4.Empirical Relationships

The indices constructed by the surveys discussed above have been used in the empirical literature to study the relationship between regulation and a range of outcome variables. Appendix Table 1 provides a summary of these studies.

Schianterelli (2005) has reviewed the literature devoted to cross-country evidence on product market regulation and economic performance. He states that, in many cases, researchers have entered measures of regulation directly as an explanatory variable in equations of factor demand, productivity, or innovation. In other cases, the effect of regulation is mediated through its effect on an intermediate variable, such as the mark-up or firms’ entry, exit, and turnover rates. This approach implicitly assumes that regulation only affects the end variable (productivity etc) through its impact on these intermediate variables.

Considering all of the empirical contributions on the relationship between regulation and firm dynamics, Schianterelli concludes that regulatory barriers in the product market have a negative effect on firms’ entry or turnover and are likely to slow the process of resource reallocation.

Those studies which take the more direct estimation approach include Alesina et al (2005). They use time-varying sector-country specific indices of regulation compiled by the OECD (Nicoletti et al 2000) to assess the effect of regulation on capital accumulation, by introducing the regulation indicators directly into an investment equation. Their overall results suggest that a reduction in regulation, particularly if it affects barriers to entry, has a significant and sizable positive effect on investment. They also find evidence that the marginal effect of deregulation on investment is greater when the policy reform is large and when changes occur starting from already low levels of regulation.

This direct evidence, and the indirect evidence provided by Griffith and Harrison (2004) suggests that deregulation has a positive effect on investment.

The cross-country studies provide conflicting evidence on the effect of lower regulation on direct input measures of innovative activity. Both Griffith and Harrison (2004) and Cincera and Galgau (2005) find that deregulation has a negative effect on R&D intensity, while Bassanini and Ernst (2002) and the OECD (2003) find evidence that deregulation has a positive effect on innovation activity. Also, Nicoletti et al (2001) find that strict employment protection legislation (EPL) has a negative effect on innovation activity but the OECD (2003) find no evidence to support this.

There are several papers which address the relationship between product market regulation and productivity or output growth. Most of the studies that include measures of regulation directly in the regression tend to find a negative effect of tighter regulation on total factor productivity or per capita output growth. However, studies that use the mark-up as the channel of transmission find that decreases in the mark-up associated with deregulation are associated with lower productivity growth (or level). On the other hand, relying on turnover or entry as the variable through which the effect of deregulation is transmitted suggests a positive effect of lowering regulatory burdens on overall productivity growth.

Gust and Marquez (2002) find that burdensome regulatory environments and in particular regulations affecting labour market practices have impeded the adoption of information technologies and slowed productivity growth. Their two-step approach uses the EPL index constructed by the OECD to measure labour market regulations, and data on regulatory burdens constructed from the World Competitiveness Report 1993 (by the IMD and WEF) and Global Competitiveness Report (published by the WEF) surveys.

Nicoletti and Scarpetta (2003) use four sets of regulatory indicators to estimate the relationship between regulatory reform and multifactor productivity growth. Their four sets of regulatory indicators are: economy-wide regulation (from the OECD survey 1998), industry-level regulation, regulatory reform (i.e. time-varying indicators of regulation), and privatisation. They find that economy-wide product market regulations that curb competition and private governance have a negative effect on productivity, mainly by slowing down the technological catch-up process.[20]

The OECD Employment Outlook (1999b) finds that EPL may have a positive effect on the employment rate for prime-age men, but provide only weak evidence for a negative effect on other groups. They do not find any relationship between EPL strictness and overall unemployment, although there is some evidence for a reduction in unemployment of prime-age men with an increase in EPL strictness. Stricter EPL was found to be strongly associated with higher rates of self-employment, a result also found by Grubb and Wells (1993), and with lower turnover in the labour market, with both jobs and unemployment spells tending to last longer.

Bertola and Rogerson (1997) find that the degree of flexibility in wage-setting appears to affect the strength of the link between EPL and employment, with rigid wage setting in the presence of strict EPL being a potentially unfortunate mix.

As well as estimating the effect of labour market regulations on employment, Nicoletti and Scarpetta (2004) also assess the effect of product market reforms on employment. They use the time-varying indicator of product market regulation used in Alesina et al (2003) and Nicoletti and Scarpetta (2003), and find that reforms in both labour and product markets are needed to raise significantly long-run employment rates. They also find evidence of significant interactions between regulations in product and labour markets (allowing for the coefficient of the product market regulation indicator to vary according to the stringency of labour market policies). The estimated negative effects of strict product market regulations on employment are stronger when labour institutions – by strengthening workers bargaining power or reservation wage – push workers to seek a higher share of product market rents.