Analyzing and improving compliance is the key to strengthening regulators’ performance.
Despite the integral role that corporations play in providing the goods and services that society needs, corporate incentives do not always align fully with the interests of the overall public. When these so-called market failures arise, regulation is needed. But just adopting a regulation will not guarantee that regulatory problems are solved. Regulations will only work if they influence corporate behavior so that it aligns better with society’s overall well-being.
As I explain in a longer article, if regulation is to be effective, it must proceed through three fundamental steps, with corporate compliance situated in the middle—as a bridge, if you will, between the first and last steps.
First, the government must take action by adopting regulations and then pursuing enforcement and other compliance-oriented activities. Second, these governmental actions must induce changes in the behavior of the entities that regulation targets—ideally, changed behavior through compliance with the rules. Finally, this changed behavior must result in improved conditions in the world, such as by reducing bank failures, fraudulent transactions, harmful environmental emissions, workplace accidents, and other regulatory problems.
In this simple, three-step model of effective regulation, what ultimately matters for society are the outcomes realized at the final step. Under the best-performing regulations, these outcomes will improve because efforts at the first step—governmental actions—lead to behavioral change at the second step—corporate compliance. Yet, unfortunately, regulators have historically paid insufficient attention to measuring the outcomes at the third step and to assessing whether they have been affected by what the regulator does at the first step.
The first step, though, is relatively easy to measure. Perhaps for that reason, regulatory thinking too often both begins and ends at the first step. Regulators, the media, policymakers, and even scholars focus where the light is: that is, on the adoption of a new rule or on easily acquired numbers of rules, audits, and enforcement actions undertaken by a regulator. Easily visible, too, are the size of penalties assessed when enforcement actions result in penalty assessments or case settlements.
But a focus only on step one is merely counting beans. To be sure, it is not completely irrational to want to know how much activity a regulator is engaged in or how large its enforcement penalties are. In isolation from the other two steps, though, focusing only on what the regulator does at the first step is of little value. After all, a world with no enforcement actions by the regulator could be, without knowing anything more, equally consistent with either a total free-for-all state of rampant noncompliance or a world in which all regulated entities are fully complying with all the applicable rules so that no enforcement is needed. Any regulatory agency should be so lucky as to get to a point where it no longer needs to take any enforcement actions because all firms are in full compliance.
What really matters is the last step: the outcomes in the world. But even there, outcome data by themselves cannot answer the question of whether regulation is making a difference. Outcomes could well be improving following the adoption of a regulation and its enforcement, but this does not necessarily mean that the improvements have come about from the regulation.
Consider the regulation of industrial pollution. Over the last fifty years, the air quality in the United States has seen marked improvements. Ambient levels of various regulated pollutants have declined dramatically. These improvements in air quality might seem to suggest that environmental regulations are working. But other unrelated factors, such as the shift in the United States from manufacturing to a service economy, can also play a significant role. Conversely, worsening outcomes do not necessarily mean that the regulator’s actions have not been beneficial. Regulation may indeed help to reduce the frequency or severity of negative outcomes, even if some bad events still occur.
To provide a comprehensive assessment of regulation’s efficacy, we need to think rigorously about any causal connections between regulatory actions and outcomes. That is where compliance enters into the picture. It represents a bridge between the rules on the books and the rules in action. If regulatory outcomes show little sign of improvement, is that because too few firms are complying with the rules? If so, then regulators need to find ways to improve compliance. On the other hand, if regulated entities are generally complying with the rules, but bad outcomes remain, then the regulations on the books need revision. It is possible, of course, that both poorly designed rules and insufficient compliance exist.
Much research shows that noncompliance is ubiquitous. Admittedly, investigating the extent of noncompliance is not easy due to the inherent clandestine nature of most non-complying behavior. Yet certain strategies, such as random audits conducted by regulators, provide some estimates. For instance, tax noncompliance in the United States reportedly leads to hundreds of billions of dollars in uncollected tax revenue annually. A similar pattern of substantial noncompliance is observed with environmental regulations, where noncompliance rates have been estimated to range between 35 percent to 60 percent for different rules.
Understanding what leads to this extensive noncompliance by itself is not the ultimate end goal. It can, though, help unlock valuable information about whether regulation is working as intended. That understanding can then help inform efforts to redouble enforcement or to modify rules to do better in terms of achieving the goals of regulation. In some cases, increased audits and inspections—or larger fines—will be needed. In other instances, the use of digital technologies, such as artificial intelligence, will help regulators more effectively monitor, detect, and potentially prevent noncompliance.
To make regulation work better, regulators always need to view compliance as a critical step in their model of performance—that is, as the bridge to improved regulatory outcomes. Only with smart regulatory action that shapes corporate behavior by inducing compliance can regulation solve the major problems that society depends on it to solve.
This essay originally appeared in the Oxford Business Law Blog. It draws on a larger article titled “Building Better Compliance” that was published by the Texas Law Review.
