Young, Not Small, Businesses Drive Job Growth

A new study bucks the conventional wisdom that firm size is what matters.

It's hard to get both sides of the aisle in Washington to agree on much of anything. As soon as someone suggests a measure that helps small businesses, however, politicians practically stampede to be the first to proclaim their support. One of the biggest complaints by Republicans about allowing the Bush tax cuts to expire for those who earn $250,000 or more is the effect it will have on small business. Yet, President Obama's recent stimulus efforts are also said to be aimed, in part, at small business. So even if politics gets in the way of how to best help small business, just about no one doubts that it's a worthy beneficiary for support. Small business has become an important American ideal.

Why is it so revered? In part because the often quoted figure is that small businesses account for 60% of all job creation. But what if there's no casual relationship between the size of a business and how many jobs it creates? In fact, a recent economic study asserts just that. It finds that the age, not the size, of a firm is a more important indicator for job creation.

The report by John C. Haltiwanger, Ron S. Jarmin, and Javier Mirandauses uses historical data to analyze job creation. It does, indeed, find that firm size matters for job creation. But when it the economists took into account firm age, they quickly found that age is a bigger driver than size. Of their findings, they write:

Once we add controls for firm age, we find no systematic relationship between net growth rates and firm size. A key role for firm age is associated with firm births. We find that firm births contribute substantially to both gross and net job creation. Importantly, because new firms tend to be small, the finding of a systematic inverse relationship between firm size and net growth rates in prior analyses is entirely attributable to most new firms being classified in small size classes.*

Intuitively, this sort of makes perfect sense. When a firm sprouts up from nothing, jobs are necessarily created. Moreover, new firms are, after all, generally pretty small. So the job creation that small business has generally been given credit for was more coincident than casual.

Moreover, think about a small business that has been in existence for, say 15 to 20 years. Imagine it's a local restaurant. It is certainly important to its community -- no one doubts that. But it's unlikely that there would be a sudden catalyst for its owners to suddenly hire additional people if the business has hit a plateau. If the owners intended to expand, they would likely have already done so by now.

Next consider the case of a start-up, at its infancy. In its first decade or so, a firm that experiences tremendous success will be more likely to expand or franchise. Of course this isn't to say that it's never the case that established small businesses never expand, but growth is far more common for newer firms. These findings make sense.

But the economists found that start-ups are responsible for a lot of job destruction as well -- because they often fail. After about five years, any jobs created are considered fairly safe. They write:

Each wave of firm startups creates a substantial number of jobs. In the first years following entry, many startups fail (the cumulative employment weighted exit rate derived from Figure 5 implies that about 40 percent of the jobs created by startups are eliminated by firm exits in the first five years) but the surviving young businesses grow very fast. In this respect, the startups are a critical component of the experimentation process that contributes to restructuring and growth in the U.S. on an ongoing basis.*

(Sorry, I can't include the chart in figure 5, due to copyright restrictions.)

Again, this makes sense. New firms aren't as likely to survive for a variety of reasons. Their owners are less experienced in business, so may make rookie mistakes. They might not be able to convince creditors to give them additional loans if they run into temporary problems. Or maybe its product was part of a fad that wore off.

So if public policy seeks to help job creation, the way to do so isn't to blindly cater to small business. Instead, it should have two aims. First, it should encourage start-ups, probably through making investment and credit easier to acquire for fledgling firms. Second, measures should be put in place to help start-ups learn how to avoid correctable problems that often lead to their demise.

* Each of these excerpts are © 2010 by John C. Haltiwanger, Ron S. Jarmin, and Javier Miranda.