Economics

America's Small-Business Fetish

When it comes to job creation, size doesn't matter.

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On February 12, House Majority Leader Eric Cantor (R-Va.) sent a message to his 62,550 followers on Twitter: "Small business is the job growth engine in this country and we need to pursue policies that reflect that reality to create jobs." Cantor was wrong on both counts. Despite overwhelming conventional wisdom to the contrary, small businesses are not the engine of growth. And the small businesses that do create jobs rarely stay small for long, which makes crafting policies that favor those fast-growing firms both difficult and unnecessary.

The cult of the small business is so prevalent that you are treated like a heretic in Washington if you don't pledge to do something nice for the little guys. Targeted tax credits, special regulatory exemptions, preferential access to government contracts—nothing is too good for America's DIY manufacturers and social networking startups. Support for the Small Business Administration (SBA), a federal agency tasked with handing out goodies to the modestly sized, remains strong, despite dozens of compelling studies demonstrating that its efforts amount to little more than poorly targeted corporate welfare.

In his 2011 budget, President Barack Obama requested $1.4 billion to fund SBA programs. Most of the agency's money is spent on special credit programs for small businesses that have difficulty getting loans from regular banks. In fiscal year 2011, the SBA guaranteed $30 billion in such loans, which theoretically don't cost taxpayers anything. In practice, however, whenever the economy goes south, the SBA can't cope with the number of small businesses that default on the loans. In 2011 the SBA ended up spending $6.2 billion, a $4.8 billion increase over its requested amount, mainly because so many small businesses couldn't make their payments.

The idea that small is glorious or that small businesses are the engine of growth is based on bad economics, and the result is bad policy.

The government's definition of a small business has become absurdly broad. The category officially includes the "mom and pop" firms with fewer than 10 employees that most people think of when they hear the term. But companies with hundreds or even thousands of employees (depending on the industry) are also eligible for benefits and other preferences; they win the coveted designation by virtue of the fact that they are small relative to other firms in their industry. Based on the federal government's bizarre classifications, 99.7 percent of firms in America qualify as small. 

The percentage of people who work at these small companies has remained constant during the last decade, holding steady at about 50 percent of the private sector work force. This fact alone should cast doubt on the claim that small businesses account for the bulk of new jobs. If that figure was accurate, it would mean that half of American workers are employed by 0.3 percent of firms. Shouldn't we instead be cheering the tremendous job creation record of those powerhouse companies? 

The ubiquitous statistic that small businesses create 70 percent of all net new jobs is also misleading. The source of this figure is none other than the Small Business Administration itself. In a 2005 study published by the American Enterprise Institute, I noted that to arrive at this figure, the SBA divides net small business jobs—a figure that includes every single current employee of a small business—by the net job creation from all businesses combined. This is not an accurate way to determine the share of new jobs created by small businesses.

The results can be comical: One table published by the SBA in 2005 showed that small businesses created more than 100 percent of new jobs, a truly heroic (if fantastical) result. We should stop using this junk statistic.

Our national obsession with small businesses misses the point. It's not micro-firms that drive our new, entrepreneurial economy. Young firms—the startups that will grow to be the next Facebook—do tend to be small. But their newness is the relevant factor, not their size.

A 2010 National Bureau of Economic Research paper by University of Maryland economist John Haltiwanger and researchers at the U.S. Census Bureau found there was no consistent link between net job growth rates and the size of a business. Instead, the researchers found that firms younger than 10 years, particularly startups, are the real sources of job growth. 

Another study, published the same year by economist Tim Kane of the Kauffman Foundation, came to the same conclusion after examining more than 30 years of data from the Census Bureau's Business Dynamics Statistics. Both large and small firms continuously create jobs, Kane found, but also continuously destroy them. The Kauffman report found that without startups—defined as firms younger than one year old—there would be no net job creation in the United States. As Kane writes in the study, "Startups aren't everything when it comes to job growth. They are the only thing." 

Former Obama administration economic adviser Jared Bernstein explained this concept concisely in an October 2011 New York Times op-ed. "It's not small businesses that matter, but new businesses, which by definition create new jobs," Bernstein wrote. "Real job creation, though, doesn't kick in until those small businesses survive and grow into larger operations." 

Today, according to Haltiwanger and his co-authors, businesses younger than a year account for 3 percent of U.S. employment but almost 20 percent of new gross jobs. Furthermore, 60 percent of small businesses that have been around more than five years act as a slight drag on the number of jobs available. These older small businesses cut about 0.5 percent more staff than they add in a typical year, according to Haltiwanger.

Real job growth comes not from people dreaming of being small but from entrepreneurs committed to building large and sustainable companies. This shouldn't be news. A seminal 1987 study by David L. Birch, a former MIT researcher, explained that small-firm job creation occurs within a relatively few firms, the ones he calls "gazelles." Gazelles are high-growth entrepreneurial companies that start small and quickly grow larger. This subset of small firms, not small firms in general, is the powerful job creator of every central planner's dreams. 

Which means that even if it were the government's role to create jobs, it wouldn't be able to. No one can identify a gazelle before it leaps. The label can be applied only by looking at past growth, long after the firm has created those sought-after new jobs. Since no one knows where true innovation will come from, it is impossible to accurately pinpoint the job-creating firms in advance.

In other words, we should value innovation, not smallness. The conventional wisdom that all small businesses deserve special attention is flawed. They do not merit preferential government treatment by virtue of their size. In fact, such policies can have perverse consequences. In a 1995 National Tax Journal article, economist Douglas Holtz-Eakin explained that if the tax code favors small firms over large ones, it will make it more profitable to stay small rather than grow. This disincentive to grow will lead to a misallocation of resources away from their most productive uses and will interfere with the natural growth and evolution of firms. Preferential regulatory treatment has the same effect. 

Firms lose most small-business benefits when their employment, assets, or receipts surpass a certain limit specified by law. If a firm stays smaller than 50 employees, it avoids mandatory family and medical leave. If an employer does not hire more than 10 employees, he is exempt from most Occupational Safety and Health Administration requirements for recording and reporting injuries and illnesses. Such policies discourage growth.

Instead of preferential policies, the government should establish an environment that encourages businesses with strong growth potential to evolve into successful large enterprises. This means low tax rates, low levels of regulation, and a stable legal structure that protects property rights. 

Contributing Editor Veronique de Rugy is a senior research fellow at the Mercatus Center at George Mason University.