Reporting regulation typically aims to improve the functioning of capital markets and to protect firms’ investors and other stakeholders. Despite substantial evidence of capital-market benefits from corporate disclosures (Healy and Palepu 2001), firms frequently oppose disclosure and reporting regulation, arguing that it forces them to reveal proprietary information to their competitors, customers, or suppliers. In particular, reporting regulation could make it harder for firms to reap the gains from innovation and, in turn, hurt their incentives to innovate (Arrow 1962).
How serious this concern is, however, remains unclear. For one, firms could point to proprietary costs to disguise that they oppose transparency for ulterior reasons (Berger and Hann 2007). Moreover, even if a mandate forces firms to reveal proprietary information, other firms benefit from these information spillovers (Zingales 2009). This redistribution could be beneficial in aggregate. For instance, it could speed up the adoption of novel processes and products, generate substantial follow-on innovation by other firms, and reduce wasteful duplication of R&D expenses. Thus, it is still an open question if imposing a reporting mandate on firms hurts corporate innovation or is net beneficial.
This question is particularly important against the backdrop of concerns about a slowdown in productivity growth in many economies in the last decade and particularly significant in the EU because it requires millions of small private firms to disclose annual financial statements to the public. The EU’s requirements are in sharp contrast to those in the US, where mainly large listed companies are required to disclose financial statements. More than 99.9% of US firms are exempted from such requirements, and only a small proportion of these firms voluntarily disclose financial information to the public (Minnis 2011).
What are the key arguments for why corporate transparency and reporting regulation could hurt innovation?
The main criticism raised by managers is that it forces them to reveal proprietary information to the market (Graham et al. 2005, Minnis and Shroff 2017). For example, the revelation of profit margins, cost structures, R&D expenses, among other mandated disclosures, can facilitate direct and indirect learning by competitors. It can influence competitors’ decisions about strategic investments or which markets to enter (e.g. Darrough and Stoughton 1990, Wagenhofer 1990). Information in the financial statements can also trigger more search by competitors. For instance, the revelation of low production costs could trigger attempts to figure out and copy process innovations.
Moreover, mandated disclosures can weaken a firm’s bargaining power with its contracting partners. The disclosure of profit margins could prompt a customer of a high-margin firm to renegotiate prices or to search for alternative producers with lower margins (e.g. Max-Planck-Institute 2009, Minnis and Shroff 2017).
In sum, the requirement to disclose financial information can impose various competitive costs on firms, especially on innovative ones. These costs lower firms’ rents from innovations, and thus decrease their incentives to innovate.
But these arguments are only one side of the coin. The aforementioned negative effects could be completely offset by positive spillover effects on other firms.
To shed light on the net effect of mandatory reporting on innovation, we conduct a market-level study that aggregates both negative direct and positive indirect effects (Breuer et al. 2020). We define the market at the country-industry level, which allows us to estimate the average net effect of reporting regulation on innovation, netting all effects that might occur within a country and a broadly defined (two-digit) industry.
Although this aggregation level goes beyond prior research at the firm level, we acknowledge that our approach misses potential cross-country or cross-industry spillovers.
Evidence based on Europe’s Community Innovation Survey
The main data source we use for our analyses comes from the Community Innovation Survey (CIS). It is a confidential survey that collects comprehensive information about European firms’ innovation activities. The European Commission requires firms to fill in this survey, irrespective of any national financial reporting mandate.
The anonymised micro dataset – made available for researchers at the premises of Eurostat’s Safe Centre in Luxembourg – allows us to use detailed input and output data on various types of corporate innovation. Hence, we do not need to rely on patent data that only capture a relatively narrow (albeit important) slice of corporate innovation.
In using more comprehensive innovation data, we can also show that patents can be a misleading measure of innovation effects in our context. Disclosure regulation makes secrecy a less effective strategy to protect intellectual property, which in turn increases the use of patents as an intellectual-property protection strategy. This indirect effect muddles the interpretation of effects in patent data.
To empirically examine the impact of reporting regulation on innovation inputs and outputs, we rely on two quasi-experimental research designs. In the first setting, we exploit the fact that countries in Europe have distinct firm-size exemption thresholds that generate variation in the share of firms facing mandatory reporting across industries. This variation allows us to employ a cross-sectional difference-in-difference design, where we essentially compare differences in innovation for industries with many versus few large firms in countries with high versus low exemption thresholds.
To ensure that (potentially endogenous) differences in firm sizes across countries or time do not confound our measure of regulatory disclosure intensity, we make use of a simulated instrument, akin to a Bartik instrument. Our approach alleviates concerns about reverse causality (e.g. industry technology shocks causing firms to grow above the thresholds) and omitted factors correlated with countries’ firm-size differences (e.g. industrial policies and specialisation).
In our second research design, we exploit an enforcement reform that occurred in Germany, which required limited-liability firms to disclose financial statements to the public. This enforcement change creates a drastic shift in public disclosure within local markets. The exogenous variation allows us to use a time-series difference-in-differences design, where we compare changes in innovation activity across local markets over time.
Compared with the EU setting, the within-country regional aggregation we use is at a much more granular level. Hence, it neglects potential important spillovers that occur across local markets. This research design thus mainly captures the direct impact of disclosure regulation on innovation. The rich data available in the German version of the Community Innovation Survey, however, allow us to uncover some of the underlying forces of the net impact. In this sense, the enforcement reform analysis complements the aggregate analysis in the European setting.
Reporting regulation is negatively associated with corporate innovation at the country-industry level
Across the different settings and databases, we find remarkably similar results. The main effect that we document is that reporting regulation is significantly negatively associated with corporate innovation at the country-industry level. We find that disclosure regulation leads to a reduction in the number of firms that innovate. More specifically, fewer firms seem to generate product and process innovation. This holds for innovations that are new to the firms and those that are new to the market.
Although we also provide evidence of positive spillovers, our analysis suggests that the negative direct effect of reporting regulation on the number of innovating firms outweighs the spillovers at the country-industry level. It is unclear whether the net impact is still negative for the economy as a whole, once potential cross-industry and cross-country spillovers are accounted for. Similarly, it remains unclear whether total innovation spending declines, as we do not observe conclusive evidence at the aggregate level. We leave these issues for future research.
Reporting regulation concentrates innovative activity among a few, typically larger firms
In addition to the evidence on the net effect at the country and industry level, the analysis uncovers notable distributional effects of reporting regulation. In particular, we find that reporting regulation concentrates innovative activity among a few, typically larger firms.
In the German setting, we document that negative effects mainly stem from firms operating in niche markets with few or any local competitors. These ‘monopolists’ appear to frequently stop innovating altogether. In this sense, our results are consistent with recent and broader trends toward a concentration of innovation activities (Rammer and Schubert 2018, EU 2019).
Our evidence of reduced innovation activity by local ‘monopolists’ does not appear to reflect improvements in innovation efficiency due to reduced duplication of effort. Inconsistent with such improvements, we find that reporting regulation is negatively associated with a broad set of measures on returns to innovation, namely a reduction in firms’ profit margins, sales from new-to-market innovations, and cost reductions due to process improvements. The reduction in returns supports the idea that reporting regulation affects firms’ innovation activities through proprietary costs.
In summary, our evidence suggests that reporting mandates can have important but presumably unintended consequences for innovation. Since regulators and policymakers have become increasingly concerned about the role of innovation for economic growth, it seems important that they should also consider competitive costs for firms when setting reporting regulation.
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