Research suggests removing barriers to entry would effectively lower global income inequality.
Relatively few observers would disagree that income inequality has become a serious global challenge. The majority of respondents to an international survey conducted in 2014 by the Pew Research Center described the widening gap between rich and poor as a “very big problem.” Even in the United States, where bipartisan consensus is rare, the majority of both Republicans and Democrats agree that widening inequality is a very big problem.
Despite this consensus on inequality, little agreement exists on how to address this concern. The typical policy response is to raise taxes on high-income earners and either redistribute income directly to poorer households or expand social services. This is the approach President Barack Obama advocated in his 2015 State of the Union address, in which he proposed higher taxes on the top 1 percent of income earners and expanded childcare and college tax credits. That same year, a summit of leaders from the G20 urged member nations to take action to promote fairness by preventing businesses from shirking tax rules and by coordinating related tax collection efforts.
Although these measures reduce inequality in consumption, they do little to rectify the underlying lack of economic inclusion. Fortunately, recent evidence suggests that targeted regulatory reform can promote social mobility through expanded entrepreneurship, without the need to raise taxes or increase public expenditures.
In a new article that I coauthored with Patrick McLaughlin and Laura Stanley, we investigate the relationship between income inequality and the amount of red tape faced by would-be entrepreneurs in 115 countries, as measured by the World Bank’s Doing Business Index. We hypothesize that startup regulations—such as applications, permits, licenses, and fees—act as a barrier to entry, making it difficult and in some cases nearly impossible for entrepreneurs with modest resources to legally enter a market or profession. For example, the data indicate that it took 43 days on average to start a business legally in Colombia in 2004, during which time applicants were required to complete 19 distinct steps and spend 28 percent of their annual income toward starting that business. In turn, these steps suppressed entrepreneurship and concomitant economic mobility.
Using a wide assortment of statistical techniques, we find that nations with a greater number of entry regulations exhibit higher rates of income inequality. Specifically, increasing the number of steps required to start a new business by one standard deviation—3.37 steps—is associated with an increase of income inequality by 12.9 percent in nations with average levels of inequality. This result is intriguing because it suggests that reducing startup regulations may be an effective strategy to reduce income inequality, without the need to raise taxes, increase deficit spending, or place additional stresses on already limited public finances.
Moreover, recent case studies of Portugal and Russia provide evidence suggesting that startup deregulation promotes entrepreneurship and job formation in small firms.
In 2005, Portugal embarked on an aggressive effort to reduce startup regulations faced by entrepreneurs to jumpstart its moribund economy. According to a 2010 study by Lee G. Branstetter, Francisco Lima, Lowell J. Taylor, and Ana Venâncio, the Portuguese reforms were among “the most complete and thorough deregulation efforts of any country in Western Europe, moving up 80 places in the World Bank’s Doing Business index and winning international accolades for the government in the process.” Branstetter and his coauthors estimated that within eligible industries, the reforms increased the rate of business formation by 17 percent and the rate of job formation by 22 percent. The researchers also noted that relatively less educated and less experienced entrepreneurs opened a large share of these new firms, providing additional evidence that these reforms boosted economic inclusion.
These results, however, are not unique to Portugal. In a 2013 study, Evgeny Yakovlev and Ekaterina Zhuravskaya describe Russia’s sweeping deregulation efforts from 2001 to 2004, which three national laws initiated. The laws aimed to ease entry and maintenance of businesses by loosening requirements for inspections, licenses, and registration. Government agencies—like those associated with sanitary or labor conditions—could only inspect firms once every two years. More than one hundred types of businesses that needed licenses in the past no longer needed them. Registering firms also became streamlined by reducing requisite registration paperwork.
Yakovlev and Zhuravskaya found that in regions with better governance, the reform efforts were successful and resulted in more small business startups. Moreover, these post-reform small businesses enjoyed greater sales growth and employed a greater share of the labor force than they did before the reforms.
Given the evidence from these studies, we make two policy recommendations concerning new entry regulations—in addition to recommending the rollback of existing entry regulations. First, the burden of proof should be placed on regulators to demonstrate that the social problem they seek to address with new entry regulations is in fact widespread and that the proposed regulations will effectively solve the problem without substantial unintended consequences. Second, regulators should thoroughly enumerate the full suite of alternative policy options and evaluate the social costs and benefits of each before reflexively adding additional regulations on startups.
By adhering to these recommendations and stemming the introduction of new business entry regulations, regulators can better support entrepreneurship as a means of decreasing income inequality.