Regulation and Economic Growth

Regulation and Economic Growth

Herbert Grubel

Professor of Economics (Emeritus)

Simon Fraser University

Draft of July 1, 2016

Abstract

At the initial stages of economic development regulations increase productivity and create a positive relationship between the stock of regulation and economic growth but this relationship is subject to diminishing and ultimately negative returns  At later stages of development regulations are increasingly used to satisfy income-elastic demand for government-supplied social benefits and public goods, which reduce growth in the market sector but increase the growth of income defined to include these ephemeral benefits. This model describes conditions existing in the advanced economies of the world.

            The study also discusses the difficulties inherent in the estimation of costs and benefits of regulation, especially in the case of social benefits and public goods. Public choice theory suggests that modern economies are over-regulated.

            The study implies that traditional policies to stimulate growth are bound to fail because of the public’s demand for social benefits and public goods. More political oversight and transparency is recommended to deal with public choice issues around regulations.

JEL Classification: D61, D62, D63, D73, H10, H21, H41, L51, O40

The secular decline in rates of economic growth in the world’s developed countries since the 1970s has been analyzed widely, especially after the unusually poor record of growth after the Great Recession of 2008. Economists have suggested a number of causes such as income inequality, fiscal austerity, excessive levels of private debt and the absence of scientific and technological breakthroughs.

One cause mentioned by all studies of the slow growth phenomenon mention excessive government regulations. This paper focuses on this relationship because of its importance. According to Gordon and Katz (2015) “...regulatory excess increasingly inhibits economic growth. Unless constrained, the regulatory state will overwhelm America’s entrepreneurial spirit...”[1]

In the first part of this paper I argue that for many years in the past the relationship between regulations and economic growth has been positive because regulations during that time tended to enhance economic efficiency and productivity. However, in recent years regulations have reduced growth rates because high average incomes resulted in a public demand for regulations designed to produce social benefits and public goods, which decrease economic growth measured in conventional national income accounts but increases growth in non-measured dimensions of income

Part two considers the implications of the change in the dominant goal of regulations from increasing efficiency to creating social benefits and public goods. My model suggests that a marginal increase in regulations can reduce conventionally measured growth rates but increases rates of growth in income that includes social benefits and public goods. This result is consistent with recently observed conditions in developed countries.

The third part of this study discusses the problems associated with the valuation of the costs and benefits of regulations, which make unreliable all estimates but especially those providing social benefits and public goods.

In part four, public choice theory and the theory of bureaucracy are used to establish a strong presumption that the incentives facing politicians and regulators lead to excessive amount of regulation for the creation of social and public goods.

The concluding section considers the policy implications of the preceding analysis and reviews policies that can and have been used to curtail over-regulation.

The Optimum Level of Regulation

Consider a primitive economy that initially is without a government in which economic growth is determined solely by increases in population and the accumulation of capital in a fixed amount per person. The absence of regulations protecting property rights prevents productivity-enhancing innovations and increases in the stock of capital.

In Figure 1 the annual rate of economic growth and the existing level of regulation are measured along the vertical and horizontal axes, respectively. Under the preceding assumptions, the level of regulation is zero and the annual rate of growth is assumed to be equal to OA.

Figure 1

Now assume that the residents of this economy form a government and give it the authority to establish regulations to protect property, create a police force to enforce them and collect taxes to cover the costs of these policies. The protection of property encourages the accumulation of capital and entrepreneurs to develop new productivity-enhancing technologies and products. The resultant gains in productivity and output are greater than the government and private costs of the regulation. This development is reflected in the upward slope of the curve in Figures 1.

The growth in the size and complexity of the economy following the protection of property is assumed to lead to the adoption of ever more comprehensive productivity-enhancing regulations like those that govern road traffic, standardize units of measurement and money, protect intellectual property and increase education.

This positive relationship is assumed to continue until diminishing returns to regulations set in. This development is reflected in the levelling of the curve in Figure 1 in line with the higher levels of regulation. At the level of OQ regulations the marginal costs and benefits are equal and the optimum level of regulation is reached at the OB rate of economic growth.  Further regulations generate costs greater than benefits and lower the growth rate until it becomes zero at OR regulations.[2]

The growth depressing regulations are especially severe when they reduce the innovative activities of entrepreneurs[3] and the high costs of compliance on established private businesses makes some non-profitable so that the labour and capital they used are redeployed in uses where they are less productive.[4]

New Goals of Regulation

The negative effect of regulations on economic growth is increased as average incomes rise and the people demand social benefits that are not sold in private markets such as protection from the loss of income due to ill health, unemployment, retirement and disabling accidents. The people also demand that the government supply public goods such as human rights for minorities, a more equal distribution of income and wealth, the creation of desirable industries and the protection of consumers, the environment and culture.

The value of these social benefits and public goods are not included in national income estimates based on existing accounting conventions but their production requires labour, capital and generates losses in the efficiency of the private sector and thus reduces conventionally measured economic growth. 

A Different Optimum Level

In Figure 2 the horizontal axis measures the stock of regulations. The vertical axis on the left side represents growth rates for GDP measured according to present accounting conventions. The right vertical axis measures growth rates for GDP including the value of the currently non-measured benefits from the consumption of social and public goods.

In Figure 2 the solid line AR replicates that shown in Figure 1.  The broken line AT shows the relationship between regulation and the new index of national income that includes social and public goods as well as the traditionally measured income. The two lines coincide until regulations are at OX.  Thereafter, the two curves diverge and the curve reflecting additional value of social and collective benefits is a broken line.

I hypothesize that conditions existing in the real world are described in Figure 2 when the level of regulations is at OS, the growth rate of conventionally measured income is OD and the expanded measure of income is at SC. These conditions are the result of the public’s demand for income-elastic social and public goods, which use resources that cause conventionally measured growth to be low.

The preceding analysis has important policy implications. The low levels of economic growth of recent times that has attracted so much attention cannot be cured by the traditional policies stimulating investment and innovation. The slow rates of growth are the cost of creating social and public goods, which absorbs the capital and innovative efforts that otherwise would be used to increase the output of conventional goods and services.

Unfortunately, the data needed to test the validity of the model presented here do not exist. The costs of regulations bringing both efficiency-enhancing and social and public goods have been measured but the measurement of the benefits is elusive, especially those involving the ephemeral nature of the social and public goods. However, for reasons discussed in the next section, there exists a strong presumption that these benefits are over-estimated and have led to inefficiently high levels of consumption and regulation.

Figure 2

Estimating the Costs and Benefits of Regulations

In a number of studies the level and cost of regulation is assumed to be proportional to the number of regulations in effect. A variant of this approach counts the number of pages required to list existing regulations in the document published by regulatory agencies.

The indices created by this basic methodology suffer from the fact that regulations are very heterogeneous. For example, a regulation restricting the use of a small area of farm land to protect an endangered species costing $1 million annually counts as much as another one-page regulation prohibiting the use of an herbicide affecting millions of farmers and costing billions.

For this reason, the proper measurement of the level of regulation should weight each by the costs it causes. These costs consist of spending on the creation, enforcement and policing of regulations by the government agencies plus the cost of compliance by regulated enterprises and the economic cost resulting from the shift of resources out of their most efficient use in the private sector.

The basic problem with this methodology is that estimates of the costs of regulation encounter a well-known accounting problem. Government agencies and private firms have large fixed costs and no objective and universally acceptable principle exist for allocating proportions of this fixed cost to specific regulations. This fact is important because it can lead to systematic biases in the estimates of costs made by civil servants with ideologically driven policy agendas.

Additional problems with the measurement of the costs of regulation arise from the fact that some require the use of sophisticated mathematical models that employ many assumptions about future developments, which makes the estimates highly uncertain and subject to the introduction of ideologically driven bias.

Economic costs resulting from the effect of regulations on entrepreneurial activities and innovation are especially difficult to measure since statistical surveys cannot obtain information about the extent to which the regulations prevent entrepreneurs from bringing their innovations to market or are completely discouraged from even starting their work.

In spite of these problems with estimates of the costs of regulation, a number of studies have calculated them.  A recent study is by Clyde Crews (2015) who found that for the US economy in 2014 the costs came to $1.88 trillion, or about one half of federal government spending that year. 

The Benefits of Regulation

The benefits of regulations are even more difficult to quantify than the costs. For example, the regulation forcing the installment and use of seatbelts in automobiles reduces injuries and deaths. Savings in medical costs and the preservation of incomes of accident victims from the use of seatbelts can be estimated, but what is the value of the avoided pain and suffering?

Estimates are even more difficult in the case of regulations producing social benefits. For example, what is the value to individuals and society from knowing that their incomes are made more secure through the public provision of health care and pensions?

The value of the benefits from regulations producing collective goods is also impossible to estimate. For example, the value to individuals and society resulting from regulations that reduce the discrimination minorities and women encounter in economic and cultural activities is ephemeral and cannot be measured. Another example is the value of the benefits from the prevention of global warming. The forecasts of temperatures with and without regulations are very uncertain as are their effects on extreme weather incidents, crop yields and property damage.

It is highly unlikely that the problems of producing reliable estimates of costs and benefits of regulations will ever be overcome and the existing, imperfect measure will be used to provide at least some useful information for analysts. However, the next section presents theoretical considerations, which imply that the cost/benefit calculations made by the regulatory agencies are biased in favor coming up with net benefits for specific projects, which lead to the adoption of regulations that objective evaluations would have prevented.

Biased Estimates of Costs and Benefits of Regulation

In democracies politicians are expected to pass legislation only if it improves the well-being of society after due consideration of the resulting costs. Civil servants in ministries and regulatory agencies design regulations needed to put into effect such legislation, with each regulation implemented only if its benefits exceed its costs.[5]

It has long been assumed that politicians and civil servants make these cost/benefit calculations motivated only by the desire to maximize the well-being of society. However, this assumption has been challenged not so long ago by the theory of public choice developed by James Buchanan and Gordon Tullock (1962) and the theory of bureaucracy by William Niskanen (1971) (1975). Buchanan and Tullock argued that politicians are motivated not just to improve the welfare of society but also by the desire to be elected or to stay in office and government. Niskanen argued that the motives of civil servants in the evaluation of regulations are influenced by their desire to enjoy a successful career, high pay, good reputation and important influence on events.

 The work of politicians involves a difficult calculus. On the one hand, they are constantly besieged by groups of citizens and organized businesses with demands for specific laws and regulations allegedly improving the well-being of all citizens. On the other hand, they face the risk that the vast majority of citizens who have to pay the cost of the benefits to the interest may oppose the legislation. While the interest group guarantees the politicians votes and financial support, if only a relatively small proportion of the rest of the population withdraws its electoral support, the politicians’ re-election chances can be doomed.[6]

Buchanan’s analysis suggests that individual voters either do not know about the cost such legislation imposes on them or they believe the cost to be so low that it is rational for them to ignore the issue. As a result, much legislation serving mainly the interest of relatively few citizens is passed even if politicians know that a rational cost/benefit analysis shows it to reduce overall public well-being and a properly informed electorate would vote against it.[7]

Civil servants in charge of designing, implementing and policing regulations are also subject incentives that bias their decisions. On the one hand, if they approve the marketing of a new product that turns out not to be effective or safe, their careers and incomes are threatened. They therefore delay their approval until research indicates that it is effective and safe at a probability much higher than it would they did not face these personal costs. On the other hand, the delay of their approval imposes costs on the owners of the new product and on consumers who would have benefited from buying it. These costs do not enter into the civil servants’ personal calculus determining the conditions for licensing a product. This problem is especially serious in the case of pharmaceuticals, where the delay in the approval of new medications can cause serious, unnecessary suffering by patients with painful and life-threatening diseases.

Finally, it is worth mentioning that over-regulation also takes place because civil servants and politicians are entering these occupations because they believe in the need for governments to deal with the shortcomings of free markets, which they see in producing great inequalities in income and enabling large corporations to exploit consumers and spoil the environment. Given the uncertainty surrounding estimates of costs and benefits of regulations affecting these alleged problems with free markets, their views are likely to under-estimate costs and over-estimate benefits.

Policy Implications

The main policy implication of this study is based on the conceptual framework, which distinguishes between regulations that increase efficiency and economic growth and regulations that bring social benefits and public goods. The shift from the first to the second type of regulation in recent times caused economic growth measured traditionally to slow but has increased growth of income including social benefits and public goods.

This result implies that the existing low rates of economic growth cannot be improved by policies that stimulate capital formation, education and innovation as the increase in these factors of production is likely to be used to meet the public’s demand for more social and collective goods.

It is an open question whether the present mix of investment in the two types of output meets the true preferences of the public because the trade-off between them is not known to the public and politicians and has not been a major issue in election campaigns. The need for such discussion is especially important to counter the populist notion presented by the leading candidates in the 2016 presidential election who argue that economic growth can be returned only by protectionism, isolationism and income redistribution, economic planning and other illiberal policies. These policies will be costly and fail to achieve the desired objective.

The second half of this study implies that the public discussion of the proper mix of regulations aimed at the two types of benefits should take account of the strong presumption that the motives of politicians and civil servants for private gains has resulted in an excessive production of social benefits and public goods.

A broad public discourse on the optimal mix of regulations is important but likely to take a long time to improve political decisions and regulatory practices. In the meantime, governments can adopt policies that ensure that the analysis of costs and benefits is correct and protected from the biases stemming from the selfish motives of politicians and civil servants.

Leading Washington think tanks have done much research, published many studies on regulatory policies and presented proposals for reforms of the regulatory system: The CATO Institute has for more than 25 years been publishing in its periodical Regulation Magazine papers on regulation reform by distinguished researchers; The Competitive Enterprise Institute has been publishing periodic updates focusing on the cost of regulation, the latest of which is by Crews (2016)); and The Heritage Foundation published a volume (Gordon and Katz (2015)) containing recommendations for policy reforms written by a number of experts.

Almost all of the published studies on regulation criticize specific policies on the grounds that the costs exceed the benefits. These studies are valuable and can serve as useful guides for changes in specific policies if and when the people of the United States elect a government willing to consider such changes.

More important are the recommendations found in these studies for fundamental changes in the way the costs and benefits of past and future regulations are determined: The primary responsibility for this task should be returned to the elected members of Congress and away from the unelected the civil servants operating regulatory agencies. To protect the process from politicians attempting to use it for personal gains, the work of Congress should be made transparent and accessible to the media and public scrutiny.

Under these proposed reforms elected officials would face mountains of additional work organizing and attending relevant committee hearings and voting on proposed regulations. Their workload could be eased by restricting the Congressional evaluation of regulations to only those with a likely cost of a certain level, such as $500 million.

Another policy change would be for Congress to invite public petitions for review of specific regulations regardless of the costs estimated by the regulatory agencies. This process should be triggered only if the petitioners exceeded a specific number set high enough to deter frivolous use of the instrument. Such reviews would create an important obstacle to the existence of regulations for which costs exceed benefits and would encourage regulatory agencies to be more diligent in their own research on the costs and benefits they design and consider for adoption.

Strong and effective Congressional oversight of regulations is not much different from that required of military, social and other spending programs. The results of these efforts are unlikely ever to be perfect, but they would almost certainly increase the chances that regulations are efficient and respond to the demand of the general population.

Another approach to reducing the level of regulation in the economy involves using market signals and competition. Chris Edwards (2016) recommends privatization of publicly owned enterprises so that market forces reveal the damage done by regulations and lead to their abandonment rather than rescue by further regulations. Privatization efforts have met with some success but run into powerful opposition from interest groups benefiting from public ownership.

Grubel (1983) suggests the creation of free market zones in which regulations are at a bare minimum and whose commercial success encourages regulated businesses to demand equal treatment. The most successful experiment in this spirit has been the creation of special economic zones in China. The success of the first zones has inspired the creation of many others, led to the reduction in regulations throughout the country and provided the conditions for China’s economic growth. Free market zones have also been created successfully in some developing countries, but few can be found in advanced market economies where political and interest group opposition is pervasive.[8]

References:

Becker, Gary (1976), “Toward a More General Theory of Regulation”, The Journal of Law & Economics, Vol. 19, No. 2, pp. 245-248 found at https://www.jstor.org/stable/725165?seq=1#page_scan_tab_contents

Buchanan, James M. and Gordon Tullock (1962), The Calculus of Consent: Logical Foundations of Constitutional Democracy, Ann Arbor: University of Michigan Press, reprint found in June 2016 at http://www.econlib.org/library/Buchanan/buchCv3Cover.html

Chao, Johnny and Herbert Grubel (1998), “Optimal Levels of Spending and Taxation Canada”, pp. 53-68 in Grubel editor, How to Use the Fiscal Surplus: What is the Optimal Size of Government, Vancouver: The Fraser Institute found at https://www.fraserinstitute.org/sites/default/files/HowtoUseFiscalSurplustblContents.pdf

Crews, Clyde Wayne Jr. (2016), Ten Thousand Commandments: An Annual Snapshot of the Federal Regulatory State 2015 Edition, Washington: Competitive Enterprise Institute, accessed June 13, 2015 at https://cei.org/sites/default/files/10%2C000%20Commandments%202015%20-%2005-12-2015.pdf

Edwards, Chris (2016), Privatizing the U.S. Postal Service, Tax and Budget Bulleting No. 75, Washington: CATO Institute found at http://www.cato.org/publications/tax-budget-bulletin/privatizing-us-postal-service

Gordon, Robert and Diane Katz, Editors (2015), Environmental Policy Guide: 167 Recommendations for Environmental Policy Reform. Washington, DC: The Heritage Foundation, accessed June 2016 at http://thf_media.s3.amazonaws.com/2015/pdf/EnvironmentalPolicyGuide.pdf

Grubel, Herbert (1983), Free Market Zones: Deregulating Canadian Enterprise, Vancouver: The Fraser Institute found at https://www.fraserinstitute.org/sites/default/files/free-market-zones.pdf

-------------------- (2016), “Canada’s New Immigration Policies 2016: Good Politics, Bad for the Country”, Optimum Online: Journal of Public Sector Management, 46, 2, summer; found at http://www.journals4free.com/link.jsp?l=29062666

 

Laffer, Arthur (2004), The Laffer Curve: Past, Present, and Future, Backgrounder #1765 on Taxes, Washington: Heritage Foundation, found at http://www.heritage.org/research/reports/2004/06/the-laffer-curve-past-present-and-future

 

Niskanen, William A. (1971), Bureaucracy and Representative Government, Aldine, Atherton

--------------------------- (1975) “Bureaucrats and Politicians”, The Journal of Law & Economics, Vol. 18, No. 3 

Regulation Magazine published quarterly by the CATO Institute, found at http://www.cato.org/regulation/about

Scully,  Gerald (1989), “The Size of the State, Economic Growth and the Efficient Utilization  National Resources”,  Public Choice 63, pp. 139-164

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[1] The quote is from Gordon and Katz (2015) page 31.

[2] The shape of the inverted U with the right end of the curve at zero growth rates used here is the same as that found in the study by Laffer (2004), which has tax revenue on the vertical axis and the level of taxation on the horizontal axis and that by Scully (1989), which has economic growth and government spending on the two axis. The study by Chao and Grubel (1998) contains an empirical estimate of the Scully curve for Canada.

[3] The effects of regulation on entrepreneurial innovations, productivity and economic growth are nearly impossible to measure. The legendary entrepreneurs that created computers and other successful products and services in their garage came to the attention of statistical agencies only after they marketed their products successfully, employed workers and capital and paid taxes. There are no records of the entrepreneurs who stopped their work because the regulatory requirements and delays caused them to run out of money or of the entrepreneurs who were discouraged from pursuing their dreams because they knew of the regulatory costs they would face.

[4] The economic costs of regulation caused by the closing of businesses are also nearly impossible to measure because such closures take place all the time for other reasons and in practice it is very difficult to identify the role played by the cost of regulation and other factors affecting profitability.

[5] The study by Gordon and Katz (2015) indicates how policies set by law leads to regulations designed and executed by regulatory agencies. For example the “Clean Air Act” and “Clean Water Act” authorize the Environmental Protection Agency (EPA) of the United States to design, enforce and policy regulations needed to achieve the objectives of these acts.  The Bureau of Land Management, the U.S. Forest Service, the U.S. Fish and Wildlife Service, and the National Park Service pass regulations to achieve the objectives of the “Endangered Species Act” and some provisions of the “Clean Water Act”.

[6] Gary Becker (1976) suggests that the political system leads opposition politicians to make the public aware of the costs of special interest legislation passed by the government. This effort by opposition politicians represents a restraint on the ability of politicians to buy votes and on the size of the costs their legislation imposes on the population.

[7] Current immigration policy in Canada illustrates this proposition. According to the analysis found in Grubel (2016) the government headed by Justin Trudeau elected in 2015 increased the annual admission of immigrants from 270,000 to 300,000. Canada’s large immigrant communities benefit from this new policy as it strengthens their political and economic influence in the country and allows them to grow their cultural traditions and institutions. This legislation brings the Trudeau government many votes from the immigrant communities, which in some electoral districts can decide the outcome of federal elections. 

The government does not risk a significant loss of votes from the rest of Canadians because they do not know that the legislation imposes serious costs on them or because they have been persuaded that immigrants increase economic growth, prevent labour shortages and create a favorable demographic balance need to finance social insurance program.

In fact, however, these benefits are illusory while recent immigrants impose a heavy fiscal burden of $30 billion annually on taxpayers, mainly because recent immigrants pay taxes much below the national average but consume government services equal to the average. Immigrants also aggravate the problem of income inequality as they raise returns on capital and lower the incomes of labour. In addition they increase the cost of housing and the levels of pollution, traffic congestion and shortage of medical services.

[8] When first I published some studies on this subject and it attracted interest from the media and some jurisdictions in Canada, a powerful mandarin in the federal government wrote to me that he and his government opposed the creation of free market zones because eventually they would spread throughout the country.