May 4, 2016

Are Federal Regulations Hurting Your State's Economy?

Adam Millsap

Assistant Director, L. Charles Hilton Jr. Center for the Study of Economic Prosperity and Individual Opportunity, Florida State University
Summary

Why does federal regulation, which is binding in all states, have a disparate impact across states? To understand this we need to acknowledge a fact about the US economy – firms in a particular industry tend to cluster together.

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Estimating the impact of regulation on the economy is difficult, mainly because regulation is hard to quantify. Economic models can incorporate different tax rates relatively easily since they are straightforward numbers – researchers can plug in a rate of 30% and then a rate of 40% and see how the different rates affect things like output and employment. Regulations, on the other hand, are collections of words with many unknown costs and benefits which makes it harder to estimate their impact.

Luckily there are some smart people who are creating new ways to quantify regulation so that we can better understand how it affects the economy. Two of my colleagues at the Mercatus Center at George Mason University recently released the Federal Regulation and State Enterprise (FRASE) Index. The index ranks the 50 states and Washington D.C. according to how much they are affected by federal regulation. The most affected state is Louisiana and the least affected is New Hampshire.

But why does federal regulation, which is binding in all states, have a disparate impact across states? To understand this we need to acknowledge a fact about the US economy – firms in a particular industry tend to cluster together. Some examples of this include technology in Silicon Valley in California, financial services in New York City, automobile manufacturing in Michigan, and the film industry in Los Angeles.

The two economic causes of firm clustering are economies of scale and agglomeration economies. A firm has economies of scale when the average cost of producing a good declines as more is produced. A primary reason for declining costs is specialization. As more of a good is produced it will make economic sense to have different workers focus on different tasks.

For example, I worked at a GM plant one summer while I was in college and my job was to install gas tanks on SUVs. Since we were producing around 500 cars per 9 hour shift it made sense for GM to have me focus on this one activity. Each of us became experts at our individual task, which reduced mistakes and waste. With each of us focusing on one job the car could move quickly down the assembly line, which increased output.

The combination of more output for a given amount of overhead and less mistakes decreases the average cost of producing a product and leads to large firms that hire hundreds of workers, all of whom live in relative proximity to one another. This is the beginning of a city and a cluster.

The second cause is the existence of agglomeration economies. One feature of agglomeration economies is that workers tend to be more productive when surrounded by other workers in the same industry. Often this is due to knowledge spillovers. This increased productivity induces firms in the same industry to locate near one another. Together, economies of scale and agglomeration economies generate firm clusters in specific areas.

Of course, geography and natural resources also play a role in an area’s specialization. Hawaii and Florida have large tourism industries due to their weather, while West Virginia has a large mining industry due to its endowment of coal.

Firm clustering is possible within the U.S. because residents of states are free to trade with one another; it’s not necessary for each state to produce everything its residents want to consume. Instead people and firms in different states can specialize in the production of certain goods and services and then trade for the other things they want.

Since firms in particular industries tend to cluster together, federal regulation that disparately impacts certain industries also disparately impacts certain states. Louisiana ranks poorly because it has a large chemical products manufacturing industry and oil and gas extraction industry, both of which are highly regulated at the federal level. This disparate impact is an inevitable outcome of specialization and unrestricted interstate commerce.

This does not, however, mean that industries are forever bound to particular states. An industry may concentrate in a new state for a variety of reasons. The first is that new methods of production can change the relative attractiveness of different areas. For example, shale and natural gas in the Dakotas, Ohio, and Pennsylvania has largely displaced West Va. Coal in the production of energy.

A second reason why an industry may relocate is changes in state and local policy. There is evidence that states with simple tax codes and stable, lucid regulatory environments have better economies that are more attractive to both people and firms.

Third, entrepreneurs are constantly inventing new products and services that displace old ones and such innovation can occur in unlikely places. State policy makers cannot ensure that productive innovation takes place in their state, but states that implement a simpler tax code and regulatory environment will create the conditions that foster innovation, and this makes it more likely that industry-changing innovation will occur in those states.

Since in the long run firms can and will move in response to these factors, federal regulations that impact an industry in one state will follow that industry to other states. The table below shows the five states with the largest share of U.S. employment in the most regulated industries according to the FRASE Index in both 1998 and 2014.

Click here to view table: Employment data are from the Bureau of Economic Analysis. Shares are author’s own calculations.

As shown in the table, over a span of 16 years there were some changes in the location of employment in these industries. The shaded states in the 1998 panel (on left) were replaced by the shaded states in the 2014 panel (on right). For example, in the air transportation industry Georgia replaced Illinois as the #3 state in terms of employment.

In chemical manufacturing, Illinois and Ohio replaced New York and Pennsylvania respectively. Illinois and Ohio are now well-positioned to increase their share of employment in chemical manufacturing as the industry grows and evolves since they now have the benefits of agglomeration economies on their side. Of course, the firms and employees in Illinois and Ohio will also have to contend with the federal regulations that followed the industry to their state.

Because federal regulations follow industries across state lines policy makers from all states need to be aware of how the cumulative effect of regulation can harm an industry’s growth. Recent research shows that the cumulative effect of federal regulation has cost the U.S. $4 trillion in lost GDP since 1980, or $13,000 per person. Since federal regulations do not impact states equally this $4 trillion dollars of lost output has not been shared equally either; states like Louisiana, Indiana, West Virginia, Kentucky, and Texas have been impacted the most.

While individual regulations may be largely benign in terms of their effect on growth, the cumulative effect severely hinders firms’ ability to innovate and create new jobs and opportunities for residents. When employment opportunities disappear, workers will move to states with better economies – such as those with less federal regulation – choose to retire early, or in the worst case scenario be forced to rely on family, friends, and public assistance to make ends meet. This puts further pressure on already distressed state budgets.

For these reasons, state officials around the country should push for reducing and simplifying federal regulation.