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Bridges | Spring 2005

Entrepreneurs Thrive in America— Federal, State Policies Make a Difference for Those Facing Risk

The entrepreneurial spirit is alive and well in the United States. A recent study revealed that the U.S. population is quite entrepreneurial when compared with that of other countries: More than 70 percent of Americans would prefer being an entrepreneur to working for someone else. This compares with 46 percent of adults in Western Europe and 58 percent of adults in Canada.1 Another study on entrepreneurial activity for 2002 found that, of 36 countries studied, the United States was in the top third in entrepreneurial activity and was the entrepreneurial leader when compared with Japan, Canada and Western Europe.2

One can argue that the desire of individuals to create new businesses, develop new technologies and venture into the unknown has propelled the United States from a small collection of colonies to one of the greatest economic powers in the world. Entrepreneurship means growth.

Given the relationship between entrepreneurship and economic growth and development, what policies should government—be it local, state or federal-pursue to foster entrepreneurship? There are many such policies, each of which fits into one of two categories: active policies and passive policies. Active policies include targeted tax breaks and targeted subsidies. As a result, these policies are often aimed at specific forms of businesses or entrepreneurs. Passive policies, however, include laws and regulations designed to lower the cost of doing business and provide a business atmosphere that encourages entrepreneurship. This article discusses several policies in the United States that influence entrepreneurship and economic growth. These U.S. policies are compared with and contrasted to policies in other countries as well as to policies in states across America.3

Why Passive Policies Are Important

Community development leaders and interest groups often focus on active policies for entrepreneurs, such as tax breaks for certain types of small businesses or subsidies from various federal agencies, usually in the form of economic development or small business loans and grants. Government plays a crucial role in promoting entrepreneurship through active policies. However, while small businesses do create economic growth, they are not necessarily entrepreneurial. Only those small businesses that focus on new and sometimes risky opportunities and investments can be considered entrepreneurial. With passive policies, the role of government is to create an environment that is "friendly" to entrepreneurs without regard to specific businesses or groups of individuals. It is this entrepreneurial-friendly environment that will allow any individual or business-regardless of size, location or mission-to expand and to thrive. As will be seen, passive policies in the United States are different from the policies of other countries.

Policies That Influence Entrepreneurship

Four policies that have an impact on entrepreneurship are: tax policy, regulation, start-up costs and access to capital markets, and legal protection and property rights. Each policy is discussed through the lens of economic analysis.

Tax Policy

Some minimal level of taxation is required to have a functioning government. While few people would disagree with this statement, disagreement does arise over what constitutes "minimal." Regardless, one fact is clear: A tax on any activity increases the cost of the activity, thereby discouraging the activity.

Entrepreneurship is an activity that requires investment, consumption and income generation to be successful. A sales tax reduces personal consumption, higher personal income taxes reduce the incentive to work, corporate income taxes reduce the incentive to start or expand a business, and capital gains taxes reduce the incentive to invest. A recent study provided estimates on the effect of taxes on economic growth in the United States.4 Using data on the United States for the period 1977 to 1992, the authors of the study found a negative and statistically significant relationship between state per capita personal income growth and tax collections (and the size of government relative to personal income).

Various tax policies, both active and passive, are in place across U.S. states to foster entrepreneurship.5 In response to a recent survey from the Kauffman Center for Entrepreneurial Leadership, many states said they focus on lowering the overall tax burden through a reduction in tax rates or by expanding exemptions to promote entrepreneurship. About 10 states have more active tax policies, such as targeted tax credits for business location, research and development, and capital requirements. Several states have also reduced or eliminated their capital gains tax and inheritance tax.

Policy-makers concerned with entrepreneurship should understand that a trade-off exists between entrepreneurial growth and taxes. The benefits of additional government programs funded through taxation must be weighed with the costs of reduced economic growth and entrepreneurial activities. Also, because targeted tax breaks foster only certain types of businesses or businesses in certain locations, a more passive tax reduction policy will be less restrictive in terms of the type of entrepreneurial activities that may occur and where these activities occur.

Regulation

Labor market and business regulations can be costly for entrepreneurs. However, when compared with European countries, regulations in the United States are much less restrictive.6 For example, many European countries place restrictions on the number of hours a business may be open or how late into the evening the business may be open. In addition, there are laws regulating the maximum length of the work week-35 hours per week. There are also more restrictions on the ability of businesses to hire and fire workers in Europe than in the United States.

A less regulated labor market serves the American entrepreneur well. There are several areas in which states have reduced the costs of regulation on U.S. entrepreneurs, as reported by the Kauffman Center survey. First, nearly all of the states responding to the survey said that reducing the compliance costs of regulation is a goal to help entrepreneurs. Reducing compliance costs is accomplished by providing one-stop service centers where entrepreneurs can find help; by allowing electronic filing and storage, which reduces paperwork; and by making compliance reporting uniform across a state. Many states recognize that while these improvements might not be large cost reducers, they will have an effect on where a new entrepreneur will locate his or her business.

Reducing regulation outright is another means of fostering entrepreneurship. The Kauffman Center survey reported that five states have reduced the regulatory burden in hopes of fostering entrepreneurship. States have also reduced the cost of doing business through regulatory reform, such as tort reform, utility deregulation and worker compensation adjustments. While some regulation is likely necessary to protect workers and businesses, states should evaluate their regulations to ensure their relevancy. Many regulations are created in a political environment and might be the result of special-interest lobbying rather than a general desire to help the public or businesses.

Start-Up Costs and Capital Access

The costs of starting a business are certainly a factor one considers before embarking on any entrepreneurial activity. Start-up costs include the number of procedures and days it takes to form a business entity, the fees required to establish a business, and a minimum level of required capital. According to the World Bank, start-up costs in the United States and European countries are quite different.7 For example, there are no fee payments in Denmark. In other countries, fees range from $210 in the United States to $4,565 in Italy and $8,115 in Greece. Capital requirements, as a percent of per capita income, vary from none in the United States and the United Kingdom to 145.3 percent in Greece. The average length of time to form a business entity ranges from four days in Denmark and the United States to 115 days in Spain. Given these large start-up costs in some countries, one should not be surprised at the level of entrepreneurship in the United States.

Entrepreneurs cannot operate or expand their ventures without access to capital markets. Unfettered access to adequate capital markets will provide the greatest opportunities for entrepreneurial expansion. Many states have recognized the importance of capital to entrepreneurs and have implemented policies to ensure access to capital. The Kauffman Center survey reports that most states implement active policies to provide entrepreneurs with adequate capital through loans. These loans usually have modest interest rates and reasonable repayment periods. However, while there appear to be adequate capital resources available to entrepreneurs through state governments, there is little done in the way of planning and management of this capital. So, once entrepreneurs acquire their needed capital, they might not have the experience or education necessary to properly manage it. This is something state and local governments should address.

Legal Protection, Property Rights and Economic Freedom

No entrepreneur can succeed in a society lacking respect for individual property rights and a legal system that protects these rights. Property rights are defined as the right to control, use and obtain the benefits from a good or service. While this sounds reasonable, think of how little entrepreneurship would occur if individuals did not have the right to their property and the profits that they acquire from using this property in the most valued way. Without property rights, there would be little incentive to invest, expand or create because any gains from such endeavors would be transferred to the state. And granting individual property rights without enforcing them by means of a well-established legal system would be pointless. One of the most significant reasons centralized economies like the former Soviet Union collapsed was the lack of individual property rights and a legal system that advocated for these rights.

Property rights and legal protection of these rights are part of a passive policy environment that promotes entrepreneurship. Other policies, such as moderate taxation and regulation, also contribute to the entrepreneurial environment. Economists have quantified a country's active and passive policies through a measure called the Economic Freedom of the World (EFW) index. This index, ranging from 0 to 10, evaluates a country based on five general criteria: size and scope of government, legal structure and property rights, access to sound money, freedom to exchange goods and services, and the regulation of credit, labor and businesses.8 Not surprisingly, recent research has found that countries with a higher EFW index, such as the United States (8.2), Canada (7.9) and the United Kingdom (8.2), have higher rates of entrepreneurship and growth than more centralized countries, such as Russia (5.0), Ukraine (5.3) and Indonesia (5.8).9

While the EFW index allows only cross-country comparisons, it does provide lessons for state and local governments here in the United States. Specifically, the relationship between a country's growth and EFW index suggests that states with greater economic freedom will have higher rates of growth. The earlier discussion of differences across states regarding tax policy, regulation and start-up costs certainly suggests differences across states in terms of growth.

Conclusion

Government can conduct both active and passive policies to encourage entrepreneurship. Although active policies, such as targeted tax breaks and subsidies, are the most commonly discussed, it is passive policy that is important for generating an entrepreneurial-friendly environment. This article has addressed several areas of policy, both active and passive, that encourage entrepreneurship. Evidence was presented here on cross-country and cross-state differences in entrepreneurship as a result of different active and passive policies.

One point should be clear: Institutions matter. Institutions that lower the cost of doing business, either through tax policy, start-up costs or regulation will encourage entrepreneurship. More broadly, a complete respect for private property rights and a well-functioning legal system that recognizes and protects these rights is vital. States and countries that respect and enforce these institutions will encourage entrepreneurship and be rewarded with greater economic growth.

The Community Affairs Office at the Federal Reserve Bank of St. Louis has focused much of its work in 2004 and 2005 on small business and entrepreneurship. This is one of several Bridges articles on those topics.

Endnotes

  1. Black, Sandra and Philip Strahan. "Entrepreneurship and the Availability of Bank Credit." Journal of Finance, vol. 57, no. 6, December 2002, pp. 2807-33. [back to text]
  2. See also Poole, William and Howard Wall. "Entrepreneurs in the U.S. Face Less Red Tape." The Regional Economist, Federal Reserve Bank of St. Louis, October 2004, pp. 5-9. [back to text]
  3. Crain, Mark W. and Katherine Lee. "Economic Growth Regressions for the American States: A Sensitivity Analysis." Economic Inquiry, vol. 37, no. 2, April 1999, pp. 242-57. [back to text]
  4. Kayne, Jay. State Entrepreneurship Policies and Programs. Kauffman Center for Entrepreneurial Leadership at the Ewing Marion Kauffman Foundation, Kansas City, Mo., November 1999. [back to text]
  5. Poole, William and Howard Wall. "Entrepreneurs in the U.S. Face Less Red Tape." The Regional Economist, Federal Reserve Bank of St. Louis, October 2004, pp. 5-9. [back to text]
  6. World Bank. Doing Business in 2004: Understanding Regulation. Washington: World Bank and Oxford University Press, 2004. Available at http://www.doingbusiness.org/Documents/DB2004-full-report.pdf [back to text]
  7. See www.fraserinstitute.ca and www.freetheworld.com. [back to text]
  8. 2002 values are from The Economic Freedom of the World: 2004 Annual Report, The Fraser Institute. Also see Sobel, Russell, J. Clark, and Dwight Lee. Freedom, Barriers to Entry, Entrepreneurship, and Economic Progress. Entrepreneurship Center, College of Business and Economics, West Virginia University. Available at www.be.wvu.edu/ec/Papers/SobelClarkLee.pdf. [back to text]