Does regulation hurt innovation? This study says yes

Betsy Vereckey

Jun 7, 2023

Why It Matters

Firms are less likely to innovate if increasing their head count leads to additional regulation, a new study from MIT Sloan finds.

Can too much regulation hurt innovation?

It’s a timely topic for both cryptocurrency and generative artificial intelligence, with policymakers struggling to establish guardrails around wildly popular innovation while continuing to spur development.

Technologists may be justified in regarding regulation with caution: A new working paper for the National Bureau of Economic Research shows that regulation can dampen innovation. Specifically, companies are hesitant to invest in their operations when hiring more employees increases regulatory oversight.

The paper details findings by John Van Reenen, a digital fellow at the MIT Initiative on the Digital Economy, and co-authors Philippe Aghion and Antonin Bergeaud, who created a model that can be used to assess the impact of market regulation, even in countries whose regulations differ from those of the United States.

In most countries, including the U.S., regulations vary based on firm size. If a company’s head count remains below a certain number, it usually isn’t subject to more stringent regulation, Van Reenen said. In the U.S., for example, if a business has at least 50 full-time employees, the company is considered an applicable large employer and is subject to employer shared responsibility provisions and employer information reporting provisions.

The prospect of regulatory costs discourages innovation.

John Van Reenen Digital Fellow, MIT Initiative on the Digital Economy

In a recent conversation with IDE co-director Andrew McAfee, Van Reenen explained that he and his colleagues chose France to test their model, given that the country has some of the world’s toughest employment regulations. According to data from the Organisation for Economic Co-operation and Development, France and Belgium rank highest in terms of regulation.

“In France in particular, when firms get to a certain size — 50 employees — a variable tsunami of labor market regulation comes down on them,” Van Reenen said in a presentation. Specifically, firms have to:

Create a works council with employee representation.
Offer union representation.
Create a profit-sharing scheme.
Spend a minimum percentage of revenues on training.

The authors wondered about the impact of increasing head count: Were firms unwilling to expand when they knew that having more than 50 employees would mean more regulation?

They analyzed a data set spanning 1994 to 2007 containing companies’ tax records, with the goal of identifying French companies and their related employment information. They then matched the results with a global patent application data set for that same period, which they used as a proxy for innovation. Finally, they matched patents to the French companies using a machine learning algorithm and measured market size using French customs data to characterize export markets, studying 182,348 distinct firms.

Regulation hurts innovation

Van Reenen and his co-researchers discovered that two groups of companies were especially affected.

Companies close to the 50-employee mark innovated less. “As you get to the 50 mark, there’s this real slowdown” in patent innovation, and it flattens just past 50, Van Reenen said. “There’s a valley of innovation just before this 50 threshold, consistent with the idea that firms are innovating less because they’re afraid to cross the threshold. Firms under 50 employees respond less to promising market opportunities because they know they’ll have to pay an extra cost.”
Larger companies are affected too. The incentive to innovate declines as companies get bigger because they know that every time they innovate, they stand to be taxed on the profits. (The authors were able to equate regulation with tax using their model. They concluded that the impact of regulation is equivalent to a tax on profit of about 2.5% that reduces aggregate innovation by around 5.4%.)

In addition, the researchers found that market size affects innovation: Firms innovate more as the market size increases. The bigger the market, the more incentive firms have to innovate to get profits from that market.

“As the market size gets bigger, firms innovate more,” Van Reenen said. “They can spread the R&D costs over a greater number of units, so you see more innovations.” The authors didn’t delve deeply into sectors but noted that exporting manufacturing sectors were more patent-intensive than others.

How companies try to mitigate regulation

Van Reenen said that if a company wanted to grow without facing increased regulatory oversight, it could adopt more digital technologies instead of employing more workers.

A firm could also ask employees to work longer hours instead of hiring more people to do the work, or rely on more skilled workers rather than unskilled workers, based on the assumption that they are also smarter workers.

In fact, Van Reenen said that the research showed that some firms make some of these changes as they approach the 50-person threshold.

“There’s a whole panoply of things that people are doing to try and substitute around the regulation that is going on,” he said. “The problem is these things are not perfect substitutes. Digital isn’t a perfect substitute for labor. You can’t work workers for an infinite number of hours.”

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