Small businesses complain about regulation. All the time. Ask any small business owner what is holding back his sales, investment, hiring or profits, and you can be pretty sure he will point the finger at regulation. (Large businesses complain too, but they put their money where their mouth is and lobby for special exemptions.)
Some regulations are necessary, of course. The air and noise pollution generated by your factory is damaging my health, for example: a case of what economists call "externalities." Unlike free-market solutions, where an individual acting in his own self-interest tends to benefit others, in the case of a negative externality, an outside authority must step in to correct the adverse effect on a third party.
Some regulations may even be beneficial, especially those that correct market failure or increase competition. Environmental regulations that improve the health of the workforce will increase productivity and output.
But — you knew this was coming — too much regulation strangles innovation and economic growth. A new study by George Mason University’s Mercatus Center, a libertarian economic think tank, examines how regulatory costs build up over time. The study finds that if regulations had been frozen at 1980 levels, by 2012 the U.S. economy would have been about $4 trillion, or 25 percent, larger in inflation-adjusted terms than it actually was.
Let’s start at the beginning. Federal regulatory agencies are required to conduct impact analyses on any "economically significant rules," defined as those with a cost exceeding $100 million per year. Most attempts to quantify the costs of regulations — compliance, the purchase of new equipment, additional staffing needs — examine each regulation individually and assess the marginal impact along with the potential benefit. The Mercatus study went deeper, and it found that when it comes to regulation, one plus one is greater than two.
Unlike cost-benefit analyses that focus on macroeconomic outcomes, the Mercatus study and model are about "microeconomic choice: the decisions individuals and firms make that will lead to outcomes we measure as economists," said Patrick McLaughlin, a senior research fellow at the Mercatus Center, who co-authored the working paper with economists Bentley Coffey and Pietro Peretto. "Macro focuses on outcomes. We wanted to get down to details."
For example, each government intervention has a static cost. But because regulations "deflect resources from their highest value uses," they have a cumulative effect as well, McLaughlin said. Regulation "doesn't always mean less investment, although our study finds empirically that is the case. It means investing in a different mix of investments than you would have otherwise."
The result: Businesses end up putting resources to less-than-optimal use. What would have been the effect on productivity and economic growth had those resources been influenced by market signals rather than government restrictions?
The economists answered the question by first building a model that shows how investment decisions affect economic growth. Once they were comfortable the model could predict investment and GDP growth as functions of regulations, they used specific data sets for 22 industries to answer the counterfactual: What would have happened absent the accumulating pile of regulations.
Innovation and net job creation tend to come from business start-ups, according to research from Kauffman Foundation. After all, new firms represent the fruition of an idea, be it a better mouse trap or a more efficient communication system. To the extent that regulations create barriers to entry, it's not hard to understand why the effect on what-could-have-been is huge.
And as for the cumulative effect, just think about regulation in the same way you think about the compounding of interest — except with interest, compounding is a plus!
Why is this important? To the extent that economic growth depends on investment, any disincentive to invest translates into less innovation and slower productivity growth. The depressing effect of regulations is even more relevant today when productivity growth has slowed to a crawl, reducing potential GDP — or how fast the economy can expand without creating inflationary pressure — in the process.
So what was the overall effect on U.S. real GDP growth in the period from 1977 through 2012, according to the Mercatus study? An average reduction in annual growth of 0.8 percentage point, which computes to that total I mentioned of $4 trillion over a 35-year period, or nearly $13,000 per capita.
That's a big deal. The Competitive Enterprise Institute, in its annual snapshot of the federal regulatory state, pegs the cost of regulation to American consumers and businesses at $1.9 trillion in 2014 alone.
Two very different estimates, to be sure. What gives the Mercatus model credence, at least from this financial journalist's point of view, is its microeconomic foundations. What we know about economics — and I mean know for certain — comes from the field of microeconomics, the study of how individuals and firms behave in the allocation of resources. Macroeconomics, which focuses on the aggregate economy, is pretty much a crap shoot. Heck, John Maynard Keynes has been dead for 70 years, and economists still can't agree on whether government spending stimulates the economy or not.
Challenge the math if you like, but the message is pretty clear. Regulation costs the nation. And it costs a lot.