Adapted from “Quantifying the Impact of Red Tape on Investment: A Survey Date Approach,” by Bruno Pellegrino of Columbia Business School and Geoffrey Zheng of New York University Shanghai.
Regulation is a constant concern for business leaders, who often see it as a hindrance to innovation and growth.
Now researchers have developed a new methodology to measure the economic cost of regulatory red tape. This innovative approach estimates the impact of regulations on GDP, allowing for comparative analysis among seven European countries.
“The impact of regulation is an evergreen issue in economics,” says co-author Bruno Pellegrino, assistant professor of business in the Finance Division at Columbia Business School. “It’s a topic that’s important in every country in the world because no country lives in anarchy. Every country needs regulation and needs to choose how much to regulate the business environment.” Therefore, he says, the topic is always relevant.
Pellegrino also has a personal interest in the topic: He comes from Italy, where, he says, people have a strong sense that regulation has a negative impact on the business environment. “So I was always fascinated by the idea of being able to quantify this impact –– to put a price tag on it in terms of euros.”
How the research was done: For the study, Pellegrino and co-author Geoffery Zheng of New York University Shanghai used a data set called European Firms in a Global Economy, which combined firm-level balance sheet data with survey responses from a representative sample of 14,759 firms in Austria, France, Germany, Hungary, Italy, Spain, and the United Kingdom. The data set is uniquely valuable, because it’s rare to have both survey data and balance sheet data matched at the firm level.
The researchers created a novel statistical methodology to analyze the data, modeling bureaucracy as a “shadow tax” on capital investment. Firms that incur a bigger shadow tax require bigger rates of return on capital.
Because the bureaucratic shadow tax diminishes the rate of return on investment, firms that have a higher shadow tax from regulation should, in theory, display a shift in the distribution of their revenue.
Indeed, the research showed there was a shift, and that shift represented the cost of taxation. By measuring the shift, Pellegrino and Zheng were able to quantify how big and varied the impact of shadow taxes was across the seven countries studied.
What the researchers found: Overall, the study found regulatory burden for firms can make a substantial difference in aggregate economic activity, at an average of 0.8 percent of a country’s GDP. The cost of regulation varied greatly among the seven countries studied: regulation cost 0.1 percent of GDP in the United Kingdom but 4 percent of GDP in France. Pellegrino found this surprising, as the seven countries were “homogenous on their face, because they were all ‘developed’ European countries.”
Why it matters: The researchers assert that their methodology is a first-of-its-kind way to measure the cost of regulation at the firm level and to calibrate those measurements with macroeconomic models. “The findings come with a message for policymakers and the general public: Regulation comes with a cost, and it’s a cost that is not trivial,” Pellegrino says. That, he argues, disproves the common attitude among policymakers that regulations do not impose substantial costs to economies.
“We’re not claiming that there isn’t a role for regulation in a market economy — we’re not free-market fundamentalists,” Pellegrino adds. “But the message is that whenever we think about imposing a new regulation, we should consider the trade-off: what we think the advantages are and what we think the potential costs are.”
Now, with the new methodology, policymakers have a tool to do just that. In the future, the researchers’ model could be used to measure the costs of specific regulations that have been put in place to predict the costs of potential new ones.
