Regulation and productivity🍋

Is there a connection? And who cares?

The long-term prosperity of a country depends in large part on its productivity. Productivity is a measure of how well an organisation, industry or country is using the resources available to it. Productivity is most usefully seen from a longer-term perspective. The size and quality of investments made in a country’s people, communities, infrastructure, other structures, plant and equipment, institutions, and knowledge will determine its productivity and, in turn, the material living standards of citizens, their children and future generations.

Productivity growth is not just about producing more output. Increasing productivity is about getting more (output) for less (input) – not about people working harder, wearing out plant and machinery, or depleting natural resources. Productivity is not the only influence on wellbeing, but in determining our material living standards, it is an important one.

Black Giants, Fiordland. Dave Heatley

Productivity growth plays a crucial role in improving wellbeing by increasing a nation’s incomes and its ability to produce and afford the goods and services that underpin happy, healthy lives. It also offers the option to work fewer hours and enjoy more free time. Additionally, higher incomes allow a country to invest in public goods and services that benefit everyone, such as schools, hospitals, infrastructure and a better natural environment. Higher productivity promotes the growth and prosperity of Aotearoa New Zealand to safeguard wellbeing, today and in the future. By providing more income to invest in the nation’s wealth and through using our existing resources more efficiently and sustainably, productivity can create a brighter future and better quality of life for all New Zealanders (NZ Productivity Commission, 2023).

Regulations can both support and damage productivity

Regulations can exert significant influence on productivity and productivity growth – either positively or negatively. The positive effects arise when regulations:

• create the conditions for markets and competition to operate well (e.g. regulations to establish property rights, trust, enforcement of contracts and information disclosure);

• underpin the provision of public goods and infrastructure;

• control/limit the negative externalities arising from business or personal activities (e.g. pollution, congestion); or

• mitigate serious risks that markets alone leave individuals and communities exposed to.

Even in these cases of positive effects, the benefits vary depending on the design and implementation of the regulations.

Regulations can have negative effects on productivity in several ways including when they:

• impose a compliance burden on businesses adding to their costs including by causing delays in investments or operations;

• create barriers for new players to enter existing business areas or for new or old players to innovate and start up new business areas (importantly such regulations can inhibit competition and slow the reallocation of capital and other resources in the economy from low to high productivity uses);

• create uncertainty about property rights undermining incentives to invest and innovate; or

• have a non-economic purpose (which may be a worthy one such as freedom, safety, privacy or equity) the pursuit of which conflicts with efficiency and productivity.

A tendency towards excessive regulation

Adding to these negative effects is a general tendency towards excessive regulation. This tendency comes from both the demand and supply sides of the “market” for regulation.

Demand for regulation can come from the media, firms, unions and consumers.

Firms seek strategic advantage and subsidies. Unions seek job protection, low hours, higher wages, and safety. Consumers adversely affected by monopoly, externalities, and other market failures are confronted with the ‘wrong’ prices in the sense of being above marginal cost. This has an income effect, transferring a rent from consumers to producers and polluters. Demands for regulation from consumers are essentially an attempt to return these rents. (Helm, 2006, p. 172)

Demand tends to be excessive because only a small part of the cost of regulation falls on the entity demanding it, and the “market” is mediated through the political process. Or it may be that the costs of the proposed regulation are not revealed or properly considered in the process of its development.

The supply of regulation also tends to be excessive because political leaders want to be seen to do something to tackle problems or reduce risk. In addition, regulating can be an attractive alternative to spending interventions because the latter, unlike the former, are subject a budget constraint and greater value-for-money scrutiny (Gill, 2019, p. 7).

In other cases, politicians effectively “buy” political support in exchange for protecting certain interests. When risks materialise rarely, an asymmetry exists: an occurrence of an event sparks calls for regulation but the converse when the event does not happen doesn’t lead to re-setting regulation to make it appropriate for the risk.

In addition, regulators have a bias towards enlarging the size and scope of their responsibilities, and therefore their budgets, salaries and careers. When professions self-regulate (as they are often permitted to do), they have a bias via standards, qualifications or vetting to restrict entry to the profession. This has the effect of enhancing the incomes of the incumbent members.

In summary, some regulation is necessary for productivity through supporting property rights, markets, competition and innovation. Other regulations have non-economic objectives, which may conflict with productivity, but are important for other aspects of wellbeing. This calls for good design to strike the right balance or trade-off. Even when regulation has an economic objective, poorly designed regulations can have significant negative impacts on productivity. Given the tendency for regulation to be excessive, this calls for rigorous processes to design and operate regulations in ways that maximise their benefits and minimise their costs.

Regulatory capture is a persistent risk

Helm (2006) defines regulatory capture as “the process by which vested interests bias the incentives of regulators and governments to act in their interests rather than the broader public interest.” Regulatory capture is likely to reduce productivity and wellbeing. Combatting it calls for good decisions about whether to regulate, the choice of regulatory instruments, and institutional architecture. It is intimately connected with the tendency towards excessive demand for and supply of regulation.

Lobbying of politicians by regulated parties, political donations, and the same parties getting overly “close” to the regulatory organisation and staff can lead to regulatory capture. More subtle means are the strategic revelation of information by regulated parties to influence the behaviour of regulators, and revolving doors from political leaders and regulators to well-paid jobs in industry. Consumer groups and NGOs may also seek to capture regulators. Dal Bó (2006) uses a principal-agent framework to explore regulatory capture mechanisms.

Evidence on regulation and productivity growth

A considerable body of evidence shows that poor and/or excessive regulation can have significant negative impacts on productivity and productivity growth. Many of these studies use a cross-section of countries to study whether differences in regulation across the countries and over time have a discernible impact on productivity performance, controlling for other influences on productivity.

For example, studies cited in Crafts (2006) and later studies showed the following broad patterns.

Deregulation in heavily regulated developing countries induces markedly faster growth in GDP per person consistent with improved productivity and rapid catch-up growth, but deregulation in relatively lightly regulated OECD economies has made much less of an impact. (These studies used largely subjective measures of regulation.)

Detailed and more objective OECD measures of product-market and labour‑market regulatory quality have provided opportunities to study differences in regulation and deregulation across OECD economies.

• Nicoletti and Scarpetta (2003) estimates suggest that if European countries over the 10 years to the early 2000s had aligned their regulatory regimes with the “best” OECD country, they would have raised their annual multifactor productivity (MFP)¹ growth by up to 1.1 percentage points.

• Javorcik and Spatareanu (2005) found that stricter employment protection deters foreign direct investment (FDI), especially in the service sector. Their estimates imply that the UK’s less strict employment protection compared to France increased the likelihood of FDI by between 12 and 26 percent.

• Superior productivity growth in the US compared to the EU in the decade after 1995 came from stronger US performance in ICT adoption and use particularly in services such as distribution. Regulations affecting the uptake of ICTs, the reorganisation of working practices and the entry of new firms appears to have had a major influence on whether the productivity potential of ICTs is realised.

Andrews et al. (2016) found that a striking feature of the widespread productivity slowdown in OECD countries following the GFC was that the labour productivity of firms at the productivity frontier rose, but overall productivity growth suffered because of an increasing divergence between frontier and non-frontier firms. The increasing divergence likely reflects a slowdown in diffusion of ideas and best practice from the frontier to the lagging firms. Looking across industries and countries, the rise in divergence was much more severe in sectors where pro-competitive reforms of regulations in product markets were least extensive, suggesting regulatory barriers to diffusion in these economies.

Cette et al. (2016)² used a country*industry*year dataset of MFP growth covering 14 OECD countries and 18 industries from 1987 to 2007, together with the OECD indicators for the severity of regulations of product markets in non-manufacturing industries, of tariffs and of employment protection. They investigated whether reforms to improve the market friendliness of regulations in “upstream” industries (such as communications, transport, finance) had any impact on MFP growth in downstream manufacturing industries. They found significant positive impacts of the reforms. The mechanism in their model was that restrictive regulations enabled firms in the upstream industries, facing less competition, to earn economic rents through charging higher prices, which then got divided between the firms (as excess profits) and the workers in those firms (as higher wages) – at the expense of higher productivity.

Aghion et al. (2023) studied firms in France where the regulatory burden sharply increases for firms once they reach the size threshold of 50 employees.  This reduces the incentives of firms just below the threshold to invest in R&D and other forms of innovation because it lowers their net returns from expanding to fully exploit their investments.  The researchers found that firms just below the threshold do indeed innovate less with regulation reducing aggregate innovation by 5.7%.

NZ ranks only just above average on product market regulation

A consistent pattern in the results from these studies was, not surprisingly, that the potential for further productivity gains from regulatory reform was greatest in countries with the most restrictive regulations. For countries scoring better on the OECD indicators, the scope for further gains from matching best practice was small. New Zealand would have been among this group in the latter part of the 1990s and into the 2000s. While it then scored well across most of the OECD indicators, New Zealand has slipped in the latest OECD product market regulation (PMR) indicators (OECD, 2024) to only just above the average for the 43 assessed countries.

The current situation suggests the potential in New Zealand to make further worthwhile productivity gains from well-chosen and well-implemented regulatory reforms. As the OECD states in relation to pro-competitive regulatory reform:

“more competitive markets tend to encourage innovation and diffusion of leading technologies by reducing barriers to the entry and growth of new innovative businesses. In the face of competition, incumbents are forced to improve their products and services, production processes, and management practices. The corollary is that in more competitive markets, less productive firms will face higher pressure to downsize or exit, which will release scarce resources and permit the growth of more productive and innovative firms.” (OECD, 2024, p. 6)

By Geoff Lewis

Geoff Lewis is an economist who has recently been working with the Ministry for Regulation in an advisory capacity.

The Monument and Lake Manapouri, Fiordland National Park. Dave Heatley

References

Aghion, Philippe, Antonin Bergeaud, & John Van Reenen. (2023). The Impact of Regulation on Innovation. American Economic Review, 113 (11): 2894–2936.

Andrews, D., Criscuolo, C., & Gal, P. N. (2016). The Best versus the Rest: The Global Productivity Slowdown, Divergence across Firms and the Role of Public Policy. OECD. https://doi.org/10.1787/63629cc9-en

Bourlès, R., Cette, G., Lopez, J., Mairesse, J., & Nicoletti, G. (2013). Do Product Market Regulations in Upstream Sectors Curb Productivity Growth? Panel Data Evidence for OECD Countries. The Review of Economics and Statistics, 95(5), 1750–1768. https://doi.org/10.1162/REST_a_00338

Cette, G., Lopez, J., & Mairesse, J. (2016). Market Regulations, Prices, and Productivity. American Economic Review, 106(5), 104–108. https://doi.org/10.1257/aer.p20161025

Crafts, N. (2006). Regulation and Productivity Performance. Oxford Review of Economic Policy, 22(2), 186–202. https://doi.org/10.1093/oxrep/grj012

Dal Bó, E. (2006). Regulatory Capture: A Review. Oxford Review of Economic Policy, 22(2), 203–225. https://doi.org/10.1093/oxrep/grj013

Gill, D. (2019). Regulatory management toolkit (NZIER Public Discussion Document 2019/3). NZIER. https://www.nzier.org.nz/publications/regulatory-management-toolkit-nzier-public-discussion-document-20193

Helm, D. (2006). Regulatory Reform, Capture, and the Regulatory Burden. Oxford Review of Economic Policy, 22(2), 169–185. https://doi.org/10.1093/oxrep/grj011

Nicoletti, G., & Scarpetta, S. (2003). Regulation, productivity and growth: OECD evidence. Economic Policy, 18(36), 9–72. https://doi.org/10.1111/1468-0327.00102

NZ Productivity Commission (2023). Productivity by the numbers 2023. https://www.treasury.govt.nz/publications/pcrp/productivity-numbers-2023

OECD. (2024, July 10). Product Market Regulation Indicators: Key takeaways from the 2023-2024 PMR indicators. OECD. www.oecd.org/en/topics/sub-issues/product-market-regulation.html

1. Multifactor productivity (MFP) measures the ability to produce more output with a given bundle of capital and labour. It is sometimes referred to as total factor productivity (TFP).

2. A related paper is Bourles et al. (2013).