Are Small Businesses the Engine of Job Growth?

What do George W. Bush, Bill Clinton, Ronald Reagan and Barack Obama have in common (besides a conviction that the camera loves them)? They have all promoted the notion that small businesses are the engine of America’s economic growth. But new research shows that the role of small businesses has been overstated.

The Small Business Administration (SBA), an independent agency of the federal government, highlights the contributions that small businesses (defined as firms with fewer than 500 employees) make to the overall economy. According to an SBA publication, a major part of private-sector job generation takes place in the small-firm sector.

But according to recent studies, small-business employment has been misinterpreted for decades due to one critical issue: firm age. Newly formed firms have a disproportionate effect on net job growth, and many new companies are small.

But even that important distinction does not tell the whole story. Large firms play a key role in creating jobs and retaining employees.

A report by Goldman Sachs economist Kris Dawsey explains that comprehensive data tracking to account for firm age is now feasible. This data reveals “the process of young firms (which do tend to start out small) growing into larger firms is the true contributor to job growth.” Dawsey states that controlling for firm age also proves that “the vast majority of small firms start small and do not grow significantly.”

I will begin by explaining why small businesses have been and continue to be credited for contributing disproportionately to job growth. I will then look at the typical lifecycle of new, small firms and compare their economic value in terms of job creation to that of large mature, firms.

What started the misconception?

More than 30 years ago, academic David Birch became the first to publish a study1 that labeled small businesses as the engine of economic growth. Politicians and the business press have embraced this finding ever since. The SBA, in its publication noted above, goes as far as to praise Birch for discovering “that the end result of small businesses’ creative destruction was a net increase in employment.” Moreover, the SBA claims, this finding was “the seed for the small business employment discussion that continues to this day.”

Birch’s research proved to be provocative. Ittriggered an exponential rise in statements from politicians supporting small businesses. For instance, in 1982, President Ronald Reagan said that a “vigorous small business sector is essential to a productive and competitive economy. … Most of the new jobs actually created are in small private enterprises.”

Birch’s findings are plagued with statistical and measurement errors. These analytical inaccuracies were identified by John C. Haltiwanger, a research associate of the National Bureau of Economic Research and a senior research fellow at the Center for Economic Studies at the U.S. Census Bureau. Haltiwanger argued that Birch published his results when there was a lack of suitable data. For example, Birch’s findings were usually presented in terms of gross job creation, rather than in net terms, which is the more economically meaningful metric.

These numbers failed to account for the high job-destruction rate of small businesses. Birch’s conclusions inflated the economic value of small businesses in terms of job creation.

Thepositive corollary was that his claims inspired more studies on small business.We are now seeing that the research he prompted is disproving the results of his papers.

1. Birch, David L. (1979), The Job Generation Process. Cambridge, MA: MIT Program on Neighborhood and Regional Change.