The Small Business Myth

When the government tries to help small businesses, it hurts businesses (and taxpayers) of all sizes.

Who better embodies the American dream than a small-business owner? Independent, self-reliant, flexible, and hardworking, small-business owners, we are always told, are the cornerstone of economic growth and prosperity. That's why lawmakers are always pushing policies to help them prosper.

During recessions, small businesses are inevitably hailed as the key to recovery and showered with still more targeted programs. This latest recession is no exception.

In his State of the Union address this year, President Barack Obama announced that "jobs will be our number one focus in 2010, and we're going to start where most new jobs do, with small business." Since then he has proposed and signed a series of targeted tax breaks. The president also asked Congress recently to use $30 billion that had been set aside from the Troubled Asset Relief Program to start a new program providing loans and tax credits to small businesses.

These policies are based on a myth. It's not true that the key to boosting employment is to help small businesses, even though Washington's definition of the term is far more expansive than you might think. According the Small Business Administration, a small business is a firm with fewer than 500 employees—not just your average mom-and-pop shop. By this definition, 99.7 percent of all employer firms are small. Still, big companies—the ones that employ more than 500 workers—account for about half of the country's total employment. In the 1990s, as the McKinsey Global Institute economists James Manyika and Byron August recently explained in The Washington Post, large multinational corporations created jobs more rapidly than other companies, and they have been vital to employment in the subsequent decade as well. In other words, new jobs come from small and big businesses. If your goal is to boost jobs, it doesn't make sense to favor one over the other. 

In any case, the effectiveness of the policies aimed at helping small firms is dubious. Consider the tax credit for new hires, a favorite of every administration. Obama wants to give enterprises of any size a $5,000 tax credit for each employee they add to their payroll this year. Startups launched in 2010 would be eligible for half of the tax credit. This is a bigger version of the $1,000 tax credit passed by Congress with the help of four Republican senators back in February.

These politicians rightly assume that lowering the cost of employment helps firms keep their current employees or hire new ones. They're wrong, however, to think that tax credits are the best way to reduce costs. A tax credit is useful only if you have a tax liability to use it against. If your business is slow, it is likely that your tax liability will be significantly reduced or even nonexistent. No customers means no need for additional employees, tax credit or not.

Direct or guaranteed loans to small businesses are another common approach. The idea here is to help small businesses get access to capital, allowing them to create jobs. With that in mind, the administration included $730 million in the stimulus bill to increase government guarantees for some Small Business Administration loans, thereby reducing lender risk, and to cover borrowers' fees up to $75,000 per loan. The government also took aggressive steps to boost bank liquidity, with up to $15 billion aimed at unfreezing the secondary credit market, where most commercial and small-business loans
are made.

So far the efforts have been fruitless. These policies are based on the assumption that small businesses aren't borrowing money, investing, and hiring because risk-averse banks won't lend them the money. The reality is not as straightforward. Banks are more careful about lending money these days, and the credit market is certainly tighter. But the demand for credit has dropped dramatically. Borrowing money, investing, and increasing staff are things to do during good times, not bad.

Public policy uncertainties also tend to decrease business investment. The health care overhaul will bring new but still unknown obligations to insure employees; the Bush-era tax cuts are set to end next year, but their fate is unclear; legislation aimed at tackling climate change could raise businesses' energy costs. Meanwhile, as government spending increases, so do the chances of more taxes in the future. As a result, companies are freezing new hires, cutting benefits, and delaying expansion plans.

Which raises the question: Are Obama's tax policies doing more to help small businesses or to hurt them? According to the National Federation of Independent Business, the largest small business association in the country, two-thirds of small businesses report their business income through the personal income tax system. Letting the Bush tax cuts expire means that these business owners will see their tax bill increase and
will have less money to spend on hiring or keeping employees. Why give with one hand to take back with the other?

Richard Fisher, president and CEO of the Federal Reserve Bank of Dallas, agrees. In a July speech, he said: "Businesses and consumers are being confronted with so many potential changes in the taxes and regulations that govern their behavior that they are uncertain about how to proceed downfield. Awaiting clearer signals from the referees that are the nation's fiscal authorities and regulators, they have gone into a defensive crouch." Federal Reserve data confirm this impression. Today businesses are sitting on $1.8 trillion in capital instead of investing it. From 2008 to 2009, small-business capital expenditures plummeted by $63.6 billion (see chart), while owners' personal investments in their businesses fell by $2.5 billion following a decrease of $9.2 billion the previous year.

Neither small nor large businesses can flourish in an environment of anxiety about government intrusions and burdens. By reaching into virtually every sector of economic life and by picking winners and losers, the government is injecting uncertainty into the marketplace and making it harder for the economy to recover. To start helping American business, Obama needs to stop trying to help. 

Contributing Editor Veronique de Rugy ([e-mail]) is a senior research fellow at the Mercatus Center at George Mason University and reason's economics columnist.