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When Reducing Barriers Leads to More Failed Businesses

Wednesday, May 9, 2012

While you get more business formation if you reduce the barriers to starting companies, you don’t necessarily get more successful entrepreneurship.

During a speech to students at Otterbein University in Ohio last week, presumptive Republican presidential candidate Mitt Romney said, "We’ve always encouraged young people: Take a shot, go for it, take a risk, get the education, borrow money if you have to from your parents, start a business."

Democratic activists pounced on the comments, saying that Romney’s suggestion that students borrow from their parents to start companies shows that he is out of touch with the financial realities of most Americans.

In their haste to paint Romney as an out-of-touch rich guy, the Democrats missed the point. Romney was explaining why the government should let entrepreneurs reap the rewards of their success. (He was criticizing the president for “attacking success” when he made the statement.)

Romney believes that successful entrepreneurship involves solving problems. To get more of it, you need to give entrepreneurs an incentive to overcome obstacles.

Romney believes that successful entrepreneurship involves overcoming obstacles. To get more of it, you need to give entrepreneurs an incentive to overcome obstacles.

That means keeping taxes on entrepreneurs low. If you tax successful entrepreneurs heavily, then you lower the incentive to take the risk of starting a business. This point was well made by Romney’s economic advisor, Glenn Hubbard, in an interview with Columbia magazine in 2005. Professor Hubbard said that people will not take on the risk of starting businesses if the government takes a big chunk of their profits if they succeed, but does not share their losses if they fail.

President Obama disagrees. He believes that you will encourage more entrepreneurial success by reducing the obstacles to business formation. For example, he proposes reducing federal student loan payments to one-tenth of college graduates’ income because he thinks that high levels of student loan debt are deterring recent graduates from starting businesses.

President Obama’s logic is flawed. While you do get more business formation if you reduce the barriers to starting companies, you don’t get more successful entrepreneurship. Because entrepreneurship involves overcoming obstacles, you don't get successful entrepreneurs by making the process easy. Getting rid of obstacles just attracts more unsuccessful entrepreneurs.

Consider the ease of borrowing money. When banks made small business loans easy to get, as they were before the housing bubble burst, more people started companies than are doing so now that credit is tighter. The easy credit made it possible for people to start marginal businesses that they would not start now that credit is tight.

But it’s precisely because it’s easier to start marginal businesses that reducing the obstacles to entrepreneurship does not give you more successful entrepreneurship. Encouraging people to found more businesses unlikely to succeed just gives you more unsuccessful businesses.

When banks made small business loans easy to get, as they were before the housing bubble burst, more people started companies than are doing so now that credit is tighter.

Similarly, research shows that people who earn less are more likely to start businesses than people who earn more, because the former are giving up less to start their companies. However, those with lower opportunity costs generally start less successful businesses. The reason is simple: The less you are giving up to be an entrepreneur, the less potential your business idea has to have for you to be willing to pursue it.

Romney’s logic is sounder than the president’s. Allowing entrepreneurs to keep more of the profits from running their own businesses provides an incentive to overcome obstacles, like a lack of capital. If you tax entrepreneurs heavily, you reduce their incentive to overcome these obstacles and make them more likely to close down their companies, analysis by University of Tennessee Professor Donald Bruce shows. Increasing entrepreneurs’ taxes also makes them less inclined to grow their businesses, research by Robert Carroll, now of the Tax Foundation, and co-authors reveals.

While the real message here does not fit in a tweet like the pseudo issue does, the point is clear. Improving the payoff to overcoming obstacles to entrepreneurial success is a better approach to stimulating successful entrepreneurship than making it easier to become an entrepreneur.

Scott Shane is the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University.

FURTHER READING: Shane also writes “Why Aren’t Banks Lending to Small Business? Ask Bernanke,” “Getting Venture Capital Back on Track,” and “Equity Crowd Funding: A Good Idea Whose Time Is Now.” David Shaywitz contributes “Good Start-Up, Bad Corporation: The Cost of Trading Passion for Process.” Nick Schulz discusses “Steve Jobs: America's Greatest Failure.”

Image by Rob Green / Bergman Group

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