Contagious Deregulation

Abstract

Each year, the federal government distributes awards worth $900 billion to states, localities, and nonprofit organizations. Awards exceeding a specified threshold are reviewed by an auditor who is chosen by the recipient. Using a unique award-level dataset covering $23.7 trillion in awards, we exploit a major deregulatory reform that raised the threshold and exempted nearly 10% of awards from auditing. In a difference-in-differences framework, we find that treated auditors – who had clients below the new threshold before the reform – nearly ceased to issue negative audits for their remaining clients after the reform. Further tests show that treated auditors struggled to retain clients after the reform and offered more lax supervision to stay competitive. Thus, the deregulation of smaller awards unintentionally weakened the oversight of larger, non-deregulated awards. In a structural model, we identify key cost factors that discourage auditors from issuing negative opinions, especially when the demand for auditors declines. We estimate that the deregulation nearly doubled those costs, prompting auditors to show leniency even when clients potentially mismanage their awards. We evaluate alternative policies, such as subsidizing auditor costs or nationalizing the auditing process, to deregulate markets without compromising the quality of monitoring. Combined, our paper reveals the unintended contagion effect of deregulation, which can impose externalities on non-deregulated firms, service providers, and taxpayers.

Keywords: Economics of regulation, federal grants, nonprofit finance, auditor incentives