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Market-Based Solutions to Vital Economic Issues
Kenan Insight
Apr 25, 2024

Up to Code: The Costs of Regulation and Regulatory Uncertainty

Part of our series on Business Resilience

Perennially controversial, extraordinarily complex and ingrained with challenging trade-offs, the U.S. regulatory system’s aggregate costs and benefits are difficult to measure. One common metric used to assess the “quantity of regulation” in the U.S. Code of Federal Regulations tracks the number of prescriptive words, such as “shall” and “must”; it shows that such restrictive verbiage has grown from 400,000 words in the 1970s to over 1.1 million today. This expansion in regulatory scope is not unique to the U.S. As governments try to keep up with broadening economies and address new areas, such as climate change, data protection and artificial intelligence, the regulatory pace is increasing globally.

A great deal of governmental oversight in the U.S. is exercised by federal agencies through “regulatory guidance” – what some observers call regulatory “dark matter” – rather than formal rulemaking. This complicates an already confusing landscape, creating a less predictable and potentially more burdensome regulatory environment for businesses. In this Kenan Insight, we explore how regulations affect businesses, looking at direct and indirect costs as well as the broader effects of regulatory uncertainty and exposure.

Measuring Regulatory Costs

To build resilience to uncertain, shifting regulatory burdens, firms must develop an understanding of their regulatory exposure, its costs, and how these encumbrances affect business outcomes. Several confounding factors complicate efforts to quantify regulatory costs. First, regulatory requirements differ from industry to industry – the rules for mining companies are not the same as the ones for financial services firms. Second, firms are often compelled to comply with regulations across multiple jurisdictions, such as the federal, state and local levels, some of which may overlap or muddle one another. Third, specific exemptions relieve some firms from regulatory obligations, and certain rules may be less burdensome for particular ownership structures or business forms. Despite these challenges, a growing body of academic literature attempts to measure regulatory costs at the firm level and connect these burdens to firm outcomes.

The Direct Costs of Compliance

From the perspective of the regulated, there are direct costs of compliance, including the time spent simply filling out paperwork disclosing the vast amount of information required by federal regulators. Compliance costs also include losses that companies accrue in meeting regulatory requirements associated with firm operations. If a plant, for instance, could produce goods at a lower cost, yet the company makes additional outlays to bring its pollution levels in accordance with Environmental Protection Agency regulations, such compliance increases production costs for the firm and is counted as a direct cost of regulation. And when the Food and Drug Administration modifies its current good manufacturing practice regulations for human drugs, as it did in 2007, it redirects how pharmaceutical firms must run their operations, including quality control, facility design and maintenance, and even employee training – changes that add layers of compliance and increase firms’ operational costs.

A recent study by Joseph Kalmenovitz1 of the University of Rochester’s Simon Business School uses machine learning to estimate of the cost of compliance associated with regulatory paperwork in the U.S. From 1980 to 2020, the study reports, 292 billion hours were spent on preparing and filling 2.24 trillion forms to comply with 36,702 regulations. Federal regulatory paperwork imposed a cost equivalent to 3.2% of total working hours in an average year.

A separate study2 by Francesco Trebbi of the UC Berkeley Haas School of Business, Miao Ben Zhang of the USC Marshall School of Business and Michael Simkovic of the USC Gould School of Law tries to put a dollar figure on firms’ direct compliance costs by tallying up how much companies pay employees whose work pertains to adhering to government rules. With a sample period from 2002 to 2014, the researchers found that the average U.S. firm spends about 3% of its total wage bill on regulatory compliance.

Direct Regulatory Costs Vary by Firm Size

If government policies are designed to support small businesses through lighter regulation, compliance requirements may only affect larger firms. The downside of such carve-outs is that they could deter firms from expanding, with company leaders instead choosing to remain small to stay “under the radar,” even when not efficient. Yet without special considerations for smaller firms, relative regulatory costs could decrease as companies grow, hindering smaller competitors and discouraging firm entry.

Professor Trebbi and his fellow researchers find that these opposing forces operate simultaneously. Consistent with a tiered regulatory system, compliance costs tend to be lighter for smaller businesses, with regulatory burdens increasing for companies as they grow, up to about 500 workers. Beyond this threshold, it pays to be big: Direct compliance costs decrease with size, as larger firms are able to centralize and consolidate regulatory compliance efforts in the hands of employees dedicated to these tasks and thus benefit from economies of scale.

Measuring Regulatory Exposure

Direct costs of compliance are certainly important, yet they may make up only a portion of the total regulatory burden borne by firms. Perhaps more important, yet harder to measure, is the cost of uncertainty around regulation, or what we call regulatory risk. This risk is characterized by ambiguity regarding the regulatory future and unknowns around how rules are enforced by various government agencies across different administrations. Such uncertainty may, for instance, prevent firms from making investments, resulting in substantial opportunity costs. Firms with greater exposure to government regulation would therefore bear higher regulatory costs than what is captured by direct costs alone.

Measuring a firm’s regulatory exposure is challenging. A firm may have greater exposure than others because it is subject to multiple government agencies or more requirements, or perhaps because a single mandate’s effects are more pronounced for that particular company. Moreover, a firm’s exposure to one agency may be very different than its exposure to another, depending on its business. Even firms in the same industry can have varying levels of exposure because of legal exemptions or perhaps political connections. Examining regulatory exposure at the firm level is key for understanding how regulatory burdens are distributed as well as how firms can mitigate some of the regulations’ encumbrances.

A new study3 by UNC Kenan-Flagler Business School accounting professors Stephen Glaeser and Jeffrey Hoopes and accounting Ph.D. student Daphne Armstrong takes on the challenge of assessing firm-level regulatory exposure. The researchers create text-based measures of exposure by counting the number of sentences in firms’ 10-Ks – annual reports required for publicly traded companies by the Securities and Exchange Commission – that reference federal agencies along with specific agency action words. The proportion of such sentences to the total number of sentences in a firm’s 10-K is what the researchers call a firm’s total regulatory exposure. Because the authors construct this measure for each firm and for each government agency, they can track a firm’s regulatory exposure to distinct government agencies. The researchers find, for instance, that firms exhibited a greater measure of exposure to the SEC after the Sarbanes-Oxley Act extended the SEC’s reach in 2002. Similarly, the study shows that budget cuts to the Internal Revenue Service in 2013 had a meaningful impact on the extent of the agency’s oversight. Firms that previously were more exposed to IRS regulation exhibited lower IRS exposure and decreases in their effective tax rates following the budget cuts.

The study finds evidence that firms care a great deal about their exposure to government agencies – companies devote a similar space in their 10-Ks to discussing regulatory exposure as they dedicate to discussing competition. The authors observe that not only has total regulatory exposure increased over time, but so has the variance in exposure across firms, showing that regulatory costs are distributed unevenly across the economy and some firms can better mitigate the burden. The most frequently mentioned agencies are the FDA and the SEC, followed by the IRS, the Centers for Medicare & Medicaid Services, the Federal Communications Commission and the EPA.

Estimating the Cost of Regulatory Exposure

As expected, the authors find that a firm’s regulatory exposure to government agencies is negatively associated with its profitability. The researcher’s estimate that, in a given year, a firm in the top quartile of regulatory exposure has 1.35% lower profitability than a similar firm in the bottom quartile. While not showing causation, this result supports the hypothesis that greater regulatory exposure imposes greater costs on firms. Other research suggests a possible cause, finding that companies with heavy regulatory burdens spend a significantly larger fraction of their revenue on sales, general and administrative expenses and costs of goods sold.4

Looking for evidence of causation, the authors use the surprise election of Donald Trump to the presidency in 2016 as a natural experiment. After he campaigned heavily against government regulation, Trump’s election triggered an unexpected change in the anticipated future strength of government agencies. Examining stock market activity, the researchers found that, on the day after the election, firms with high regulatory exposure experienced significantly greater equity market returns relative to less exposed firms. With investment dollars, the market spoke: Companies that had greater regulatory exposure stood to reap financial benefits from the gutting of federal regulatory agencies.

The study also finds that the negative impact of regulatory exposure on profitability is more pronounced if the subjected firm faces regulatory fragmentation, which often means redundancies and inconsistencies in requirements from overlapping regulators. Other research supports this finding, showing that regulatory fragmentation lowers firm productivity and growth, deters entry and increases smaller firms’ propensity to exit.5

Resiliency to Regulatory Burdens

Intended to protect the public and level the corporate playing field, regulation is also a financial and bureaucratic burden for firms. Regulatory policies impose direct and indirect costs on the companies exposed to them, and some firms are more resilient than others to the excision of the proverbial pound of flesh. In some cases, it helps for a company to be small, to exploit carve-outs that government agencies give to the little guy. Otherwise, the leviathan firms exhibit the greatest resiliency, as they can reap the benefits of scale. No matter the size, exposure to regulation is an encumbrance for any company, and reducing vulnerability to regulatory laws is key for a firm to increase its resiliency to such liabilities. The fewer resources a company dedicates to understanding the regulations that pertain to it, the more it can commit to investment, security and growth.

1 Kalmenovitz, J., 2023, “Regulatory intensity and firm-specific exposure”, Review of Financial Studies, 36, 3311-3347.

2 Trebbi, F., M.B. Zhang, and M. Simkovic, 2023, “The cost of regulatory compliance in the United States”, working paper.

3 Armstrong, D.M., S. Glaeser and J.L. Hoopes, 2023, “Measuring Firm Exposure to Government Agencies”, working paper.

4 Kalmenovitz, J., 2023, “Regulatory intensity and firm-specific exposure”, Review of Financial Studies, 36, 3311-3347.

5 Kalmenovitz, J., M. Lowry, and E. Volkova, 2023, “Regulatory Fragmentation”, forthcoming in Journal of Finance

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