Transaction Costs and the Economics of Payroll Compliance Platforms

A fundamental idea in microeconomics is transaction cost economics, created by Ronald Coase and later enhanced by Oliver Williamson, which explains the rationale for how firms choose to do some things in-house and purchase other things from the marketplace. The transaction cost theory provides clarity regarding the typical or expected question, “Why would a firm invest in software to manage payroll, instead of manually managing payroll?”

When you look at payroll, it appears to be just a standard, periodic administrative task. However, payroll is a very complex function because it is subject to multiple layers of regulation. To comply with all the law enforcement regulations, an employer must calculate how much to pay an employee, withhold income tax from an employee’s pay, report and/or remit taxes on behalf of employees, purchase workers’ compensation insurance for employees, comply with the rules and regulations related to unemployment insurance, and apply multiple reporting and employee benefit rules, across several different geographical locations, all while attempting to accomplish these tasks accurately and on time. For small and mid-size businesses, this creates a significant administrative burden.

From an economic standpoint, challenges that arise from payroll and compliance systems present many challenges through transactional costs such as: search (searching for correct regulatory information), coordination (aligning payroll processes to legal requirements), monitoring (ensuring compliance over a period of time), and compliance (financial/legal impact of mistakes). When the aggregate of these costs/transactions become large, it is more economical for companies to either outsource or use specialized tools for handling processes.

The forces that influence and support the rapid growth of payroll and compliance platforms are largely driven by the increasing complexity of regulation. For example, in the United States alone, there are multiple levels of tax systems at the state, local and Federal level with different filing frequencies and requirements. According to the Office of the National Small Business Association, over 40% of small business owners spend more than 80 hours working on Federal taxes per year. When factoring in additional requirements imposed by States and local governments, this commitment is multiplied significantly for small businesses.

The making or buying decision is an important one for companies. They may either manage payroll on their own and spend time and money to learn about compliance and how to comply with regulations or choose to buy access global payroll and compliance platform that will automate the management of payroll and compliance. Transaction cost economics states that companies will choose the option with the lowest total cost to the company, including direct monetary costs and indirect time costs.

The cost of using manual payroll systems as their primary payroll solution also produces high opportunity costs for business owners. The amount of time spent understanding tax law or tracking tax filing due dates creates time that is no longer available for revenue-generating activities such as building sales, developing products, and providing customer service. This opportunity cost is much larger for smaller companies, where owners have limited managerial expertise and are most likely to manage many tasks. When smaller companies outsource payroll processing to a payroll software solution, they can use these resources for other higher-value activities.

Another important factor in understanding Payroll Compliance is the concept of "bounded rationality." People can process information in a limited way because their ability to process a lot of information is bounded. Payroll compliance (i.e., staying compliant with all the rules around payroll) has constantly changing rules, lots of complicated calculations, and very strict deadlines to meet. Even business owners with a lot of knowledge about payroll will not realistically get all the changes to the rules or regulations for every jurisdiction tracked at once. As a result, there is a significant incentive to use computer systems that can process large amounts of information more accurately and consistently than humans.

This change can be seen using examples from the real world. There are now many different companies and products in the payroll field (i.e., Gusto, ADP, Deel) that have been able to scale their businesses rapidly by integrating payroll, tax filing, and compliance into the same offering. A specific example is Deel; it has positioned itself as the global leader for payroll and allows companies to hire and pay employees in over 100 different countries while still complying with local regulations. The examples above demonstrate that as the labor market becomes more global, so does the corresponding complexity of regulations that are involved.

The cost implications are significant. Research suggests that payroll errors can cost businesses billions annually in penalties, corrections, and lost productivity. The Internal Revenue Service has reported that a large proportion of small businesses incur penalties related to payroll tax mistakes at some point. By reducing error rates, automated systems lower not only direct financial costs but also the uncertainty associated with compliance.

New businesses will benefit from lower transaction costs (e.g., hiring employees, moving into new areas, operating internationally) because payroll services eliminate many of the cost, regulatory, and logistical barriers that inhibit business formation and growth.

More broadly speaking, software products are transforming the market landscape and creating new dependencies on platform providers. As more and more organizations begin using these products to manage their business operations, organizations may be subjected to increased switching costs and will ultimately become dependent on the software. Invariably, the economic rationale remains unchanged: As the cost of navigating through regulatory systems outweighs the economic benefit derived from using compliant and accessible payroll services, organizations will turn to tools that simplify the compliance and payroll process in order to continue focusing on their core business activities.