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Cascade: No. 88, Summer 2015

Are Tax Incentives the Answer to More Job Creation?*

You can't discuss job creation without talking about entrepreneurship — and that is a hot topic right now. Television shows such as Shark Tank and the film The Social Network have elevated the popularity of entrepreneurship in America. Alongside this media and entertainment interest is the explosive growth in college-level entrepreneurship education programs, which have increased from about 250 in 1985 to more than 5,000 in recent years.1

But entrepreneurship is not a recent phenomenon. In fact, the risk-taking pursuit of new ideas that is characteristic of entrepreneurs is embedded in the ethos of the American dream. As citizens of the United States, we — like entrepreneurs before us — were brought up to believe that anything is possible with hard work and determination.

Ewing Marion Kauffman, a successful entrepreneur from Kansas City, MO, also believed in the power of entrepreneurship. After starting Marion Laboratories, a pharmaceutical company, in the basement of his home in 1950, the one-man operation grew to a firm with 3,400 employees and more than $900 million in revenues. When it merged in 1989 with Merrell Dow Pharmaceuticals, some 300 people became millionaires overnight.

To help others achieve economic independence through educational achievement and entrepreneurial success, Kauffman founded the Ewing Marion Kauffman Foundation.2 The foundation pursues the vision of its founder by directing grant making and operations in the areas of education and entrepreneurship. In addition to supporting and developing programs for entrepreneurs, the foundation pursues research that contributes to a more in-depth understanding of what drives innovation and economic growth in an entrepreneurial world.

One of the foundation's most significant findings is that small businesses are not the same as new businesses. Small businesses are certainly important to the economic and cultural fabric of our communities, but, when it comes to job creation, the age of a firm matters much more than its size.3

Today, with all the attention given to entrepreneurship, one might assume that the state of entrepreneurship in America is strong. Unfortunately, many factors indicate otherwise. Like the economy as a whole, entrepreneurship took a hit during the Great Recession. But even before the recent economic downturn, the rate of new business creation in the United States was on the decline.4 This decrease in entrepreneurship has real consequences for the economy.5 Yet, as policymakers have sought to spur job creation, significant financial resources and time have been invested in a zero-sum game of attraction.

For example, a common way in which many state and local elected officials have sought to create jobs has been to offer special tax incentives to firms6 that either remain in or move company operations to their jurisdictions.

Are New Jobs Being Created, or Are Jobs Being Reshuffled?

When states or cities compete for companies to relocate within their boundaries, they most often are competing for companies with existing jobs rather than competing for companies that will create new jobs.7 From a macro perspective, this reshuffling or reordering of jobs does little to nothing to increase overall U.S. economic growth.

Take the case of Tesla's "gigafactory." Tesla planned to build a battery production facility, which meant jobs would be created to staff the giant factory, but the company needed to find a place to locate the plant. Selecting a location would happen regardless of the incentives states offered — the incentives would just benefit Tesla by lowering the costs associated with the facility. After a long competition among several states, Nevada "won" with an offer of free land, generous tax abatements, and electricity discounts.8 In exchange, Nevada received the right to host the factory and the jobs that came with it. Essentially, the jobs were already created; it was just a matter of where the jobs would be located.

In this case, and others like it, the incentives might be credited with attracting the firm, but not the creation of jobs. Some research has added empirical evidence to this observation. In an analysis of an incentive program in Kansas, firms that received the state incentive were no more likely to create new jobs than were firms of a similar size and type that did not receive the incentive.9 These findings point to the ineffectiveness of incentives in creating new jobs.

In regions where state lines divide metropolitan areas, this type of behavior can have particularly damaging effects, especially when companies move several miles from one side of the line to the other to claim tax breaks.10 The Kauffman Foundation has witnessed this in its own backyard with the "border war" in Kansas City between Missouri and Kansas.11 Over the course of several years, these two states spent a combined $217 million in forgone tax revenue to lure companies from one side of the state line to the other.12 The constant shuffling of jobs between two counties in Kansas and one in Missouri resulted in a net gain of only 414 jobs to Kansas at an estimated price of $340,000 per job.13

All told, local governments that compete for jobs by offering incentives to businesses to locate to their cities or states cost U.S. taxpayers an estimated $70 billion14 annually, and, in addition, these governments frequently miss the real job creators in the U.S. economy — new and young firms.15

Are Young Firms the Real Job Generators?

New and young firms are the engines of job growth. Firms in their first five years tend to either fail or become strong contributors to economic growth.16 This behavior is known as the "up or out" dynamic, where successful companies grow rapidly and others quickly crumble.

Using data from the U.S. Census Bureau, the Kauffman Foundation took a snapshot of job creation in four metropolitan areas surrounding the Federal Reserve Bank of Philadelphia: Atlantic City-Hammonton, Philadelphia-Camden-Wilmington, Harrisburg-Carlisle, and Trenton-Ewing. As Figure 1 shows, compared with older firms, new and young firms are responsible for the overwhelming proportion of net new jobs created. In 2012, firms in business for five years or less created 49,771 net new jobs in these four metropolitan areas combined.

Figure 1: Net Job Creation by Firm Age in Four Metropolitan Statistical Areas of the Third Federal Reserve District in 2012

CAPTION Source: Ewing Marion Kauffman Foundation analysis of data from the U.S. Census Bureau Business Dynamics Statistics

Not only do young firms create the most new jobs, but in every year since 1988, these firms have been a consistent and positive source of net job creation (see Figure 2 below).

Figure 2: Net Job Creation by Firm Age in U.S.

CAPTION Source: Ewing Marion Kauffman Foundation analysis of data from the U.S. Census Bureau Business Dynamics Statistics. Previously published in the Kauffman Foundation Entrepreneurship Policy Digest, September 25, 2014, available at http://ow.ly/Ocbls

Young firms also contribute to the economic dynamism of their communities by injecting competition into markets and spurring innovation.17 These young firms are also more likely to hire the young, talented workers18 that cities desire.

What Are Some Alternatives to Tax Incentives?

Some policymakers have expressed a desire to end the practice of tax incentives,19 but many feel that they are forced to continue with this practice. Until other states and cities abandon the practice, pressure remains to compete for companies that will bring jobs to one's jurisdiction.

The Kauffman Foundation has met with state and local policymakers and asked them how the practice of incentive programs might be improved and to consider alternative strategies that support the creation and growth of firms — new businesses, to be specific — that have proven to create jobs.20 A few of those alternative strategies are discussed here.

Let Entrepreneurs In

Immigrants are more than twice as likely21 as native-born Americans to become entrepreneurs. Though federal law governs much of U.S. immigration policy, states and cities can welcome immigrants by providing resources and facilitating the formation of networks that support emerging immigrant entrepreneurs.22 A local entrepreneurial ecosystem with an immigrant presence not only boosts firm formation rates23 but it also provides industry and individual diversity that make the ecosystem stronger.

Nearly one-third of the immigrants have a college degree or higher. Yet, when applying for licenses or other credentials, immigrants often face the challenge of applying their academic achievements earned abroad to satisfy domestic requirements, contributing to one-in-five highly skilled immigrants being underutilized. States can ameliorate this by developing clear processes for evaluating training, skills, and education earned abroad so that more immigrants can work and potentially start companies in fields related to their education.24

For immigrants and native-born Americans, the growth of occupational licensing can pose substantial barriers that have the effect of fencing them out of entrepreneurial opportunities while protecting the already licensed from competition. These barriers can include meeting minimum levels of education, demonstrating competency by passing tests, and paying fees that can exceed $500.

An alternative regulatory structure to licensing, especially for industries that do not pose large public health or safety threats, is certification. For occupations that require workers to be licensed, only individuals who are licensed can legally practice. A system of certification, however, allows any individual to perform the service but recognizes those who have achieved a certain level of experience or education with a state certificate of competency. These certificates can signal to consumers that a professional has a recognized proficiency. A system of certification increases competition and lowers the barriers to entrepreneurial entry.

Certification as a system of credentialing has worked for a number of professions, including car mechanics and travel agents. The body that issues the certification (sometimes a government agency, other times a private nonprofit entity) ensures the quality of the service performed. And the service performed doesn't have to be of a lower quality just because a less strict form of regulation was enacted. Certain professions can function with the same level of customer satisfaction and no extra public safety hazards when the level of occupational regulation is lessened or even removed.25,26 States can examine how they currently license professions and discern which ones truly require the rigor of licensing and which can exist without it.

Let Entrepreneurs Compete

Regulatory burdens, laws that favor incumbent firms, and tax complexity can all make the entrepreneurial process more challenging. Entrepreneurs need a level playing field on which to compete. Yet, many policies, such as noncompete agreements, can stop or slow their business pursuits.

Noncompete agreements, which prevent workers from moving to a competitor or starting their own entrepreneurial venture based on acquired knowledge, can depress entrepreneurship and limit the number of talented workers27 who are available to young, growing companies. When workers are able to move between employers or found their own startups, it creates a more fluid labor market that allows workers to better match their skills to their jobs.

Enforcement of noncompete agreements varies by state, with some states, such as California, rarely enforcing these restrictions. Policymakers must ultimately make decisions regarding the degree of enforcement, allowable scope, and duration of noncompete agreements based on their assessment of what is best for their state.

Why Are Good Measures Important?

When the decision is made to embrace entrepreneurship as a method of economic development, it is important to understand how to measure the success of the new strategies. States and cities consistently express interest in knowing how to measure their entrepreneurship ecosystems, and some have deployed unique and thoughtful methods.28 When considering the question of what to measure and how, the Kauffman Foundation believes measurement efforts should center on four indicators of entrepreneurial vibrancy29 — density, fluidity, connectivity, and diversity — which will reveal the strength of the entrepreneurial ecosystem.

Density indicates how frequently an entrepreneur will "run into" or come in contact with a fellow entrepreneur. When entrepreneurs are more often in contact with each other, they are more likely to develop innovative ideas that they might not have had if they were working separately. These spillover effects are a benefit to society at a very low cost. Density also refers to the amount of employment within new and young firms.

Fluidity refers to the growth of new firms, as well as the ability of workers to find their most productive fit. When workers are able to move from job to job, the quality of matches between workers and jobs improves, and workers see higher wage growth30 throughout their careers. Additionally, young workers tend to work at younger firms. Since younger workers are more likely to change jobs,31 both young workers and young firms would benefit from having a more fluid entrepreneurial ecosystem.

Connectivity is how intertwined entrepreneurs are with each other and the resources available to them. This measurement includes spinoff rates, which indicate the successive waves of new companies that are created.

Finally, diversity refers to the breadth of industries in which new firms exist. No city or state should be overly reliant on one industry. Diverse entrepreneurial ecosystems are more resilient32 and better able to weather economic downturns.

Conclusion

Entrepreneurship can be an engine of economic growth by spurring the creation of new and young firms that "punch above their weight" and disproportionately contribute to new job creation. But cities and states need to create an environment through public policy that allows entrepreneurs to enter markets and compete on a level playing field. Through improved regulatory and legal policies, a more welcoming attitude toward immigrants, and better attempts to recognize and measure entrepreneurship, policymakers and elected officials can seize the opportunity that entrepreneurship provides and shift economic growth into "drive," leaving economic development tax incentives behind.

For more information, contact Chris Jackson at cjackson@kauffman.org Email Link or visit www.kauffman.org. External Link

  • * The views expressed here do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.
  • 1Ewing Marion Kauffman Foundation, "The Future of Entrepreneurship: Millennials and Boomers Chart the Course for 2020," February 11, 2015, available at http://ow.ly/NCfXp. External Link
  • 2See Ewing Marion Kauffman Foundation, "Our Founder," available at http://ow.ly/NCguN. External Link
  • 3 John Haltiwanger, Ron S. Jarmin, and Javier Miranda, "Who Creates Jobs? Small Versus Large Versus Young," Review of Economics and Statistics, 95 (May 2013), pp. 347-361, available at http://ow.ly/NCr9Y. External Link
  • 4Ryan Decker, John Haltiwanger, Ron S. Jarmin, and Javier Miranda, "The Secular Decline in Business Dynamism in the U.S.," Working Paper, 2014, available at http://ow.ly/NCgEi External Link , and John Haltiwanger, Ian Hathaway, and Javier Miranda, "Declining Business Dynamism in the U.S. High-Technology Sector," Ewing Marion Kauffman Foundation, February 2014, available at http://ow.ly/NCgNi. External Link
  • 5E.J. Reedy and Robert E. Litan, "Starting Smaller; Staying Smaller: America's Slow Leak in Job Creation," Ewing Marion Kauffman Foundation, July 11, 2011, available at http://ow.ly/NCki8. External Link
  • 6 See Julia Terruso, "N.J. Offers Sixers $82 Million in Tax Credits," The Philadelphia Inquirer, June 12, 2014, available at http://ow.ly/NCkpF. External Link
  • 7 See Louisiana Economic Development, "Enterprise Zone Program 2009 Annual Report," March 2010, available at http://ow.ly/NCqqn. External Link
  • 8 See Peter Elkind, "Inside Elon Musk's $1.4 Billion Score," Fortune, December 1, 2014, available at http://ow.ly/NCqAe. External Link
  • 9 Nathan Jensen, "Evaluating Firm-Specific Location Incentives: An Application to the Kansas PEAK Program," Working Paper, Ewing Marion Kauffman Foundation, 2014, available at http://ow.ly/NCqKE. External Link
  • 10 See Missouri Chamber of Commerce, "Hall Family Foundation Study Shows Missouri Has Lost $217 Million in Taxes in Border War," Missouri Chamber of Commerce Blog for Business, February 7, 2014, available at http://ow.ly/NCqR5. External Link
  • 11 See "The New Border War," The Economist, March, 22, 2014, available at http://ow.ly/NCqXH. External Link
  • 12 See "Missouri Legislators Hear Bill to Embrace Truce in Kansas-Missouri Tax Border War," Topeka-Capital Journal, February 5, 2014, available at http://ow.ly/NCr3Y. External Link
  • 13 See Marshall Griffin, "Missouri Lawmakers Try to End 'Border War' Between Missouri and Kansas," St. Louis Public Radio, February 5, 2014, available at http://ow.ly/NCuCC. External Link
  • 14 Kenneth P. Thomas, Investment Incentives and the Global Competition for Capital. London: Palgrave Macmillan, 2010.
  • 15 John Haltiwanger, Ron S. Jarmin, and Javier Miranda, "Who Creates Jobs? Small Versus Large Versus Young," Review of Economics and Statistics, 95 (May 2013), pp. 347-361, available at http://ow.ly/NCr9Y. External Link
  • 16 Jason Wiens and Chris Jackson, "The Importance of Young Firms for Economic Growth," Ewing Marion Kauffman Foundation, September 25, 2014, available at http://ow.ly/NCrhl. External Link
  • 17 Jesper B. Sorensen and Toby E. Stuart, "Aging, Obsolescence, and Organizational Innovation," Administrative Science Quarterly, 45 (March 2000), pp. 81-112.
  • 18 Paige Ouimet and Rebecca Zarutskie, "Who Works for Startups? The Relation Between Firm Age, Employee Age, and Growth," Working Paper 2013-75, Federal Reserve Board, 2013, available at http://ow.ly/NCrpd. External Link
  • 19 Office of the Governor of Missouri, "Gov. Nixon Signs Bill Addressing ‘Border War' in Kansas City Metropolitan Area," July 1, 2014, available at http://ow.ly/NCrxv. External Link
  • 20 See Incentives to Innovate Conference 2014, Ewing Marion Kauffman Foundation, available at http://ow.ly/NCrDY.
  • 21 See Kauffman Index of Entrepreneurial Activity, 2014, Ewing Marion Kauffman Foundation, April 2014, available at http://ow.ly/NCrZL.
  • 22 Dane Stangler and Jason Wiens, "The Economic Case for Welcoming Immigrant Entrepreneurs," Ewing Marion Kauffman Foundation, March 27, 2014, available at http://ow.ly/NCrIy. External Link
  • 23 Cathy Yang Liu, Gary Painter, and Qingfang Wang, "Lessons for U.S. Metro Areas: Characteristics and Clustering of High-Tech Immigrant Entrepreneurs," Ewing Marion Kauffman Foundation, March 25, 2014, available at http://ow.ly/NCsfF. External Link
  • 24 Jason Wiens, Chris Jackson, and Emily Fetsch, "Immigrant Entrepreneurs: A Path to U.S. Economic Growth," Ewing Marion Kauffman Foundation, January 22, 2015, available at http://ow.ly/NCsn7. External Link
  • 25 Dick Carpenter, "Regulation Through Titling Laws: A Case Study of Occupational Regulation," Regulation and Governance, 2 (August 2008) pp. 340-359.
  • 26 Morris Kleiner, Stages of Occupational Regulation: Analysis of Case Studies. Kalamazoo: Upjohn Insititute, 2013.
  • 27 Jason Wiens and Chris Jackson, "Rethinking Non-Competes: Unlock Talent to Seed Growth," Ewing Marion Kauffman Foundation, July 21, 2014, available at http://ow.ly/NCsuE. External Link
  • 28 See Colorado Office of State Planning and Budgeting, "Startup Value Survey," available at http://ow.ly/NCsC9. External Link
  • 29 See Dane Stangler and Jordan Bell-Masterson, "Four Indicators to Assess Local Ecosystem Vibrancy," Ewing Marion Kauffman Foundation, March 16, 2015, available at http://ow.ly/NCsIX. External Link
  • 30 See Stangler and Bell-Masterson.
  • 31 Paige Ouimet and Rebecca Zarutskie, "Who Works for Startups? The Relation Between Firm Age, Employee Age, and Growth," Working Paper 2013-75, Federal Reserve Board, 2013, available at http://ow.ly/NCsOU. External Link
  • 32 See Yasuyuki Motoyama and Jordan Bell-Masterson, "Beyond Metropolitan Startup Rates: Regional Factors Associated with Startup Growth," Ewing Marion Kauffman Foundation, January 2014, available at http://ow.ly/NCsXI. External Link