Regulatory Firm Size Distortions and the Buffering Effect of Outsourcing

There is a growing concern that size-contingent regulatory taxes are causing considerable mis-allocation of resources from large efficient firms to small inefficient firms, with significant implications for welfare and aggregate productivity. Using a monopolistic competition framework, I highlight outsourcing as a much neglected channel through which firms could potentially circumvent the regulation. Specifically, the regulated firms will outsource instead of downsizing to preserve their large scale of operation without assuming the extra tax burden. The reallocation of resources in this economy is mostly vertical, from downstream firms to suppliers, and much less top-down. A series of benchmark simulations show that ignoring this possibility leads to gross underestimation in the welfare effects of size-dependent regulations. The conclusions also make an argument for promoting outsourcing in tightly regulated economies