The Rich Get Richer, While The Poor Get Poorer

Milton Ezrati

Chief Economist

Much commentary has anguished over the widening income gap between rich and poor.  Now a similar concern seems to have appeared in the business world. Income and profitability between large firms and small seem also to have diverged.  Here, the causes seem more straightforward than with the gap among individual earners. Two principal reasons stand out: 1) technology has enabled some firms to gain tremendous market power and 2) the expansion in government regulation, despite President Trump’s efforts to curtail the growth of rule making, has imposed heavy and uneven burdens on large and small firms.  Technology, if it has contributed to the problem, also might offer an answer. Indeed, it has already begun to do so.

Statistics paint a compelling picture.  According to a recent study by McKinsey & Co., the best performing decile of companies worldwide garnered 80 percent of all profits between 2014 and 2016, up from 75 percent a decade earlier.  The top 1 percent gained 36 percent of the profits. Of the array of over 5,000 firms surveyed by McKinsey, fully half were troubled. Though they may have rated as a solvent in a strict accounting sense, their return on capital fell far short of what investors would consider adequate.  Half, then, were effectively unsustainable. A separate, larger study by Aswath Damodaran of over 25,000 firms roughly verified these findings.

Some discussion of this problem has blamed globalization for the widening gap between small and large business concerns.  Though these days the winner-take-all character of global trade seems to get the blame for anything unfair or inequitable, laying this problem at globalization’s feet stretches credulity. With the Internet, global supply chains and marketing connections are now available to all.  A small retailer in Wichita, Kansas can access the same inexpensive inventory made in Asia as a giant retailer and, with inexpensive advice market those products nationally, even globally. Rather than drag out the perennial whipping boy of globalization, a better explanation might well lie with questions of market power.  Though all have access to the same suppliers, larger firms, such as Walmart and Amazon, can drive a harder bargain on price and delivery terms than smaller or mid-sized firms. Size also yields the financial power to expand through mergers and acquisitions, leaving for small players that would expand the more expensive and less reliable use of capital spending.

But more than market power or globalization, the main culprit in this matter appears to be government regulation.  Those discussing these trends in business – whether in the media or academia – have largely ignored the role of regulation, but it is nonetheless huge, and its burden clearly falls unevenly, weighing heavier on small- and mid-sized firms than on large ones.

Regulations – whether economic, environmental, or tax-related – certainly impose a great burden on American business.  According to a recent study by the Office of Management and the Budget (OMB), Congress passed only some 65 significant laws in 2013, the year under review.  In contrast, federal regulatory agencies that year issued some 3,500 regulations, an average of nine per day. Business had to accommodate every one of them.  According to the Competitive Enterprise Institute, the agencies of the federal government in 2015, the year of that study, issued some 80,000 pages of new rules.  Business had to digest these and accommodate them as well.

And all these demands on business have imposed great expenses.  According to the U.S. Chamber of Commerce, fully 11 percent of the country’s gross domestic product (GDP) goes to comply with federal regulations, and that does not even consider the burdens imposed by the 50 states, which combined have issued administrative codes for business approaching 18 million words.  By directly imposing on business for compliance and by additionally distorting investment decisions, regulations, according to the prestigious Mercatus Center at George Mason University, have slowed the economy’s growth rate by 0.8 percentage points a year. Had the regulatory structure remained steady at 1980 levels, that study points out, the country today would have a GDP one-quarter again larger than it does, giving every American more than $13,000 more income a year than he or she has presently.

Of course, these regulations also benefit the public.  Clean air and water are, after all, worth a lot, so is transparency in marketing, energy efficiency, fair treatment for workers, and highway safety, just to name a few of the aims of the regulatory structure.  The OMB’s study estimates that regulatory benefits outweigh costs by a factor of three. While some, the Mercatus Center for one, have cast doubt on the OMB calculations, that is hardly the point. Even if the OMB is accurate to the third decimal point, it is the public that benefits and it is business, the subject of this discussion, that pays, except, of course, when it can pass the costs on to customers. What is more, the data show that these costs to business, whatever the balance between overall burdens and benefits, fall harder on small- and mid-sized firms than on larger players.

The reason is that most regulatory costs are fixed.  The reporting and other compliance requirements demand staffing that imposes additional costs but that varies little with the size of the firm involved.  Even when and increasing business volumes increases regulatory costs they seldom do proportionately. Because small firms have much less revenue and fewer employees over which to spread those more or less fixed costs, their relative burden weighs more. The Small Business Administration estimates that firms with fewer than 20 employees pay on average 80 percent more per employee in regulatory costs than do firms with over 500 employees.  A rigorous academic study done some years ago under the auspices of the National Bureau of Economic Research (NBER) put this overall figure slightly lower, at 40 percent, but that is still a significant gap. For tax compliance, where most of the costs are indeed fixed, the NBER study found that compliance costs small business pays 3 times more per employee than in larger firms.

If then, it is regulation that has created the gap or a good deal of it, technology may offer a way to level the playing field.  Many fintech firms have already seized on the opportunity and moved into this space. Systems to deal with tax calculation and reporting have led the way, but increasingly players in this area are developing systems to deal with labor, environmental, and trade regulations.  Given the overall burdens involved, these systems, especially as they become more efficient and cost-effective, will offer businesses in every industry tremendous relief. If the new technologies can save only one-quarter of the amount spent presently on regulatory compliance (11 percent of GDP), they will save the business some $232 billion.  If the systems developers can capture for themselves only 10 percent of that amount, they will secure over $23 billion, an amount well worth the effort. Into the bargain the technology developers will benefit small business most of all, not at the expense of large business but simply because the greatest burden at present falls on small rather than large firms.  Doing well by doing good always has great appeal.