State Fiscal Policy and Small Business Creation

Article excerpt

Promoting entrepreneurship has emerged as a significant policy tool for regional economic growth and job creation (Friar and Meyer, 2003; Laukkanen, 2000; Rosa, Scott, and Klandt, 1996). Indeed, Maillat (1998) argues that economic development policy has shifted to promoting endogenous economic growth via entrepreneurship and away from competitive growth via attracting businesses from elsewhere.1

After more than a decade, the evidence is not particularly sanguine for the proposition that small business formation leads to economic growth. Wong, Ho, and Autio (2005) and Friar and Meyer (2003), among others, demonstrate that new growth ventures (as in Allen, 1999) stimulate economies; but new ventures in general do not. Unfortunately, these new growth ventures are not necessarily the sort of businesses the industrial/fiscal policy of the last 20 years has fostered (Friar and Meyer, 2003).

We believe that part of the reason for this disheartening result is that researchers still have only an incomplete understanding of the relationship between fiscal policies and the birth and death of businesses. To help address this issue, we take advantage of the natural policy experiment that exists among the U.S. states. On a state-by-state basis, we study business establishment and business failure as it relates to categories of state spending and state taxation. This paper parallels other papers which seek to rekft, "economic freedom" to various measures of economic performance (Kreft, 2003; Clark and Lee, 2005; Kreft and Sobel, 2005; Wang, 2005; Doucouliagos and Ulubasoglu, 2006; Sobel, Clark, and Lee, 2006). However, unlike that stream of research, we do not rely on indices of economic freedom. Instead, we focus on state fiscal policies directly.

Johnson and Parker (1994,1996) argue that firm births and firm deaths cannot be studied in isolation. Furthermore, if state policy makers' interest lies in "home growing" businesses, then their interest lies in formation of sustainable and sustained businesses, rather than a cycle of rapid start-ups and rapid failures. Lastly, an expansive literature (see, e.g., Hayward, Shepherd, and Griffin, 2006) argues that the dynamics of firm formation are separate and different from the dynamics of firm dissolution. For these reasons, we separately estimate models of firm births and firm deaths. Given the nature of our data set and research questions, fixed effects estimation with correction for heteroskedasticity is the appropriate technique.

We focus on relating changes in firm births and firm deaths to changes in economic conditions and changes in state fiscal behavior. Our results indicate that firm births and firm deaths are very different processes. For firm births, the significant point concerns what makes a state attractive for opening new businesses, that is, what leads to positive perception among would-be entrepreneurs. The decision on where to open a business is all about perception once one decides to open a business. Where do I think will be the best spot? As an entrepreneur, one is looking for a favorable environment for your investment. Because many new firms are sole proprietorships or S corporations, the most significant tax is the personal income tax. One also wants to open where business treatment is favorable. If government spending supports infrastructure then potentially there is a positive business environment. We argue that entrepreneurs interpret highway spending as a proxy for a pro-business stance by a state.

For firm deaths, reality kicks in for the inexperienced entrepreneur. Property taxes are a very real expense for the business that many entrepreneurs may not adequately consider up front. State spending on health and hospital deals with service industry spending, which is the type of industry on which many entrepreneurs focus. If a state is supporting service industries through state expenditure, more new business will tend to survive. …