Why We Don't Need New Policies to Boost Startup Rates

The Census Bureau recently released data showing that the new-business fraction of American companies has shrunk from 16.5 percent in 1977 to 8.2 percent in 2011. Some observers believe that this reduced dynamism – the replacement of existing companies with new ones – is hurting the economy because “the churning process replaces lower productivity businesses with new, more productive ones, thereby increasing productivity in the economy as a whole.” 

That's led to a slew of calls for government intervention and new policies designed to juice startup activity: savings accounts to finance new companies; immigrant entrepreneurial visas; programs to facilitate startups’ access to capital; and expanded tax incentives for new businesses.

I don’t think boosting the startup rate makes sense. The decline itself isn’t a problem -- and the interventions risk generating unforeseen problems.

The decline in the rate of new business creation over the past 30 years has not reduced U.S. productivity. Between 1977 and 2011, the rate of new business creation dropped by half, while U.S. productivity rose by 87 percent, Bureau of Labor Statistics and Census data show. While our economy is much less dynamic now that it was three-and-a-half decades ago, it is more productive.

Having fewer startups might actually be boosting productivity. Companies tend to be inefficient when they are first started, and become more productive as they age, because their owners figure out more efficient ways to do things. A smaller fraction of new businesses means a smaller slice of companies at an inefficient stage of the business life cycle.

Startup rates may be falling because existing business owners are getting better at running their businesses. Americans may be founding fewer new companies every year because the economy needs fewer businesses to replace those that have died. Census Bureau data show that the rate of business failure has been declining for the past 30 years, and that the failure rate correlates 0.61 with the startup rate. (A 1.0 correlation means two numbers are moving in perfect alignment.)

The decline in the startup rate hasn’t cut the rate of formation of two categories of companies with very high potential for wealth creation and job creation: angel and venture-capital-backed businesses. While the number of new businesses in the United States declined by 18.7 percent between 2002 and 2011, the number of angel-backed companies rose by 86.2 percent, the Center for Venture Research at the University of New Hampshire finds. Similarly, between 1985 and 2011, the number of new businesses fell by 18.4 percent. Over the same period, the number of venture-backed companies rose by 172.6 percent, the National Venture Capital Association reveals.

Startup rates might be declining because it has become harder to make a living running a business. Internal Revenue Service data show that between 1977 and 2010, the profits at the average sole proprietorship declined 40 percent in inflation-adjusted terms. Federal Reserve data show that average family income at households headed by self-employed people declined 5.4 percent in real terms between 1989 and 2010, while average family income at households headed by people working for others rose 20.4 percent in inflation-adjusted terms over the same period. The decline in startup rates might simply represent Americans’ realization that earning a living running one’s a small business has become more difficult over the past three-and-a-half decades.

While we might not like the decline in startup rates, intervening in the market to boost start-up rates would be a bad idea. Startup rates may have fallen for “good” reasons, and their decline has not blocked growth in rates of formation of high potential businesses. Artificially inflating new business formation will further erode incomes at small business-owning households. Given the law of unintended consequences, juicing startup formation could very well generate more harm than good.
 

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