In a 2020 report, the CBO found that “entrepreneurship in the economy has declined significantly over the past four decades.” This is a matter of concern because “new firms provide innovative products and services, improve the productivity of the workforce, and ensure competition in the marketplace.”
Cato Institute
May 5, 2021 | Number 916
Entrepreneurs and Regulations
Removing State and Local Barriers to New Businesses
By Chris Edwards
…To replace lost jobs and incomes, the economy needs entrepreneurs to fill the void with business startups. During the economic downturn a decade ago, the business startup rate fell and never fully recovered, which contributed to a slow recovery. Even before that, the startup rate had been trending down since the 1980s. That is troubling because startups play crucial roles in the economy. They create most net new jobs. They are a key source of innovation because new products are often pioneered by new companies. And they challenge dominant firms, which helps to restrain prices and expand consumer choices….
TRENDS IN BUSINESS STARTUPS
In the United States, entrepreneurship and business dynamism appear to have trended downward in recent decades. One indicator of this is the decline in the startup rate for employer businesses, as calculated from the Census Bureau’s “business dynamics” data.
Employer businesses have at least one employee other than the owner. The startup rate is the number of businesses less than one year old as a share of all businesses.
(T)he startup rate fell from more than 10 percent in the early 1980s to 8 percent in 2018. In 2018, there were about 430,000 startups among 5.3 million employer businesses. In most years, the overall economy is growing and there are more firms starting up than shutting down.
During the economic downturn a decade ago, the startup rate fell below the shutdown rate for several years. The startup rate did not fully recover from the decline, which is one reason why it took many years for the unemployment rate to fall to its pre-recession low. Economist John Haltiwanger noted, “One of the reasons we took so long to recover from the Great Recession is startups got clobbered and didn’t come back.” A Wall Street Journal news story concurred, “The sluggish pace of new business creation in years after the recession officially ended contributed to a slow recovery and unusually high unemployment.”
Another measure of entrepreneurship is self-employment, which includes both businesses that have employees and those that do not. Self-employment was fairly flat during the 1990s and 2000s but over the past decade has trended down. Self-employment as a percentage of total private-sector employment fell from 14.1 percent in 2009 to 12.3 percent in early 2020 before the pandemic began. This study uses “startup” broadly to mean all new business enterprises with and without employees.
Discussing the downward trend in startups, economists Germán Gutiérrez and Thomas Philippon noted, “In addition to the decline in the raw entry rate, there has been a decline in size of young firms: entrants are fewer, they start smaller and grow more slowly.” The result is that small firms and young firms are playing a diminished role in the economy.
Between 1998 and 2017, the number of small firms (less than 500 employees) in- creased 7 percent, while the number of large firms (more than 500 employees) increased 23 percent. Over the same period, total employment in small firms increased 10 percent, while employment in large firms increased 28 percent. Meanwhile, employer firms less than five years old fell from 38 percent of all firms in 1982 to 29 percent by 2018.
In response to the COVID-19 pandemic, the economy plunged into recession in 2020 and many businesses shut down permanently. Smaller firms were hit harder than larger firms. By the end of 2020, small business revenues and the number of small businesses open were down about 30 percent from a year earlier. The largest job losses occurred in the leisure and hospitality industry. Many restaurants have gone out of business, including about one-third of the restaurants in New York City.
As businesses were closing in early 2020, business startups were also falling. However, startups rebounded strongly in the summer before tapering off again in the fall, according to Census Bureau “business formation” data. These data are based on applications for new employer identification numbers.
The startup rate rebound in the summer was likely due to the delay of some startups from earlier in the year, a rise in startups pursuing new online opportunities, and people being thrown out of previous jobs. Hardship is one driver of entrepreneurship. The summer spurt in startups may have also stemmed from people registering fraudulent businesses to gain coronavirus-related disaster subsidies.
CONCERNS ABOUT THE STARTUP DECLINE
The rate of business startups has improved since the drop in early 2020, but there is concern the long-term downward trend will continue. That trend has puzzled economists. The advance of information technologies and the shift toward services in the economy have reduced the costs of running many small businesses, which should have encouraged entrepreneurship. Even before the internet revolution of the 1990s, the personal computer revolution of the 1980s provided startups with tools that were previously only available to large firms, such as software for word processing, invoicing, and databases.
Economists do not fully understand the reasons for the downward drift in startups. John Haltiwanger found that the startup decline before 2000 was concentrated in sectors such as retail trade and services where there was a move toward national chains and away from mom-and-pop stores. That transformation likely increased productivity and thus was probably beneficial for the overall economy.
However, Haltiwanger and others have found that the startup decline after 2000 has been wider spread, which may suggest growing rigidity in the economy. Economist Steve Davis looked at the employment share of firms less than five years old and found that the “drop in the young-firm share is pervasive across broad industry groups and U.S. states.” Between 2000 and 2018, the young-firm employment share fell 60 percent in high-tech manufacturing, 56 percent in information, 53 percent in high-tech, 38 percent in services, 38 percent in manufacturing, 33 percent in construction, and 13 percent in retail.19 Those declines suggest a fall in dynamism in the economy.
Ruchir Sharma, a top fund manager at Morgan Stanley, points to another factor suggesting a loss of U.S. dynamism: the rise of “zombie” firms, which are companies that have not earned enough profits over three years to even pay interest on their debt.20 Government policies may be keeping zombies alive, which is a drag on growth because resources are not being reallocated to new firms. A rising number of zombies “lowers the productivity of rival companies—and blocks the entry of new companies—by raising labor costs and making it difficult to attract capital,” notes Sharma. The percent of publicly traded companies that are zombies rose from just a few percent in 2000 to 19 percent in 2020 before the COVID-19 pandemic started.
Other indicators of falling dynamism are declines in job reallocation rates (measured by job creation and destruction) and worker allocation rates (measured by hires and separations). Davis and Haltiwanger note:
U.S. labor markets became much less fluid in recent decades. Job reallocation rates fell more than a quarter after 1990, and worker reallocation rates fell more than a quarter after 2000. The declines cut across states, industries and demographic groups defined by age, gender and education.
What is causing the fall in dynamism? Davis and Haltiwanger suggest that it is a combination of demographic changes, shifting markets, and government regulations:
Many factors contributed to reduced fluidity: a shift to older firms and establishments, an aging workforce, the transformation of business models and supply chains (as in the retail sector), the impact of the information revolution on hiring practices, and several policy‐related developments. Occupational labor supply restrictions, exceptions to the employment‐at‐will doctrine, the establishment of protected worker classes, and “job lock” associated with employer‐provided health insurance are among the policy factors that suppress labor market fluidity.
The sections below discuss the importance of regulations to startups and economic dynamism. But nonpolicy factors also play a role. One factor is America’s changing demographics. The Congressional Budget Office (CBO) found that “people between the ages of 35 and 54 are more likely to be entrepreneurial — and successful in their new businesses — than those of other ages, and their share of the workforce has fallen since 2000.”
Another factor is that young people appear to be starting fewer businesses today than in the past. A Small Business Administration study found that “At age 30, less than 4 percent of Millennials reported self-employment in their primary job in the previous year, compared with 5.4 percent for Generation X and 6.7 percent established for Baby Boomers.” Similarly, the Kauffmann Foundation noted about 20- to 34‐year‐olds: “In 1996, young people launched 35 percent of startups. By 2014, it was 18 percent.”
The decline in startups may partly stem from financial factors. High levels of student debt today may make it harder for young people to access financing and dissuade them from launching businesses.27 In polls, young people interested in entrepreneurship point to financial factors as a barrier. Also, the decline in housing prices during the 2007–2009 recession appears to have undermined startups because home equity is often used as collateral for business loans.
The climate of ideas influencing young people may also play a role. Some policy influencers of the young, including celebrities and political leaders, demonize businesses and profitmaking. But other cultural factors are supportive of entrepreneurship. Numerous television shows, such as the reality series Shark Tank, portray startups in a positive light, and some technology entrepreneurs are widely admired. Also, programs in entrepreneurship have blossomed in American colleges in recent decades.
Should we care about the level of startups and entrepreneurship?
Yes, for numerous reasons. New businesses are important for job creation. Looking at employer businesses, startups created 2.4 million jobs in 2018, which was 15 percent of gross jobs created that year. However, the effect of startups is more striking when considering net jobs. Established firms both create and lose jobs, whereas startups only create jobs. In most years, startups create most net jobs because many established companies either shrink or shut down. In 2018, the 2.4 million jobs created by employer startups accounted for nearly all the 2.5 million net jobs created by employer businesses that year.
Startups revitalize local communities by creating jobs for people displaced by shrinking businesses. Some startups grow to become large and durable companies that propel the overall economy. Economist Ryan Decker and colleagues found that about 15 percent of U.S. companies grow more than 25 percent per year. These top growers tend to be young companies, and they account for almost half of gross job creation, the authors find. In 1994, Amazon.com consisted of Jeff Bezos in his garage in Seattle, but today the company employs about one million people.
Startup activity fuels productivity growth because “newly established businesses are typically more productive than the firms that preceded them,” reports the CBO. Entrants in manufacturing industries have substantially higher productivity than exiting establishments. Looking across industries or across jurisdictions, a larger share of employment in new firms correlates with higher productivity growth. Haltiwanger notes that a “high pace of job reallocation has been largely productivity enhancing. That is, it reflects jobs being reallocated away from less productive to more productive businesses.
Startups are crucial for spearheading innovations and competition. In his research, former Harvard Business School professor Clayton Christensen highlighted the importance of disruptive innovations, which are new products that may start in a niche but eventually shake up and replace existing businesses and industries. Such innovations are often pioneered by new companies, not by established ones. Established companies tend to focus on growing their current markets and may miss shifts in tastes and technologies that startups exploit.
For instance, IBM dominated the mainframe computer market in the 1960s but was slow to recognize the shift to minicomputers, which were pioneered by Digital Equipment Corporation (DEC) and other new firms in the 1960s and 70s. Then both mainframe and minicomputer firms missed the shift to personal computers pioneered by Apple and other startups in the late 1970s. Then Apple and IBM initially missed the shift to portable computers pioneered by Compaq in the 1980s.
Christensen found similar patterns of disruption by new companies in a diverse range of industries, including disk drives, steel mills, retailers, motorcycles, ships, transistor radios, and construction equipment. Indeed, this pattern goes back at least to the 19th century. As one study on innovation noted, “New firms are a key delivery method for bringing innovations to market, and they innovate in a qualitatively different manner from incumbents.”
In addition to pioneering new products, startups can shake up overly regulated industries. Uber disrupted the taxicab industry by reducing costs and increasing convenience. Hordes of financial technology (fintech) startups are reducing costs in the financial services industry with new lending, saving, and payments options. In the 1970s and 1980s, MCI disrupted the sluggish AT&T telephone monopoly, and FedEx partly pried open the letter market dominated by the U.S. Postal Service with the introduction of urgent letters that were outside of the Postal Service’s legal monopoly.
In a 2020 report, the CBO found that “entrepreneurship in the economy has declined significantly over the past four decades.” This is a matter of concern because “new firms provide innovative products and services, improve the productivity of the workforce, and ensure competition in the marketplace.”
The lesson for policymakers is that they should remove barriers to the birth of new businesses….
Chris Edwards is the director of tax policy studies at Cato and editor of DownsizingGovernment.
Read report:
https://www.cato.org/policy-analysis/entrepreneurs-regulations-removing-state-local-barriers-new-businesses