How the Unseen Effect of Regulation Harms Economic Growth

The 2015 Economic Freedom of the World report was recently released and out of the 157 countries ranked the United States fell from the 12th slot in 2014 to 16th. This includes an especially low rank of 49th in the category “Business regulations,” which is probably not surprising to any U.S. business owner.

According to the Mercatus Center’s RegData database, federal restrictions on business activities increased 28 percent from 1997 to 2012. While these regulations may be well intentioned, excessive rules and restrictions can have pernicious effects on the economy.

A new study that uses RegData shows that federal regulations decrease new hiring. In addition to this direct, negative effect on economic activity, there is an unseen effect — the businesses that are never started because potential entrepreneurs are discouraged by all the red tape in their path.

Along with the decline in new hiring, the aforementioned study shows that more regulated industries experience fewer new entrants into the market each year. This unseen effect negatively affects economic growth in the long run and the short run.

An agency rule, restriction or regulation may not seem like a big deal on its own, but the cumulative effect can be death by a thousand cuts. For instance, the combination of new $5-per-hour parking meters and a local rule requiring establishments to verify that at least 80 percent of their business comes from the local area contributed to the recent closure of a 100-year-old fruit store in Palm Beach, Fla.

If you talk to any local business owners you know, you may get a list of similar complaints about the costs — in money, time, effort and lost opportunities — that their local government places on them. How many hopeful entrepreneurs, discouraged by the plethora of local regulations obstructing their path, decide that starting a business just isn’t worth the hassle?

Economists have long maintained that profit and loss are important signals, which relay information about the most efficient use of scarce resources. Like losses, firm failures also serve a useful function. A recent study in the Journal of Regional Science finds evidence that both firm openings and closings positively affect subsequent entrepreneurship and employment growth in metropolitan areas. The researchers contend that firm closings — when combined with new openings — transmit valuable information to future entrepreneurs about the local economic environment such as the level of demand, availability of financing, and quality of the labor force.

The more information prospective entrepreneurs have, the less likely they are to err, which increases their chance of success. This conclusion is probably not surprising to anyone who has ever learned what not to do by watching someone else make a mistake.

Regulations at both the federal and local level can prevent the information transmitted by firm openings and closings from ever materializing. This is because many regulations act as a barrier to entry that prevents entrepreneurs from ever serving a single customer. We can never know how many potential entrepreneurs have tried to start a business, only to run into some regulatory hurdle that made it impractical to continue. This type of “failure” is unseen and as such it doesn’t provide the same level of information to other entrepreneurs that traditional failures do.

Federal regulations get most of the attention, but each local government has its own set of building codes, permit procedures, tax remittance laws, zoning regulations, architectural review boards, etc., which every entrepreneur must comply with. For example, local Landmark Commissions and Historical Preservation Boards routinely block the demolition of vacant, privately owned buildings that haven’t been used in years. This delays business plans and costs money.

Cities and states that are struggling with population decline and business flight should take a serious look at their regulatory environment and get rid of unnecessary and overly burdensome regulations. Local governments that streamline their regulations will create a friendlier environment for aspiring entrepreneurs, and this can generate economic growth in both the short and long run.