Here’s an Odd Result: Strict Regulation Apparently Doesn’t Hamper Startup Growth

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Does government regulation of an industry impede the creation rate of new startups, and thus reduce innovation and dynamism? Alex Tabarrok passes along a fascinating little nugget of research on the subject:

Could regulation be increasing barriers to entry, raising the costs of reallocation, and slowing the diffusion of productivity innovations? To test the hypothesis that regulation is reducing dynamism Nathan Goldschlag and I combined data on dynamism with an industry level measure of regulation.

Our measure of regulation is produced by an innovative technique that combs the Code of Federal Regulations (CFR) for restrictive terms or phrases such as “shall,” “must,” “may not,” “prohibited,” and “required”. The count of restrictive words in each section is then associated to industries via a machine learning algorithm that recognizes similarities between the language in that CFR section and industry language (e.g. a section of the text with words such as “pipeline” would be associated with the oil and gas industry). In this way, we can associate each industry with an index of regulation derived from the entire CFR.

Now, I have some doubts about this. For starters, it’s limited to federal regulation. State regulation is the big player in some industries. It also doesn’t really test the nature of the various regulations. A routine requirement to submit quarterly tax information gets the same weight as a heavily intrusive requirement to raise capital levels or monitor pollutant levels. Finally, that machine learning algorithm better be pretty good. Is it?

Still, despite these caveats, it’s an interesting approach. And what Tabarrok and Goldschlag found was the opposite of what they expected. As the chart above shows, industries with more regulation also had more startups. Stringent regulation doesn’t seem to impede dynamism at all. In fact, it encourages it. Further tests confirm this.

But why? I’ll toss out a few possibilities:

  1. The research methodology just isn’t up to the task. Regulation really does reduce the incentive to create startups, but this particular test is too underpowered to show it.
  2. Lots of regulations explicitly exclude small firms (usually those with under 50 employees). This doesn’t matter much in, say, the hospital business, where every firm will be above that threshold. But it does matter in other industries, and it might give startups an advantage over established firms. In other words, regulating the big guys might actually make small startups more attractive than they otherwise would be.
  3. Tabarrok suggests that regulation might be associated in some way with how dynamic an industry is in the first place. That is, especially profitable and growing industries might automatically attract the attention of regulators simply because they’re more noticeable. If that’s the case, the level of regulation might not be telling us anything aside from the fact that dynamic industries attract more regulation.
  4. Perhaps increased regulation mostly just drives the growth of a consultant class that helps startups create new businesses. Because of this, starting a new business isn’t any harder, it’s just a bit more expensive. But every other business is paying the same expenses to comply with regulations, so it’s not really much of a barrier to entry.
  5. Maybe only certain kinds of regulations affect dynamism and America is pretty good at avoiding those. The ones that are on the books are generally as minimal and targeted as possible and don’t much affect startup creation.

Any other ideas? It really is a bit of an odd result, regardless of whether you’re temperamentally in favor of regulation or not.

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