The Slow-Down in Business Formation: What It Is and What We Can Do About It

The Slow-Down in Business Formation: What It Is and What We Can Do About It {
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Business formation has declined over the past decade, as RealClearPublicAffairs reported in early September. A new study from the Census Bureau found that the number of new businesses that will likely hire workers has fallen by 16 percent between 2007 and the second quarter of 2019. It’s a troubling trend — one with many potential causes and negative consequences. Thankfully, there are plenty of solutions, too.

Causes

Shrinking and Aging Labor Force

The trend of declining business dynamism is not unique to the United States — one can observe similar patterns throughout the developed world. One factor that could be involved is demographic change: populations across the U.S. and Europe are getting older, and as workers get older and retire, the labor force shrinks. Economist Adam Ozimek, formerly of Moody's Analytics and now at Upwork, found that America’s aging population was central to the country’s slow productivity growth.

Regulation

There are conflicting views regarding how regulation has impacted the decline in business formation. There’s plenty of evidence that federal regulation does have a negative impact on entrepreneurship, but a paper from Alex Tabarrok, a George Mason University economist and no advocate of big government, found that “rising federal regulation cannot explain secular trends in economic dynamism.”

Yet rising state-level regulations, like zoning and land use restrictions or occupational licensing laws, may have an even bigger impact. Particularly land use regulations — they reduce construction of new housing. But more importantly, by limiting the housing supply, they raise housing prices, making a lot of dynamic, entrepreneurial urban centers unaffordable to many would-be entrepreneurs.

Post-Great Recession Risk Aversion

An unsurprising explanation for why fewer new businesses are forming is a higher aversion to risk thanks to the Great Recession and its aftermath, particularly among young people just entering the workforce during it. The recession not only hurt the long-term earnings of college grads whose graduation years overlapped with it, but it also gave them and people in the economy as a whole a greater fear of risk. That's a problem, given that starting a small business of one's own requires at least some risk.

Low Interest Rates

Since the Great Recession, central banks across the developed world have kept interest rates very low, relative to historic levels. That’s a pretty common policy response to a recession, as lower interest rates encourage wary consumers to spend more. But there are downsides to keeping interest rates low in the long term. As a recent study from Princeton and University of Chicago economists found, a low interest rate environment might give incumbent firms an advantage over new firms —incumbent firms gain access to capital in order to aggressively try and ward off new competitors. This, in turn, means fewer new companies and less productive old firms.

Negative Consequences

Slow Productivity Growth

New small businesses help create innovation by coming up with new processes and forcing existing firms to evolve or risk being out-competed. As a recent paper in the American Economic Review found, the decline in business dynamism can be linked to the decline in productivity growth over the past couple decades. A paper published by the Federal Reserve Bank of San Francisco called this view into question, arguing that old firms are just as innovative as new ones, but on the whole, most of the evidence indicates that the entrance of new firms helps spur innovation and productivity growth.

Suppressed Wages

Fewer new businesses means fewer firms competing to hire workers. That means market concentration, giving a few large firms the power to negotiate down wages for the workforce—also known as a monopsony labor market. The Hamilton Project, a Brookings Institution affiliate, noted that both the slower productivity growth and greater market concentration brought by slower business dynamism combine to reduce wages.

Reduced Economic Mobility

Entrepreneurship has always been part of the image of the American Dream: the ability to set out on one's own and build a business from scratch. But it's more than just an idealized vision—entrepreneurs tend to have higher social mobility than workers. In a time when concerns about rising income inequality and declining social mobility have taken center stage, declining entrepreneurship likely exacerbates those trends.

Solutions

The slowdown in business formation has numerous potential causes, and there's no one policy that can truly fix the situation.. There are ways to help ease the situation— reform regulations like occupational licensing laws and zoning regulations..But regulatory reform alone probably isn't enough. Immigrants tend to be disproportionately entrepreneurial relative to their native-born peers, so increasing immigration, particularly high-skilled immigration, could provide a boost. In addition to those policies, the Center for American Entrepreneurship, a pro-entrepreneurship nonprofit, focuses on a combination of tax changes, like improving the tax treatment of research and development, increasing government spending on R&D, and increasing access to capital through both government loans and regulatory changes to make private loans more easily available.

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