Rethinking the Boosterism About Small Business

Politicians may love to extol the virtues of small business, but big companies are still the key to growth

With more than 14 million Americans out of work and the U.S. facing the prospect of a double-dip recession, it’s heartening to know that Democrats and Republicans agree on at least one way to kick-start growth: support small business. “Everyone here knows that small businesses are where most new jobs begin,” President Barack Obama said in his Sept. 8 address to Congress, unveiling a $447 billion jobs bill.

Republicans who were initially responsive to the speech have since slammed Obama for introducing what House Speaker John Boehner calls “job-killing small business tax hikes.” Politicians aren’t the only ones rushing to champion small businesses. In announcing a program to give $10 million in credits to small business advertisers on Facebook, Chief Operating Officer Sheryl Sandberg said on Sept. 26 that “small businesses are the backbone of the American economy.”

Most Americans would probably concur. The idea of small businesses as indispensable to the national welfare dates to Thomas Jefferson’s veneration of the yeoman farmer. In the popular imagination, small firms are more nimble, more innovative, and more virtuous than blue-chip companies that employ thousands. Yet the notion that small business is the force behind prosperity is not true. The longer the U.S. and other countries cling to this myth, the harder it will be to carry out the kinds of economic policies that might actually stimulate job growth.

In the U.S. in 2007 there were around 6 million companies with workers on the payroll. Ninety percent of those businesses employed fewer than 20 people, according to analysis of the latest census data by Erik Hurst and Ben Pugsley of the University of Chicago. Collectively, those companies accounted for 20 percent of all jobs. Most small employers are restaurateurs, skilled professionals or craftsmen (doctors, plumbers), professional and general service providers (clergy, travel agents, beauticians), and independent retailers. These aren’t sectors of the economy where product costs drop a lot as the firm grows, so most of these companies are going to remain small. And according to Hurst and Pugsley’s survey evidence, the majority of small business owners say that’s precisely their intent—they didn’t start a business for the money but for the flexibility and freedom. Most have no plans to grow.

Some small companies do grow, of course. Think Apple or Hewlett-Packard, which were initially run out of garages, or Google, created by two guys in a dorm room. But the vast majority of small enterprises stay small. Eighty percent of U.S. small companies that remained in business from 2000 to 2003—the most recent period for which Hurst and Pugsley compiled data—didn’t add a single employee.

Looking at a sample of companies created from 2004 to 2008, Hurst and Pugsley found that only 3 percent added more than 10 employees during that time. An even smaller proportion had applied or were in the process of applying for patents. (So much for being seedbeds of innovation.) Many small businesses simply go bust after a few years. In 2009 economist Scott Shane at Case Western Reserve University surveyed the evidence on net job creation by each year’s cohort of new companies. He found that among small companies in their second year of business, more jobs were lost to bankruptcy than were added by those still operating. The same was true in years three, four, and five.

If you’re looking for a lot of good-paying, stable jobs, you’d better hope there are some big companies around that want to hire. Kansas City Federal Reserve economist Kelly D. Edmiston’s analysis of U.S. data found that each year, 22 percent of staff in companies with fewer than 100 employees quit or are fired, compared with only 8 percent for companies with 2,000 or more workers. Edmiston also found that the jobs offered at large businesses were better than those at small businesses. Hourly wages at the largest companies, those with more than 2,500 employees, average around $27, compared with $16 in companies with payrolls of fewer than 100. Companies with more than 100 workers are almost twice as likely to offer retirement benefits and insurance, and considerably more likely to offer health care.

The story is the same in the rest of the world. A cross-country analysis of business surveys by economists Rafael La Porta of Dartmouth College and Harvard University’s Andrei Schleifer reveals that a society’s wealth is inversely proportional to the number of people who earn their livings from small businesses. Among the poorest quarter of the world’s economies, the proportion of people who are self-employed is 46 percent, compared with 13 percent in the richest quarter. The higher you go up the national-wealth ladder, the lower the number of small enterprises.

Why is that? La Porta and Schleifer’s data show that in developing countries, large companies are far more productive—with value added per worker an average of 59 percent higher. The productivity gap between small enterprises with an average of around eight employees and microenterprises with as few as one employee was even greater—more than 100 percent. That’s in part because the managers in larger companies are significantly better educated. Around a third of small enterprises were run by someone with a college education, compared with 85 percent of large companies. La Porta and Schleifer conclude that the “hope of economic development lies in the creation of large registered firms, run by educated managers and utilizing modern practices.”

Although often celebrated by development specialists, microenterprises run by poor people in the developing world are usually the result of an absence of other opportunities rather than an abundance of entrepreneurial zeal. Massachusetts Institute of Technology economists Abhijit Banerjee and Esther Duflo note that the majority of enterprises run by the world’s poor are shops making a few sales a day. They estimate that profit at the average shop in India amounts to the princely sum of $133 a year. What poor people consistently say is that they’d rather work for a stable employer. Finding such employment, argue Banerjee and Duflo, is the way rural people in India have been making their way out of poverty over the past couple of decades. What Case Western’s Shane concludes for the West is true worldwide: “Because the average existing firm is more productive than the average new firm, we would be better off economically if we got rid of policies that encouraged a lot of people to start businesses instead of taking jobs working for others.”

The good news is that in the developing world, that’s already happening. In India the number of large, internationally competitive companies, such as Infosys and Tata, is growing. That’s good news for the West, too. Tata is now the U.K.’s largest manufacturer, employing over 40,000 people. The Indian giant is pretty much the only reason there is still a British steel industry.

What does that mean for the U.S.? Although politically unpopular, attracting more large companies from China and India to set up shop in the U.S. could be a better use of resources than providing yet more tax breaks and loan guarantees for small business. Over the past decade the U.K. has attracted four times more investment from emerging-market acquisitions than the U.S. has, in proportion to the size of its economy, because Britain’s policy and regulatory environment make foreign takeovers more straightforward.

The disparities in job creation between large and small businesses also might mean that blanket animosity toward “corporate welfare” is misplaced. A few subsidies and breaks on the employer payroll tax, for example, would, if clearly linked to job creation, provide incentives for companies to hire.

Given how many “small employers” are doctors, lawyers, money managers, and other ready sources of campaign finance, there is a good probability they will continue to be pampered by politicians. And some enterprises surely deserve a boost. The trouble is that government programs aimed at helping small businesses usually help the wrong kind. Many of these outfits were never meant to generate employment for anyone but their founders. Indiscriminate support for small business as a category takes resources away from entrepreneurs and companies that actually want to expand and create jobs.

So let’s revisit the home-office tax deduction, which costs the IRS $9 billion in revenue. And maybe we should ask whether, at a time when Congress is trying to reduce the federal deficit by $1.5 trillion, it’s worth preserving a general tax cut for those earning over $200,000 merely because it affects some small business owners. (In fact, a recent Treasury study found that fewer than one-third of self-identified small businesspeople belong to the top two income tax brackets.) Perhaps we could better use those resources to inject capital in companies that do have a chance to grow. For instance, the U.S. Small Business Innovation Research program subsidizes research and development projects at small companies. This is the kind of targeted government support that has the potential to spur innovation and propel sustainable company growth.

In the developing world, support for small businesses through tools such as microfinance is part of a safety net to help those who lack better employment opportunities. But in the U.S. and Europe it is far more often a subsidy to people making a lifestyle choice that reduces national productivity, which doesn’t help the economy or promote job creation. Extolling small business might be a good way for politicians to win elections. But when it comes to creating jobs, size still matters.

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