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STATE AND LOCAL REGULATORY BARRIERS TO SMALL BUSINESS ENTERPRISE

Robert J. GastonSharon E. Bell

Applied Economics Group

Small business regulation by state and local authorities meritsincreased analytical attention as three recent trends continue tounfold. First, rapidly accumulating research points up the pivotal roleplayed by small business in the areas of job generation, marketefficiency, employee training and diffusion of technological change (seeBirch, 1979; Tornatzky, et. al., 1983). It challenges the myth thatsmall business is typified by "mom and pop" firms that contribute onlymarginally to the economy.

Second, there is a growing willingness by the U.S. Supreme Court to"extend the reach of the Sherman Act to ever more local restraints ontrade" (Kitch, 198A). These decisions increase the potentialapplications of research on state and local business regulations. Untilrecently virtually all such regulation was shielded from legal challengeunder the "State Action" doctrine. The steady erosion of this doctrinenow exposes many market closing regulations to court challenge.

Third, the pace of federal business deregulation has led someanalysts to predict that industries may seek protective reregulation atthe state or local level. This suggests the potential to rebar themarket entry door for large numbers of small business that have beenentering previously "closed" markets. The most visible examples are thebanking and trucking industries. Taken together, these trends make itespecially timely to examine state and local regulation of smallbusiness.

In the remainder of this paper, we provide an overview of theexisting literature, discuss the relative importance of monetary andnon-monetary regulation, and present a detailed example to illustratethe complexity of the problems for small business. Finally, wesummarize our findings.

LITERATURE OVERVIEWThe vast network of state and local regulations affecting small

businesses is so voluminous that it has so far defied comprehensivereview. Regulations are imposed by state legislatures, by regulatorycommissions, and by city and county governments and their subordinates.Each entity acts at times without regard for actions taken at otherlevels of government. The potential tangle is staggering when oneconsiders that there are 22,250 governmental jurisdictions with somepower to regulate.

Significant work has been accomplished which offers some limitedinsights into non-federal business regulation. This past work can beclassified into three major categories. The first category focuses on

The authors gratefully acknowledge support for this research from theU.S. Small Business Administration's Contract No. SBA-8550-AER-8A.Statements and conclusions herein are those of the authors and not theviews of the U.S. Government or the Small Business Administration.

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the impact of federal regulation and by extension the impact of similarregulations at the state and local level. Much of this analysisexamines and estimates the impact of regulation on existing firms.Within this category there are several distinct branches. Econometrictechniques form one branch (cf., Chicago Economic Research Associates,1980); other branches include theoretical models that relate firmperformance to size (Cole and Sommers, 1980), analyze specific barriersto entry, and conceptually explore the use of the regulatory appartus asa strategic tool in maintaining market share (Oster, 1980).

As recently summarized in Hogan (1983), the second categoryconcentrates on professional regulation. This research is concernedprimarily with the effect of specific regulations on workers in anoccupation and on delivery of their services to consumers. Many, if notmost, practitioners of these occupations are small business people --optometrists, plumbers, electricians, real estate brokers and attorneys,to name only a few -- whose business activity is controlled in largemeasure by state and local regulations (Carroll and Gaston, 1981).

The third category is composed of studies of specific industriesdominated by small business firms -- dry cleaners, TV repairers,opticians, denturists, and dairy farmers (c.f.. Bond, et.al., 1983).

Although past work provides to comprehensive picture of state andlocal regulations, it supports the general view that the costs thatregulations impose bear no necessary relation to any social gains.Regulations are often true fixed costs of operations -- not onlyinvariant with respect to output, but also unavoidable in the sense of atrue sunk cost. The effects of such costs are invariably greater thesmaller the size of operation. These unrefundable and irretrievablecosts are thus unalloyed barriers to entry which are especiallyburdensome to small business. That these conclusions emerge so clearlyfrom a fragmented literature underlines the important need forcomprehensive study of this area.

STATE AND LOCAL REGULATORY ENVIRONMENT: BALKANIZATION OF MARKETSIn contrast to the federal trend toward deregulation and

simplification, regulations in the smaller jurisdictions continuesapace. Small businesses face a formidable force of potential regulators-- cities, counties, states, commissions, occupational licensing boards,and others. States impose taxes directly upon the firm (incorporation,payroll, estate, franchise and license, for example), require firms toserve as agents for the state (as in the collection of sales taxes) orlegally specify market relationships and production functions for manygroups such as new car dealers, liquor stores, cosmetologists, realestate brokers, and many others. Cities, counties, and the commissionsand boards they create direct activities of taxicab fleets, airportvendors, beer, alcoholic beverage or restaurant licenses, piling theirregulations atop those imposed by the state and other government bodies.

Regardless of the responsible jurisdiction, regulations fall intotwo basic categories: monetary (i.e., taxes and fees) and non-monetary(e.g., allocative powers, licensure, and inspections). Monetaryregulations affect small business in relatively straightforward andconsistent ways. Their impact on the fixed and operating costs ofbusiness can at least be measured, once all of the relevant statuteshave been identified. Identification is no easy task and highinformation costs add to the burden of small business. CommerceClearing House (CCH) produces annually a State Tax Guide which is acomprehensive summary of standing state business tax laws and theirchanges. But CCH considers only those regulations codified in theunified revenue measures, even though other fees and taxes frequently

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exceed those explicitly stated in the basic revenue codes. Thus, itcompletely avoids dealing with local restrictions (Commerce ClearingHouse, 1983).

Far more troublesome, however, are the non-monetary regulations,whose impact may depend on the opinions and interpretations of governingcommissions or boards. Often these commissions have the power toprevent others from entering an industry based on vague criteria such as"moral character" (see Table l). When the members of the governing bodyare chosen from among current members of the industry, the potential forabuse is alarming.

TABLE 1: Selected Non-Monetary Market Entry Barriers

• Outright prohibition of some markets (e.g., retail auctionof used cars)

• Numerical limits on number of business in a jurisdiction• Exclusive or nearly exclusive franchises• Required certificates of a geographical area's "need"

(protected market areas)• Required certificates of "moral" character for owners or

employees• Ownership restrictions (who may own specific business)• Buy "locally" laws (jurisdictional preference laws)• Prohibitions on joint ventures, contracting work out,

pooling facilities• Certification or sponsorship by existing competitors• Minimum start-up capital requirements• Regulated capital/labor ratios• Prohibition of part-time or casual firms• Requirement that owners are "full-time" market participants

That non-monetary regulations effectively prevent market entry isstrongly suggested by the almost universal inclusion of "grandfather"clauses in new regulatory legislation and by incumbent firms' vigilantpolicing for new firm compliance. Often the rationale for these marketclosure regulations relies on the same rhetoric once used to justify thenumerous labor laws "protecting" women from the rigors of the labormarket while effectively hobbling their ability to compete for jobs. Inthis case, however, the victims are hard to find. They are the smallfirms that were never born or that failed early from regulatorymisallocation of their risk capital.

In the next section we illustrate the complexity and potentialmagnitude of the impact of the regulatory tangle which surroundsautomobile dealers in Tennessee. Such regulations are typical of thosefound in many states.

MOTOR VEHICLES MARKET REGULATIONSTennessee motor vehicle dealers stand in the center of a complex

web of state economic regulation. This web codifies many key marketrelationships. While state regulations have little to say about theconduct of dealers' retail transactions, they say volumes (exceeding 100substantive paragraphs) in their edicts controlling competitiveness 1)among dealers, 2) between dealers and manufacturers/distributors, and 3)between dealers and auctioneers, dismantlers and dealer sales personnel(State of Tennessee, 1979).

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Authority to interpret and enforce these regulations is vested inthe Tennessee Motor Vehicle Commission, which is composed of 13 members:two public members and 11 selected from a list of candidates nominatedby the Tennessee Automotive Association. Only individuals who have beenAssociation members in good standing for the preceeding five consecutiveyears and possess a license within the Commission's jurisdiction areeligible for nomination.

The authority of the Commission extends to new and used vehicledealers, manufacturers/distributors and their individualrepresentatives, vehicle sales personnel, vehicle auctioneers, anddismantlers. The power of the commission over these individuals extendsto granting, supervision and revocation of licenses, inspection oflicensees' books and records, inquiring into and rendering judgmentsabout individuals' personal honesty, integrity, reputation, businessassociates, ability and financial status. In addition, the commissionmust interpret and enforce the meaning of such vague phrases as"improper" prices, "misleading" statements, "just provocation," "equity"(fairness), "propriety of market entry," adequacy," and "relevant marketarea." Moreover, the Commission is charged with predicting the futurein order to restrain any licensee who is "about to commit" a violation.In Commission hearings, "any fact not expressly denied or knowledgethereof disclaimed, shall be considered admitted." Complaints upheld bythe Commission are enforceable by criminal penalties of up to $5,000fine and six months imprisonment. Judicial appeals of the Commissiondecisions may not be filed at the location of the complaint but must befiled on the Commission's "home" ground, the state capital.

The Code covers over 25 substantive areas of dealer conduct,including the usual prohibitions against fraud and dishonesty that arealready prohibited under other civil statutes. Of particular interestare those license regulations that specify market behavior beyond fraudand dishonesty. Probably the single most important of these in marketallocation (entry). The Commission must approve both the specificphysical location and specific product line for a new license or achange in an existing license. In particular, when a new dealer seeksto obtain a license, written notice must be given to existing dealers inthe area and the request must be submitted to the Commission for abinding decision. Before granting entry, the Commission must considerthe "adequacy" of the servicing of the area by existing dealers and the"propriety" of granting additional entry rights. In other words,existing dealers must approve the licensing of any new competitors.Numerous other economic prohibitions exist. For example,

• All sales personnel must be licensed; and Commissionapproval is required, both for their initial hiring and forany change of employer (e.g., brokers).

• Dealers must provide "adequate" vehicle service facilitiesand business premises which are physically separate fromany other business (i.e., these regulations effectivelyspecify minimum capital requirements and dealer'sproduction function, thus creating scale barriers toentry).

• Dealer licensees must not be primarily engaged in anyother business (e.g., no part-time owners, officers orprincipals, no department store related dealers).

• Dealers may not require purchase of equipment as a part ofa vehicle transaction, unless it is authorized by thefactory.

• Vehicle auctioneers are prohibited from selling to anyoneexcept licensed dealers.

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While numerous regulations govern manufacturers' behavior towarddealers' the code is noticeable silent about dealers' conduct in thesetransactions. A small sample of the restrictions on manufacturers'conduct are listed below.

• No tie-in sales.• No "unjust" cancellation of dealer franchises without

regard to "equities."• Manufacturers cannot sell to dealers who do not have

"proper" facilities.• Dealers cannot be "coerced" to accept vehicle or parts

deliveries, cooperative advertising, non-vehicle relatedbusiness deals or be threatened with cancellation offranchise.

• Manufacturers cannot interfere with the inheritance of adealer franchise.

• Any refund or sales inducement offered to one dealer mustbe offered to all dealers in the state.

• Manufacturers must pay not less or more than the dealer'sretail labor prices for warranty repairs. These rates arefiled with the Commission and are on public record.

As illustrated by this sample of Tennessee automobile dealer laws,regulations can be unbelievably detailed, yet rely on vague conceptssuch as "equity" and "propriety." They frequently seem to be designedby current members of the regulated field. The Tennessee example isneither of the best nor the worst. Tennessee's regulatory environmentis similar to that in many states, and the automobile industry is by nomeans unique.

In numerous industries tax and fee regulations are nominal whilenon-monetary rules seem to be aimed specifically at closing markets tonew entrants and controlling the behavior of existing firms.

CONCLUSIONWe have attempted to illustrate some of the many ways in which

state or local regulations can stifle the creation and growth of smallbusinesses. Non-monetary regulations, which can give existing firms thepower to deny market entry and effectively control the behavior ofcompetitors, are especially troublesome. Because they act primarily asa barrier to market entry, the victims are seldom seen. They are thefirms that were never born or they failed early from the regulatorymisallocation of their risk capital, and they are rarely observable.That such regulations are effective barriers to new firms is stronglysuggested by the almost universal inclusion of "grandfather" clauses innew legislation and by incumbent firms' vigilant policing for new firmcompliance. In contrast, the intended or actual benefits to the publicare much less clear.

The major victims of these laws are the same small businesses thatare crucial to job generation, market efficiency, and technologicalchange. Thus, our traditional public attitude toward small business isbased less upon sentiment and nostalgia and more so upon evidence oftheir vital contribution to the economy. Coupled with the increasingerosion of the "State Action" doctrine, this gives us both the motiveand the means to accomplish regulatory reform. Moreover, state andlocal deregulation may be the cheapest and most effective approach tosmall business development. At the very least we should rethink ourregulatory policy and cast a jaundiced eye upon new regulatory pro-posals, weighing their potential to close markets against their abilityto provide the intended public benefits. In sum, it is not so remark-able that so few small firms are able to survive but that so many do.

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REFERENCESBirch, David L. 1979. The Job Generation Process (Cambridge,

Massachusetts: MIT Program on Neighborhood and Regional Change).

Bond, Ronald S. , John E. Kwoka, Jr., John J. Phelan, and Ira Taylor.1983. "Self Regulation in Optometry: The Impact on Price andQuality," Law and Human Behavior 7 (September): 219-23A.

Carroll, S.L., and Robert J. Gaston. 1981. "Occupational Restrictionsand the Quality of Service Received: Some Evidence," SouthernEconomic Journal A7 (April): 959-976.

Chicago Economic Research Associates, Inc. 1980. "The Dynamic Impact ofFederal Regulations and Taxes on Small Businesses: A Theoreticaland Empirical Analysis," Report to U.S. Small BusinessAdministration, Office of the Chief Counsel for Advocacy.

Cole, Roland J., and Paul Sommers. 1980. Cost of Compliance in Small andModerate Sized Businesses (Seattle, Washington: Battelle HumanAffairs Research Centers).

Commerce Clearing House. 1983. State Tax Guides (New York: Commerce

Clearing House).

Hogan, Daniel (ed.). 1983. "Professional Regulation, Special Issue," Lawand Hiiman Behavior 7. Entire issue.

Kite, Edmund W. 198A. "Taxi Reform--The FTC Can Hack It," Regulation 8(May/June): 13-15.

Oster, Sharon. 1980. "Industry Rivalry and Strategy in the RegulatoryProcess." Report to U.S. Small Business Administration and FederalTrade Commission.

State of Tennessee, Tennessee Motor Vehicle Commission. 1979. TheTennessee Dealer-Manufacturer Licensing Law, as Amended. Rules andRegulations (Nashville, Tennessee: Tennessee Motor VehicleCommission).

Tornatzky, Louis G. , et.al. 1983. The Process of TechnologicalInnovation: Reviewing the Literature (Washington, D . C : NationalScience Foundation).