Published in Forbes by Ezrati
Amid the extensive commentary over the income gap between rich and poor, some have become troubled by a gap of another sort. They have identified a widening difference between the profitability of small businesses and large. Some commentators have tried to draw parallels between these two growing inequities. That is a tempting thing to do but simply too easy. These gaps have different causes. Those that affect business are much more straightforward. Here, two factors 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 it, has imposed heavy burdens on all business but disproportionately on smaller firms. The development of fintech applications does, however, promise to level the playing field, at least some.
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 garnered 36 percent of the profits. Of the more than 5,000 firms surveyed by McKinsey, fully half were troubled. Though they may have rated as 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 businesses. The winner-take-all character of global trade seems to get the blame for just about anything unfair or inequitable these days. But it would be a mistake to reach for this easy answer. With the Internet, global supply chains and marketing connections are now available to all. A small retailer anywhere can access the same inexpensive inventory made in, say, Asia as a giant retailer and, with easily accessible advice, can 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. All may have access to the same suppliers, but larger firms, such as Walmart and Amazon, can drive harder bargains on price and delivery terms than smaller or mid-sized firms. Size also yields the financial power to expand through mergers and acquisitions, leaving small players to rely on more expensive and less reliable route of capital spending.
More than market power or globalization, a major culprit in this matter appears to be government regulation. It imposes huge burdens on all businesses. 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.
With these demands come 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. That study concludes that if the regulatory structure remained steady at 1980 levels, 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.
Because the reporting and other compliance requirements demand staffing that varies little with the size of the firm involved, these burdens have fallen especially on small businesses. Even when increasing business volumes increase 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, they feel the burden disproportionately. 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 three times more per employee than in larger firms.
Of course, these regulations also bring benefits. Clean air and water are, after all, worth a lot, so is transparency in marketing and fair treatment for workers, energy efficiency 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 expressed doubt about the OMB calculations, that is hardly the point. Even if the OMB were accurate to the third decimal point, it is the public that benefits and it is business that pays, except, of course, when it can pass the costs on to customers. And a disproportionate burden falls on small business.
Technology developers have, however, begun to right this inequity. They see opportunities in devising ways to lift these onerous burdens. The trend is encouraging. 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 gain 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 and a potential that all but ensures technology developers will do the needed work.