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Small Businesses and Big Unintended Consequences

Wednesday, January 12, 2011

No matter how benevolent, intelligent, and farsighted policy makers might be, they cannot anticipate how markets will react to laws and regulation.

Winslow Sargeant, the top lawyer in the Small Business Administration’s Office of Advocacy, recently urged Congress to repeal a portion of the Patient Protection and Affordable Care Act (PPACA). Sargeant’s request was not driven by the new law’s impact on small business efforts to provide employee health insurance. Instead, he was calling on Congress to repeal the requirement that businesses issue 1099 forms to all vendors paid more than $600 per year, set to go into effect in January 2012.

This provision has angered many in business, who see it as an example of how the law of unintended consequences leads unrelated federal regulations to impose heavy compliance burdens on small business owners. In a law designed to increase employee health insurance coverage, Congress ended up forcing small business owners to expand their tax filings, an outcome that some in Congress said they did not foresee.

If this were the only example of the law of unintended consequences at work on federal small business regulation, it might simply make for a funny segment of “The Daily Show with Jon Stewart.” But Congress’s tendency to repeatedly pass laws that impose unintended costs on small business owners defeats much of the humor.

The number of accredited informal investors is unrelated to the financial fraud that has plagued the housing and banking industries in recent years.

Consider the Dodd-Frank Wall Street Reform and Consumer Protection Act. When debating the financial reform legislation, no one in Congress (or anywhere else) believed that we needed a law to reduce the number of accredited investors permitted to finance new and small companies. That is because none of the problems of fraud and abuse that triggered the reform effort was present in the informal capital market, and because the number of accredited informal investors is unrelated to the financial fraud that has plagued the housing and banking industries in recent years.

The new law, however, allows the Securities and Exchange Commission (SEC) to dramatically reduce the number of accredited investors available to finance private companies simply by indexing for inflation the financial limits for being an accredited investor. Under the old law, single people with $1 million or more of net worth or yearly earnings of $200,000, or married couples with a similar net worth or yearly earnings of greater than $300,000, were considered accredited investors and were allowed to invest in private companies with less information disclosed to them than to unaccredited investors.

By allowing the SEC to adjust these figures for inflation, Congress gave the regulatory agency the ability to dramatically reduce the number of accredited investors. A look at Internal Revenue Service data shows that adjusting the accredited investor income requirements for inflation from the time when the definition was first established would shrink the pool of accredited investors by 77 percent. A decline of that magnitude would create a scarcity of these investors in the informal capital market and adversely affect the founders of high-potential new ventures who seek capital from accredited investors.

Adjusting the accredited investor income requirements for inflation from the time when the definition was first established would shrink the pool of accredited investors by 77 percent.

A third example of the law of unintended consequences is the Sarbanes-Oxley Act of 2002. Passed in response to the accounting scandals in the early 2000s, this law requires that public companies put in place costly internal financial controls, and that the chief executive and chief financial officers of public companies personally attest to the veracity of their companies’ financial statements.

Because the law raises the cost of running a public company and makes senior management legally liable for the accuracy of the financial information it provides, fewer companies have an incentive to be public. While the law was designed to deal with financial fraud experienced at companies like Enron and Worldcom, it has had the unintended consequence of casting a pall over the venture capital industry.

While many factors have no doubt led to the decline in the number of venture-capital-backed companies going public in recent years, critics have charged that Sarbanes-Oxley is one of them. By making public companies more costly to run, the law has reduced the incentive to take start-ups public. The decline in initial public offerings is problematic to venture capitalists because the valuations of businesses that go public are higher than those that are acquired by other businesses. Therefore, the decline in initial public offerings has reduced venture capitalists’ earnings, which, in turn, has reduced the amount of venture capital available to entrepreneurs. According to a 2008 editorial in the Wall Street Journal, "The new laws and regulations have neither prevented frauds nor instituted fairness. But they have managed to kill the creation of new public companies in the U.S., cripple the venture capital business, and damage entrepreneurship.”

While the law was designed to deal with financial fraud experienced at companies like Enron and Worldcom, it has had the unintended consequence of casting a pall over the venture capital industry.

Here, again, the law of unintended consequences rears its ugly head to adversely affect entrepreneurship in America. When Congress was debating the Sarbanes-Oxley Act, no one was worried about accounting fraud at venture capital-backed companies. And no one anticipated the potential adverse effect of the law on our system of financing high-potential companies. Yet, after the law was implemented, its effects rippled through the economy, adversely affecting entrepreneurship in unintended ways.

What is the lesson here? Policy makers need to recognize the “fatal conceit” identified by Nobel Prize-winning economist Friedrich von Hayek. No matter how benevolent, intelligent, and farsighted policy makers might be, they cannot anticipate how markets will react to laws and regulation. Efforts to shape the economic system to fit the designs of policy makers inevitably result in unintended consequences. In the case of small business, this means that laws designed to solve unrelated problems often end up imposing unnecessary and counterproductive burdens on entrepreneurs and their businesses.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of Born Entrepreneurs, Born Leaders: How Your Genes Affect Your Work Life.

FURTHER READING: Shane explains “Why Small Business Owners Trust the Tea Party,” asks “Why Are There So Few Female Entrepreneurs?” and details “Why Small Businesses Aren’t Hiring.” AEI’s Kevin Hassett says a “Divided Washington Is What U.S. Economy Needs,” with Alan Viard notes “The Small Business Tax Hike and the 97 Percent Fallacy,” and says “ObamaCare Only Gets Worse Upon Further Review.”

Image by Rob Green/Bergman Group.

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