Is the secret to national prosperity large corporations or start-ups?

February 24, 2012

Harvard Business School professor James Heskett, writing in the February 1 Working Knowledge, begins an online forum with the question: “Is Support for Small Business Misplaced?”  Citing recent research, he posits that perhaps a better national economic strategy would target large multinational corporations:

Consider the conclusions from some recent research: Small businesses may not be a strong source of prosperity. Not only are they less productive than their larger counterparts, they have, according to a World Bank study, a lower rate of productivity growth because they invest only a small proportion of total R&D money. They therefore charge higher prices and pay lower average wages.

An analysis of census data by economists Erik Hurst and Benjamin Pugsley found that companies employing fewer than 20 people made up 90 percent of the six million businesses with one or more employees in the US in 2007. Most were small entrepreneurs creating what might be considered “lifestyle” jobs for themselves, intending to stay small and avoid employing many others. Eighty percent that were studied in detail didn’t create a single job between the years of 2000 and 2003. Another study, The Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live By, by Scott Shane, found that while small businesses create more jobs than their larger counterparts, they also destroy more jobs. While they created jobs in the year of their founding, they netted out destroying jobs in years two through five as most of them failed, suggesting less job security than in larger organizations.

At the international level, economists Rafael La Porta and Andrei Schleifer conclude that a nation’s wealth is inversely proportional to the share of jobs provided by small businesses. Again, this is due in part to the lower productivity of such jobs.

We believe this argument is based on a category error:  the misconception that lumps together “lifestyle” companies and high-growth start-ups.  Job growth comes mostly from new businesses which grow rapidly, not the more common short-hand of “small businesses.”  The jobs created by high-growth companies, busy inventing products and services (and sometimes industries), dwarf those lost in the ongoing employment churn experienced by small businesses.  The net result is remarkably stable cumulative job creation from start-ups despite their high failure rate.  The aforementioned study by Scott Shane may be correct that small businesses “destroy” jobs in years two through five as they fail – but by that fifth year the surviving firms still employ 78% of the jobs created, and the additional start-ups created in those intervening years more than make up for the lost 22%.

Remember this about those large companies:  they all have birthdays, either as start-ups themselves or as spin-offs from other companies who once were start-ups.  Over half the companies on the F500 were started during a recession or bear marketThe patents for the Television, Jukebox, and Nylon were granted during the greatest period of job destruction in our history:  The Great Depression.  (Although we can’t confirm any patent information on the chocolate chip cookie, it too was invented at the same time.)  This is precisely the creative destruction that makes our economy an engine of innovation and wealth creation.

At the international level, the 2008 study by La Porta and Schleifer contemplates the “informal” firms operating in gray or black markets, who intentionally avoid scale in order to avoid detection, and therefore lag in productivity gains, have trouble financing growth, and seldom mature into larger firms.  For those countries, larger – i.e., formal – is better, but obviously these reasons don’t apply to the U.S. economy.  We also suspect that in many of those countries, national wealth is skewed by the large (often government-run) operations who extract natural resources.   Any nation that favors its large corporations will indeed see less wealth created by its small businesses.  Over the long term it will see less wealth created, period.

Anyone who’s worked for a large corporation – especially in an R&D department – would not rely primarily on that model for innovation.

Anyone who’s worked for a large corporation – especially in a dying industry – would not rely primarily on that model for job growth.

Yes, start-ups lack the economies of scale and R&D budgets of larger firms; but that’s the support venture capital provides.  Those start-ups that do gain traction are able to raise capital, and, with hard work and a little luck, become large companies.  With early-stage activity at its lowest level since 1977, it’d be a good time to help restore a favorable and predictable environment for new business formation – for entrepreneurs and their sources of capital.

Derek Thompson, senior editor at The Atlantic, makes the case in The Entrepreneur State: Safety Nets for Startups, Capitalism for Corporations.”  He starts from a different question: “What if the law were biased, not toward the oil and gas industry or the cotton farmers, but to the creative, the self-employed, and the entrepreneurs?” 

The broadest debate in Washington, and on the primary trail, is about whether government needs to step up to create jobs or step back to allow the market to work by itself. But what if we need both: A stronger safety net to lessen risk for wannabe-startups and purer free market approach for established corporations?  …

This isn’t industrial planning. It’s not about picking winners. It’s making rules that increase the odds that entrepreneurs play the game in the hope that many of them will win.

As a general rule, entrepreneurs don’t win. They mostly fail. Trying to start a company is like playing a high-risk casino game with your career. It’s roulette, except thousands of dollars, thousands of hours, and unquantifiable sacrifices are on the table. If we want more people to play startup roulette, we shouldn’t focus on how much to tax them if they win $200,000. We should focus on minimizing the downside of losing so that startup roulette feels less risky. After all, startups shouldn’t just be for rich kids who can afford to take a chance on a big idea.

You can build a stronger safety net stitch by little stitch, by creating new tax deductions for startups or making long-term venture capital gains totally tax free. Or you can focus on the whole net…  We could fortify welfare for startups as we disassembled the welfare state for corporations. The corporate tax code is more holes than Swiss cheese, which distorts business decisions and forces us to keep one of the highest marginal tax rates in the world. Reducing both the rate and the exemptions would raise taxes on some companies and cut taxes for others, but it might also level the playing field, attract more investment, and even raise more money for the government. Combined with our bloated, if well-intentioned, regulatory system, corporate welfare saps the market of competitiveness and makes voters angry by what they perceive as favoritism among elites.

It would be naive to think we can cleanse the law of all biases. But what if the law were biased, not toward the oil and gas industry or the cotton farmers, but toward the creative, the self-employed, and the entrepreneurs? What if we combined a liberal approach toward mitigating risk for startups with a conservative approach toward taxing and regulating established corporations? The result might be more people playing the entrepreneur’s game, more entrepreneurs winning the game and ramping up their companies, and more companies to hire more workers.

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