulatory fragmentation faced by firms of about 10 percentage points (from 0.85 to 0.75). One notable exception is the period 2008-2010, when fragmentation temporarily increased by almost 7 percentage points. After 2010, the historical decline in fragmentation restarted. These trends hold for each of the 12 industries under investigation, although the industries differ in the magnitude of firms’ exposures to fragmentation.
Topics with particularly low fragmentation include “Nuclear materials” and “Aviation safety: inspection.” They have a score of 0.38. This means that these topics are intensively regulated by very few agencies. Conversely, topics such as “Freedom of information” and “Government Procurement: Small Businesses” face high agency fragmentation. They have an average score of 0.95: this indicates that these topics are regulated by many agencies. With the help of their innovative measure, the authors assess whether regulatory fragmentation is costly for individual firms. The idea is that having multiple agencies with similar responsibilities might lead to a larger volume of regulation, which increases compliance costs for the firms, and, in particular, might generate conflicting pieces of regulation that confuse firms on the right course of action to take.
Consistent with this insight, the authors find that companies facing higher regulatory fragmentation spend larger fractions of their revenues on sales, general, and administrative (SG&A) costs. They also exhibit lower total factor productivity (TFP), lower profitability (ROA), and lower growth in both sales and assets.
One way to quantify these effects is to consider the consequences of a sizable increase in regulatory fragmentation. Specifically, the study shows the impact of a one-standard-deviation increase in the independent variable (regulatory fragmentation) on the standard deviation of the dependent variables (SG&A costs, TFP, ROA, assets growth and sales growth). The authors find that a one-standard-deviation increase in regulatory fragmentation is associated with 3.8% standard deviation increase in SG&A costs. The same change in regulatory fragmentation is also associated with a 3.2% standard deviation decrease in TFP. Furthermore, a one-standard-deviation increase in regulatory fragmentation is accompanied by a fall in the following year’s ROA of 4.7 - 5.0%. Finally, the same increase in regulatory fragmentation results in sales growing 4.2% slower, and assets growing 5.7% slower.
The study explores whether the effects of regulatory fragmentation on firm outcomes are driven predominantly by final rules, or whether earlier stages of government activity also significantly affect firms. For this purpose, they separately calculate the regulatory fragmentation of notices, of proposed rules, and of final rules. They find that the negative effects of regulatory fragmentation extend to all government activities.
Lobbying is one of the tools firms employ to influence government activities, including new rulemaking, proposed future actions, and enforcement issues. The authors examine the extent to which changes in regulatory fragmentation are related to subsequent lobbying expenditures. They observe that greater regulatory fragmentation is associated with a significant decrease in firm lobbying. The result is consistent with firms deciding that the benefits of lobbying are lower when it is less clear where to direct lobbying efforts.
Finally, the authors focus on a key input to firm production: labor. They find that more regulatory fragmentation is associated with more hiring. This evidence is consistent with firms being forced to hire additional employees to satisfy the increased regulatory requirements. In turn, higher labor costs contribute to increased overhead costs, lower productivity, and decreased profitability.
In conclusion, this study introduces a novel and replicable approach to quantify the burdens that companies face when their businesses are overseen by a large number of government agencies. Not only does it provide evidence that regulatory fragmentation negatively affects firm performance, it also offers a tool for the government to estimate the economic costs to the corporate sector of changing the extent of regulatory fragmentation.
“Regulatory Fragmentation” by Joseph Kalmenovitz (University of Rochester), Michelle Lowry (Drexel University), Ekaterina Volkova (University of Melbourne).
