Description
This brief elucidation explores public policy and entrepreneurship joshua c. hall.
T H E C E N T E R F O R
APPLIED ECONOMICS
PUBLIC POLICY
AND
ENTREPRENEURSHIP
SCHOOL OF
BUSINESS
The University of Kansas
Suppor ti ng Regi onal Economi c Development thr ough Analysi s and Educati on
TECHNICAL REPORT 06-0717
July 2006
Joshua C. Hall
H.B. Earhart Fellow
Department of Economics
West Virginia University
Russell S. Sobel
Professor and
James Clark Coffman Distinguished Chair
Department of Economics
West Virginia University
About The Authors
Russell S. Sobel, Ph.D., is Professor of Economics and James Clark Coffman Distinguished Chair in
Entrepreneurial Studies at West Virginia University. He has authored or coauthored over 50 academic
books and articles, including a best-selling collegiate principles of economics textbook. Joshua C. Hall
is an H.B. Earhart Fellow in Economics at West Virginia University. A former staff economist for the U.S.
House’s Joint Economic Committee, he is author or co-author of several journal articles and over a
dozen policy reports.
About The Center for Applied Economics
The KU School of Business established the Center for Applied Economics in February of 2004. The
mission of the Center for Applied Economics is to help advance the economic development of the state
and region by offering economic analysis and economic education relevant for policy makers, commu-
nity leaders, and other interested citizens. The stakeholders in the Center want to increase the amount
of credible economic analysis available to decision makers in both the state and region. When policy
makers, community leaders, and citizens discuss issues that may have an impact on the economic
development potential of the state or region, they can benefit from a wide array of perspectives. The
Center focuses on the contributions that markets and economic institutions can make to economic
development. Because credibility is, in part, a function of economic literacy, the Center also promotes
economics education.
Abstract
Entrepreneurship is a primary catalyst for economic growth and regional development. Recognizing its
importance, state and local policymakers are now devoting considerable resources to fostering entre-
preneurship. After a brief discussion of the data and theories of entrepreneurship, this paper presents
a framework for thinking about government’s role in the entrepreneurial process. We then examine the
research on macro-level determinants of entrepreneurial activity and find that policies broadly consis-
tent with economic freedom, such as secure property rights, low taxes, and low regulations lead to a
robust entrepreneurial environment.
i
Table of Contents
1. Introduction ........................................................................................................... 1
2. The Definition and Measurement of Entrepreneurship ....................................... 2
2.1 What is an Entrepreneur?.............................................................................. 2
2.2 Entrepreneurial Success and Failure ............................................................. 2
2.3 Entrepreneurs and Wealth-Creation ............................................................. 3
2.4 Theories of Entrepreneurship........................................................................ 4
3. Inputs, Institutions, and Entrepreneurship ......................................................... 5
3.1 A Framework for Understanding the Entrepreneurial Process .................... 5
3.2 Entrepreneurship and Economic Growth ..................................................... 5
4. Factors Affecting Entrepreneurship...................................................................... 7
4.1 The Questionable Relevance of Liquidity Constraints .................................. 7
4.2 Government Loan Programs are Generally Ineffective ................................. 8
4.3 Regulation Limits Entrepreneurial Opportunities ........................................ 9
4.4 Taxes Distort the Decision to become an Entrepreneur ............................. 10
4.5 Institutional Quality and Economic Freedom Matter for Entrepreneurship11
5. Productive versus Unproductive Entrepreneurship ............................................ 12
6. Conclusion ............................................................................................................ 16
References .................................................................................................................. 17
ii
1
Some areas simply have more of this spirit channeled
toward wealth-enhancing private-sector entrepreneurship
than others. The central question then becomes identi-
fying what policies and incentives explain this difference
in the way entrepreneurial energies are channeled.
We begin first by providing an overview of the varying
definitions and theories of entrepreneurship, and discuss-
ing some of the issues involved in actually measuring the
rate of entrepreneurship. We then discuss the role of the
entrepreneur in economic development and growth, pro-
viding some estimates of the magnitude of this relation-
ship. Finally, we summarize the research on the factors
influencing the rate of entrepreneurship within a soci-
ety, making a distinction between entrepreneurial inputs
(like venture capital) and the policy environment (or
‘rules of the game’ like taxes and regulations).
Public Policy and Entrepreneurship
1. Introduction
Over the past two decades the focus of economic devel-
opment policy, and even of collegiate business programs,
has shifted more heavily toward entrepreneurship. This
increased interest in the entrepreneur’s role in the
economy has led to a growing body of research attempt-
ing to identify the factors that promote entrepreneurship.
This research has important implications for public
policy. Some theories of entrepreneurship, for example,
are based on the premise that there exists an “entrepre-
neurial spirit” that waxes and wanes for exogenous rea-
sons. If differences in “entrepreneurial spirit” are the
source of differences in entrepreneurship levels between
areas, then public policy can do little to foster it. Fortu-
nately, the evidence is clear that entrepreneurship is an
omnipresent feature of human nature. What differs
across areas is thus not the degree of underlying entre-
preneurial spirit but instead how that spirit is channeled.
2
2.1 What is an Entrepreneur?
One definition of an entrepreneur is someone who dis-
covers, evaluates, and exploits opportunities to create new
goods and services (Shane and Venkatamaran, 2000).
While few would disagree with such a general definition,
it is unclear if a person who opens an antique store should
be counted the same as someone like Sam Walton or Bill
Gates. If not, how do we draw a distinction? The lit-
erature has attempted to deal with this by differentiat-
ing between ‘lifestyle’ entrepreneurs and ‘gazelle’ (or ‘high
growth’) entrepreneurs. Lifestyle entrepreneurs open
their own businesses primarily for the non-monetary
benefits associated with being their own bosses and set-
ting their own schedules. Gazelle entrepreneurs often
move from one start-up business to another, with a well-
defined growth plan and exit strategy. While this dis-
tinction seems conceptually obvious, empirically
separating these two groups is difficult when we can’t
observe individual motives
Most applied economic research on entrepreneurship
uses the number of nonfarm self-employed individuals
as a share of the labor force as a measure of entrepreneur-
ship. This definition clearly includes the lifestyle entre-
preneurs too, as well as some individuals who do
part-time work outside their regular jobs. As an alter-
native, some research has used measures of the number
of new business firms, or patent activity, to isolate only
gazelle entrepreneurs.
2.2 Entrepreneurial Success and
Failure
Entrepreneurship is important because it is the competi-
tive behavior of entrepreneurs that drives the market
process and thereby leads to economic progress (Kirzner
1973). Entrepreneurs are always in search of new pos-
sible combinations of resources. A vibrant entrepreneur-
ial climate maximizes the number of new combinations
attempted. Some of these combinations will, however,
not be good ideas. In a market economy, it is the profit
and loss system that is used to sort through these new
resource combinations discovered by entrepreneurs, dis-
carding bad ideas through losses and rewarding good
ones through profits. A growing, vibrant economy thus
depends not only on entrepreneurs discovering, evalu-
ating, and exploiting opportunities to create new goods
and services but also on the speed at which ideas are la-
beled as failures or successes. Economics has long held
that business failure has a positive side, as it gets rid of
the bad ideas and frees up those productive resources for
use by other entrepreneurs. A vibrant economy will have
both a lot of new business start-ups and a lot of business
failures. Minimizing business failures should not be a
goal of public policy. If we are to maximize the number
of new combinations attempted, we will witness lots of
failures. This is a simple result of the uncertainty in-
volved in knowing whether a new idea will meet the
market test or not.
A point worth clarifying is that it is much better to have
a decentralized profit and loss system sorting through
these combinations than a public sector decision-mak-
ing process. The reason why is that the incentives facing
public officials are very different than the incentives fac-
ing venture capitalists and entrepreneurs. While each
venture capitalist and entrepreneur brings different mo-
tivations to the table, ultimately their success or failure
is determined by whether their idea generates wealth. The
same is not true for public officials in charge of handing
out tax incentives or low-interest loans as they may have
other concerns beyond creating wealth. For example,
officials have incentives to be concerned about where a
new business is located in order to maximize political
support.
The distortions associated with government intervention
into entrepreneurial decisions are not trivial. The eco-
nomic analysis of public decision-making suggests
policymakers will choose courses of actions that have
clearly defined benefits with little regard to the long-run
costs or benefits (Buchanan and Tullock, 1962; Weingast,
Shepsle and Johnsen, 1981). One example is that press
releases are issued triumphing the number of new jobs
2. The Definition and Measurement of
Entrepreneurship
3
created when tax incentives are granted but rarely does
anyone follow up to see if the jobs are ever created. When
outside observers do, they usually find that the results
have no effect on growth. Gabe and Kraybill (2002)
studied the impact of tax incentives offered through the
Ohio Department of Development and found, after con-
trolling for other factors, that firms receiving tax incen-
tives to expand actually had 10.8 fewer jobs at the end
of two years. In addition to concluding that tax incen-
tives do not lead to employment growth, they find that
tax incentives do have a positive effect on announced job
growth. They suggest that firms drastically overestimated
future job growth in an effort to win tax incentives and
that public officials did little to verify the accuracy of
estimated employment growth since they benefited from
increased “bragging rights.”
This does not mean that venture capitalists and entre-
preneurs do not err. Obviously they do. For example,
Ken Olson, president, chairman and founder of Digital
Equipment Corporation, who was at the forefront of
computer technology in 1977, stated: “There is no rea-
son anyone would want a computer in their home.”
Today that sounds funny simply because we all have com-
puters in our homes, but even those in the infant com-
puter industry didn’t see this coming. An even better
example might be the story of Fred Smith, the founder
of Federal Express Corporation. He actually wrote the
business plan for FedEx as his senior project for his stra-
tegic management class at Yale. While we all know what
eventually happened in retrospect, the Yale professor, one
of the leading experts on business strategy wrote on his
paper: “The concept is interesting and well-formed, but
in order to earn better than a ‘C,’ the idea must be fea-
sible.”
The point? Even smart professors, business leaders, and
government officials cannot possibly pre-evaluate busi-
ness ideas and pick those that will be most successful from
those that will fail. A thriving economy depends on the
ability of individual entrepreneurs to try their own ideas,
without approval from anyone else, and then let the profit
and loss mechanisms of the marketplace answer this
question once the product is developed.
2.3 Entrepreneurs and Wealth-
Creation
It is important to recognize that from society’s perspec-
tive the profits earned by entrepreneurs represent gains
to society as a whole. Because entrepreneurs must bid
resources away from alternative uses, production costs
reflect the value of those resources to society in their
alternative uses. Thus, profit is only earned when an en-
trepreneur takes a set of resources and produces some-
thing worth more to consumers than the other goods that
could have been produced with those resources. A loss
happens when an entrepreneur produces something that
consumers do not value as highly as the other goods that
could have been produced with those same resources. For
example, an entrepreneur who takes the resources nec-
essary to produce a fleece blanket sold for $50 and in-
stead turns them into a pullover that sells for $60 has
earned a $10 profit. Since the price of the resources used
by entrepreneurs reflect the opportunity cost of their
employment in other uses, the $10 profit generated by
the entrepreneur reflects the amount by which they have
increased the value of those resources. By increasing the
value created by our limited resources, entrepreneurs
increase the overall level of wealth.
Successful entrepreneurship thus expands the size of the
economic pie by allowing us to generate more wealth
from our limited resources. Sam Walton, the founder
of Wal-Mart, was an innovator in distribution warehouse
centers and inventory control. His innovations in these
areas are what allowed Wal-Mart to grow from one store
in Arkansas to the largest retail chain in the world in fewer
than thirty years. Consumers benefit in numerous ways
from his innovations including lower prices and increased
product variety. However, the business failures that re-
sult from Wal-Mart’s better ability to please consumers
also result in net gains to society. The resources they
consumed are now freed up to go into other new entre-
preneurial businesses. Many downtown retail areas rav-
aged by Wal-Mart store openings subsequently turn into
thriving cultural districts, with coffee shops, art galler-
ies, and other types of businesses that could have never
have competed for that downtown retail space with the
general retail stores that used to need to locate there. The
4
entrepreneurial efforts of Walton and other entrepreneurs
such as Microsoft’s Bill Gates, CNN’s Ted Turner, and
McDonald’s Ray Kroc have improved the quality of life
for billions of people all over the world.
2.4 Theories of Entrepreneurship
1
The word entrepreneur originates from a 13
th
-century
French verb, entreprendre, meaning “to do something”
or “to undertake.” By the 16th century, the noun form,
entrepreneur, was being used to refer to someone who
undertakes a business venture. The first academic use
of the word by an economist was in 1730 by Richard
Cantillon, who identified the willingness to bear the
personal financial risk of a business venture as the defin-
ing characteristic of an entrepreneur. In the early 1800s,
economists Jean Baptiste Say and John Stuart Mill fur-
ther popularized the academic usage of the word “entre-
preneur.” Say stressed the role of the entrepreneur in
creating value by moving resources out of less produc-
tive areas and into more productive ones. Mill used the
term “entrepreneur” in his popular 1848 book, Principles
of Political Economy, to refer to a person who assumes
both the risk and management of a business. In this
manner, Mill provided a clearer distinction than
Cantillon between an entrepreneur and other business
owners (such as shareholders of a corporation) who as-
sume financial risk, but do not actively participate in the
day-to-day operations or management of the firm.
Building on Cantillon and Mill, Frank Knight (1921)
emphasized that entrepreneurs deal with uncertainty
about the future, not with risk. Probabilities can be esti-
mated for risky activities and thus are insurable. Entre-
preneurs, however, are dealing with uncertainty about the
profitability of their new combinations of resources.
Since entrepreneurs cannot insure against the probabil-
ity that new goods and services will not be liked, entre-
preneurs bear the burden of the uncertainty associated
with the market process. While Knight makes some im-
portant points with respect to the bearing of uncertainty,
his work has been overshadowed by the research of two
other economists, Joseph Schumpeter and Israel Kirzner
who greatly advanced our understanding of the role of
the entrepreneur.
Schumpeter ([1911] 1934) stressed the role of the en-
trepreneur as an innovator. To Schumpeter, an entrepre-
neur is someone who carries out new combinations of
resources to create products that did not exist previously.
The result of these new combinations would be entirely
new industries that open up considerable opportunities
for economic advancement. From a Schumpeterian view,
the entrepreneur is a disruptive force in an economy
because the introduction of these new combinations leads
to the obsolescence of others, a process he terms ‘creative
destruction’. The introduction of the compact disc, and
the corresponding disappearance of the vinyl record,
is just one of many examples of this process. Cars, elec-
tricity, aircraft, and personal computers are others.
Schumpeter viewed this disequilibration as a beneficial
byproduct of innovation.
Kirzner’s (1973) view of entrepreneurship stands in stark
contrast to Schumpeter’s. Instead of focusing on the
disequilibrating role of innovation, Kirzner views entre-
preneurship as an equilibrating force in which entrepre-
neurs discover previously unnoticed profit opportunities
and act on them. Thus Kirzner’s entrepreneur initiates
changes that move markets towards equilibrium. An ex-
ample of such an entrepreneur would be someone in a
college town who discovers that a profit opportunity has
arisen in renovating houses and turning them into rental
apartments because of a recent increase in college enroll-
ment.
Entrepreneurship encompasses all of these functions.
Entrepreneurs take on risk, they innovate, but they also
engage in mundane activities such as arbitraging between
areas of high and low demand. The thing that all entre-
preneurs have in common is the desire to discover and
exploit profit opportunities.
1
This section draws heavily from Russell S. Sobel, “Entrepreneurship,” in David R. Henderson (ed), The Concise Encyclopedia
of Economics, Indianapolis, Indiana: Liberty Fund, Inc., forthcoming.
5
3.1 A Framework for
Understanding the
Entrepreneurial Process
To begin to think more carefully about how might be
the best ways for government policy to foster entrepre-
neurship, it is important to understand the process by
which entrepreneurial outcomes are generated. This is
illustrated in Figure 1.
Figure 1 helps to categorize our thinking on the process
of entrepreneurship. Economic inputs and resources,
such as venture capital and resource availability, are con-
verted into entrepreneurial outcomes (new businesses
created or patents issued). However, the amount of en-
trepreneurial outcomes generated from a given amount
of economic inputs depends primarily on the rules of the
game, or public policies, under which entrepreneurs
operate. This model makes it clear that increasing en-
trepreneurship can be accomplished either by increasing
the inputs into the process, or by improving the rules of
the game for entrepreneurs. It is important to note, how-
ever, that when the rules of the game are unfavorable,
increasing inputs might have little impact on the amount
of entrepreneurial outcomes.
3.2 Entrepreneurship and
Economic Growth
Entrepreneurship is important because it is a key factor
contributing to economic growth, the ultimate outcome
of entrepreneurial efforts. Figure 2 shows the strength of
3. Inputs, Institutions, and Entrepreneurship
Figure 1. The Entrepreneurial Process
Examples:
Venture Capital Availability
Skilled Labor Force
Technology & Infrastructure
Resource Availability
Examples:
Tax Burdens
Business Regulations
Legal/Judicial System
Economic Freedom
Examples:
New Business Formation
Patents Issued
New Goods and Services
6
this relationship across countries taken from the Global
Entrepreneurship Monitor.
Empirical research finds that a substantial portion of the
variation in economic growth rates can be explained by
differing rates of entrepreneurship. Reynolds, Hay, and
Camp (1999), for example, show that different rates of
entrepreneurship account for one-third of the difference
in national economic growth rates, while Zacharakis,
Bygrave, and Shepherd (2000) find that it can explain
approximately half of the difference. This relationship
has held up to testing both among subsets of, and inter-
nally within, these countries as well. Ovaska and Sobel
(2005) find that differing rates of entrepreneurship ex-
plain the divergent economic paths followed by the
former Soviet republics. Berkowitz and DeJong (2005)
find a strong relationship between economic growth
within a country over time and the rate of entrepreneur-
ial activity within that country. Kreft and Sobel (2005)
find this relationship to be true across U.S. states, and
Henderson (2002) finds it to hold at the local level within
the United States.
Figure 2. Entrepreneurship and Economic Growth: International GEM Findings
Source: Figure 6 from Global Entrepreneurship Monitor (2004).
R = 0.37
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10.000
15.000
20.000
25.000
30.000
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PERCENT GROWTH IN GDP, LOCAL CURRENCY, CONSTANT PRICES
T
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7
Clearly entrepreneurship is vital for economic growth.
But what can government policy do to promote it? This
section reviews the existing literature on how both eco-
nomic inputs and public policy impact entrepreneurial
outcomes in a society.
4.1 The Questionable Relevance of
Liquidity Constraints
One factor impacting an individual’s decision on whether
or not to become an entrepreneur might be the availabil-
ity of funding to implement their vision. In our frame-
work, this would be one of the economic inputs to the
entrepreneurial process. While some individuals may
have enough personal wealth to start their own business,
most must secure outside financing. The issue, however,
is that many entrepreneurs may lack the ability to secure
this outside financing, even in cases where the venture
would be highly successful. Thus worthwhile projects
may not get undertaken solely because of these ‘liquid-
ity constraints’. While it is easy to think of theoretical
reasons why individuals may face liquidity constraints
even in well-functioning markets (Stiglitz and Weiss
1981), it is ultimately an empirical question if liquidity
constraints are actually a binding constraint holding back
entrepreneurship.
The issue of liquidity constraints is very important be-
cause much of current entrepreneurship policy is predi-
cated on the idea that potential entrepreneurs face
significant liquidity constraints. The justification for the
Small Business Administration, for example, is that po-
tential entrepreneurs face barriers to capital and that
government grants and subsidies can spur socially pro-
ductive entrepreneurship.
A large number of studies have tested for the presence
of liquidity constraints and the results have been some-
what mixed. One of the most prominent studies on li-
quidity constraints is Holtz-Eakin, Joulfaian and Rosen
(1994b). Because every sole proprietor files a “Schedule
C” on their tax return, they use data from the Internal
Revenue Service to examine who became a sole propri-
etor between 1981 and 1985. To test the importance of
liquidity constraints on the decision to become an en-
trepreneur they looked at the role of inheritances on the
decision to become an entrepreneur. The idea is if indi-
viduals are liquidity constrained, the influx of capital
from an inheritance should increase their propensity to
become an entrepreneur, other things being equal. They
find an inheritance of $100,000 would increase the prob-
ability of an individual transitioning to entrepreneurship
from 19.3 percent to 22.6 percent. An important fea-
ture of their data that they were able to separate out those
individuals who become entrepreneurs because they in-
herit businesses from those who become entrepreneurs
because the inheritance helps them to overcome a liquid-
ity constraint. Their research is clearly consistent with
the presence of liquidity constraints, although it says
nothing about the quality of the entrepreneurial activi-
ties undertaken by the liquidity constrained versus those
who were not liquidity constrained. After all, maybe the
individuals with the least access to capital are those whose
ideas have the lowest probability of future payoff.
Holtz-Eakin and Rosen (2005) find that both U.S. and
German entrepreneurs face liquidity constraints and that
lower access to capital in Germany explains a significant
portion of the difference in observed self-employment
rates between the countries. Evans and Jovanovic (1989)
discuss how inadequate access to capital deters individu-
als from pursuing self-employment. From their data set
they estimate that liquidity constraints deter about 1.3
percent of the population from pursuing self-employ-
ment during the period studied. This is significant con-
sidering that the percentage of the population becoming
self-employed in their study was only 3.8 percent. The
implication is that removal of the liquidity constraints
facing would-be entrepreneurs would increase the rate
of entrepreneurship by about one-third.
In an important recent paper, Hurst and Lusardi (2004)
find that inheritances are more than a proxy for liquid-
ity. They find evidence that future inheritances predict
past entrepreneurship, meaning that inheritances are
probably a proxy for something other than liquidity con-
straints that is related to the probability of self-employ-
4. Factors Affecting Entrepreneurship
8
ment. Thus inheritances are probably a poor instrument
to test liquidity constraints. Instead they suggest using
gains in housing value as an instrument for increases in
liquidity, since housing appreciation varies by region and
affects a larger segment of the wealth distribution. This
link should be strong as the vast majority of new small
businesses are opened with bank financing secured by the
entrepreneur through loans against the value of their
house. Hurst and Lusardi find that households in areas
with strong housing appreciation are no more likely to
start businesses than households in areas with no hous-
ing appreciation. Thus, they argue, the relationship be-
tween wealth and entrepreneurship is flat over most of
the wealth distribution and only increases at the high end.
Hurst and Lusardi argue that business ownership is a
luxury good and that wealthy individuals start business
to gain power and flexibility over their work schedules
and activities. This is consistent with research by
Hamilton (2000) showing the non-pecuniary returns to
business ownership are high. More importantly, Hurst
and Lusardi conclude that:
…even if some households that want to start
small businesses are currently constrained in
their borrowing, such constraints are not empiri-
cally important in deterring the majority of
small business formation in the United States.
This may simply reflect the fact that the start-
ing capital required for most businesses is suffi-
ciently small. We provide evidence to this effect
throughout the paper. Alternatively, even if the
required starting capital for some small busi-
nesses is high, existing institutions and lending
markets in the United States appear to work
sufficiently well at funneling funds to house-
holds with worthy entrepreneurial projects. (p.
321-322)
Thus, they argue that liquidity constraints are not a major
deterrent to entrepreneurship, although their data does
not allow them to test whether or not business start-ups
are insufficiently capitalized due to liquidity constraints.
There are two important things to come out of the Hurst
and Lusardi (2004) paper. First, it provides a reason why
the relationship observed between wealth and the prob-
ability of self-employment found in many studies (Evans
and Jovanovic 1989; Evans and Leighton 1989; Fairlie
1999; Gentry and Hubbard 2001) might not be evidence
of liquidity constraints but instead could reflect self-
employment as a luxury good. Second, this paper dem-
onstrates why using inheritances to test for the presence
of liquidity constraints, as Holtz-Eakin, Joufainin and
Rosen (1994a, 1994b) do, may be problematic. More
research is needed on the presence of liquidity con-
straints, but Hurst and Lusardi (2004) provide some rea-
son to think that liquidity constraints are not a relevant
impediment to starting a new business.
4.2 Government Loan Programs
are Generally Ineffective
The experience with government subsidized loan pro-
grams also suggests that liquidity constraints are not a
significant impediment to entrepreneurial activity (Taub
2004). In addition, these programs can create a host of
other problems and are generally subject to manipula-
tion by powerful politicians and lobby groups. Lerner
(1999) finds that the presence of Small Business Inno-
vation Research (SBIR) funding alone had little relation-
ship with sales and employment growth except in a few
small geographic areas already dominated by private ven-
ture capital and a thriving high-tech sector. In the vast
majority of other areas he concludes that distortions in
the award process may have led to the selection of firms
that really could not benefit from the funds. In addi-
tion, firms receiving multiple awards, or large awards,
actually performed worse than other firms. He con-
cludes, “additional awards appear to have had minimal
positive benefits, and the pursuit of these awards may
even have had detrimental effects on the firms.” (Lerner
1999, pp. 312).
A Micrometrics (2002) evaluation of the Oklahoma Pro-
gram for State-sponsored Venture Investing, for example,
finds that the fund not only has high administrative costs,
but it was also ineffective in drawing additional private
equity and venture capital into the state, showed a re-
turn significantly less than half of the national average
for private venture funds, and generated relatively little
investment capital for startups in the state. Studies of
the effectiveness of particular state venture funds are far
9
and few between primarily because, according to Bartik
and Bingham (1997), program administrators fear the
political consequences of a negative evaluation, and by
not doing an evaluation it is easier to claim success. A
study of the economic development programs of the Il-
linois Department of Commerce and Community Af-
fairs (DCCA) in 1989 by the Illinois Auditor General
showed widespread poor management of loan and grant
programs and also found that officials with these pro-
grams had vastly overstated the true impact of the pro-
grams in their internal reports.
One explanation for the ineffectiveness of government
loan programs comes from Taub (2004) who shows that
state subsidized business loan programs simply cannot
provide the managerial and technical support entrepre-
neurial companies need. Private venture funds on the
other hand, not only provide this support but frequently
require the firm to take this support as a condition of
receiving private venture funding. Yet another explana-
tion for the ineffectiveness of government loan programs
comes from Cohen and Noll (1991) and Wallsten (2000)
who conclude that government funding agencies tend to
select firms based on their likelihood of success, regard-
less of whether government funds are needed, simply so
they can claim credit for the firm’s eventual success.
Eisinger (1998) points out that under such programs,
firms actively devote efforts to securing subsidies that
directly increase their profits, but have no impact on
eventual business success. With government agencies
continually pressured to show successes to receive future
funding, they too often invest in firms who would have
been successful without government funding.
Studies such as Lerner (1999) and Carsey, Rundquist,
and Fox (1997) additionally show that public officials
put significant pressure on SBIR and other government
grant-making agencies to fund companies in their dis-
trict, and attempt to ensure loans to particular areas to
secure congressional support on legislation. Even the
government’s own evaluations of these loan programs
(US GAO 1992) suggests that a few large companies
capture a disproportionate share of awards each and ev-
ery year. Many of these “SBIR mills,” as they are known,
have staffs in Washington that focus on helping to se-
cure the political support for the grants, and studies show
that these firms appear to commercialize projects at a
significantly lower rate than other firms who don’t re-
ceive government funding (Lerner 1999). The large share
of funds going to these few politically connected firms
even led to the passage of new federal legislation attempt-
ing to put additional criteria on funding for firms who
had received awards in the past (Lerner 1999).
Other studies, such as Levy and Terleckyj (1983), Irwin
and Klenow (1996) and Wallsten (2000) have also found
that firms receiving government funds respond by reduc-
ing their own private R&D spending, leading many to
question whether government funds have any positive
impact at all on overall total R&D spending. Wallsten
(2000), for example, finds that SBIR grants simply crowd
out firm-financed R&D spending dollar for dollar. Per-
haps the most striking evidence is that the U.S. states with
the largest levels and increases in SBIR grants have shown
little improvement in their rates of entrepreneurial ac-
tivity.
Government loan programs, or attempts to create pub-
lic venture funds are generally ineffective because they
tend to put ‘the cart before the horse.’ Recent research
by Kreft and Sobel (2005) tests for the direction of cau-
sality between venture capital and entrepreneurial activ-
ity. Their results show that exogenous increases in venture
capital within a state do not increase the overall rate of
entrepreneurship, but rather it is those states with the
highest underlying entrepreneurial activity that attract the
most venture capital. Thus, new ideas easily draw ven-
ture funding. Because capital is significantly more mo-
bile than labor, and because venture capital firms spend
enormous resources hunting out potential new ventures
to invest in, there simply are very few cases where prof-
itable entrepreneurial ventures go unfunded. Venture
capital will naturally and automatically flow to those areas
with more entrepreneurial ideas.
4.3 Regulation Limits
Entrepreneurial Opportunities
We now turn to the impact of government imposed regu-
lations on the level of entrepreneurship, a shift from fo-
cusing on entrepreneurial inputs to focusing on the rules
of the game set by government policy. While it is diffi-
cult empirically to determine the effect of regulation on
10
the decision to become an entrepreneur, there is some
evidence that certain types of regulation inhibit entre-
preneurship. Holtz-Eakin and Rosen (2005) find
evidence that at least part of the difference in entrepre-
neurship rates between Germany and the United States
can be explained by differences in regulatory environ-
ment that discourage individuals from transitioning from
wage to self-employment.
Kanniainen and Vesala (2005), using panel data on
OECD countries, find that labor market regulations
explain differences in the rate of enterprise formation
between countries. They utilize several different defini-
tions of labor market regulations and find that all of them
have a negative impact on the self-employment rate in a
country. For example, high unemployment compensa-
tion increases the opportunity costs of becoming self-
employed. Their measures of labor market regulations
include measures of unemployment compensation, em-
ployee protection, labor union power, trade union den-
sity, the bargaining coverage rate, and the centralization
of wage bargaining in the country.
Benson (2004) notes how regulations introduce errors
into markets because they divert entrepreneurial energy
toward circumventing new regulations and away from
society-benefiting innovations that might have otherwise
occurred. Another type of labor market regulation is
minimum wage laws. Garrett and Wall (2005) find evi-
dence that minimum wage laws deter entrepreneurship.
Minimum wage laws affect the probability to start a small
business because the majority of small businesses rely
heavily on low-wage workers. Thus mandated minimum
wages might make some types of new small businesses
artificially unprofitable.
One reason why entrepreneurship is stifled in develop-
ing countries is because often starting a new business
requires navigating a several-year long process that in-
volves layers of government officials who must think that
the idea is worthwhile before an entrepreneur can get the
go ahead to open their new business (de Soto 2000).
Although far less onerous, regulations throughout the
United States prevent entrepreneurs from satisfying con-
sumer wants. A recent study on the barriers to entrepre-
neurship in Minnesota highlights the extent to which
regulations prevent potential entrepreneurs from realiz-
ing their goals (Dranias 2006). In Minneapolis, for ex-
ample, it is illegal to hang signs without a license and
licenses can take from one to twelve months to receive,
if granted at all. Potential manicurists have to undergo
350 hours of training to receive a license, nearly double
the training required of paramedics in the state. Barbers,
plumbers, and taxi cab drivers are other potential entre-
preneurial occupations where onerous regulations above
minimal safety requirements protect incumbent interests
at the expense of consumers. The pattern documented
in Minnesota by Dranias (2006) exists throughout the
United States and regulations such as these stifle produc-
tive entrepreneurial efforts, and instead encourage
individuals to spend time simply attempting to get per-
missions, satisfy regulations, and filling out onerous gov-
ernment paperwork.
4.4 Taxes Distort the Decision to
become an Entrepreneur
Taxation matters for entrepreneurship because it lowers
the reward earned by entrepreneurs from opening a new
business venture. In this manner, higher taxes unambigu-
ously deter entrepreneurship. This relationship, however,
is virtually impossible to quantify because self-employ-
ment is one of the best ways to avoid or evade taxation.
Areas with high taxes generally have higher rates of self-
employment, not because taxes encourage entrepreneur-
ship per se, but rather because of the flexibility in realizing
or hiding income that self-employment affords individu-
als. Also, income taxes could artificially stimulate
entrepreneurship as individuals shift away from wage
work, which is taxed, to self-employment that also pro-
vides significant personal non-pecuniary returns (like
more flexible working hours, etc.) which are untaxed
(Hamilton 2000).
Research on the effect of taxes on self-employment gen-
erally finds that the evasion effect dominates in the em-
pirical data. Higher taxes drive a large number of people
into self-employment as a way of avoiding high taxes on
wages and salaries (Bruce 2000, Schuetze 2000, Bruce
2002). However, it is important to note that this avenue
through which taxes increase entrepreneurship is strictly
welfare reducing for society as a whole.
11
4.5 Institutional Quality and
Economic Freedom Matter
for Entrepreneurship
The publication of the Economic Freedom of the World
index, by James Gwartney and Robert Lawson (2004),
has significantly advanced our understanding about the
continuum of ‘economic freedom’ that exists around the
world. They derive a single index measure for each coun-
try that places them on a spectrum from zero to ten,
in which ten represents the highest degree of ‘economic
freedom’, or reliance on laissez-fare capitalism. Because
state and local policies also impact the degree of ‘eco-
nomic freedom’, authors Amela Karabegovic and Fred
McMahon (2002) released their Economic Freedom of
North America, ranking U.S. states and Canadian prov-
inces with respect to each other in terms of their degree
of free-market orientation. Generally these indexes at-
tempt to condense into a single number the degree of
economic freedom individuals have in a geographic area
in several key categories such as taxation, regulation, and
property rights. Studies using these indices such as Farr,
Lord, and Wolfenbarger (1998) and Gwartney, Lawson,
and Holcombe (1999) have consistently shown that
countries with higher economic freedom scores not only
have larger per capita incomes, but also tend to have
higher rates of economic growth.
12
One strand of literature suggests that entrepreneurship
causes the majority of economic growth, while the other
suggests that the quality of prevailing institutions causes
the majority of economic growth. Can these two seem-
ingly separate ‘fundamental’ explanations for economic
growth be synthesized? Baumol’s (1990) theory of ‘pro-
ductive and unproductive entrepreneurship’ provides the
answer. His theory is founded in the idea that the level
of underlying entrepreneurial spirit is fairly constant
across people and regions. This multitude of entrepre-
neurs, however, exploits profit opportunities not only
within private markets but also within the political and
legal arenas. Thus, differences in measured rates of pri-
vate sector entrepreneurship are due to the different di-
rections entrepreneurial energies are channeled by
prevailing economic and political institutions, through
the rewards and incentive structures they create for en-
trepreneurial individuals.
In areas with institutions providing secure property
rights, a fair and balanced judicial system, contract en-
forcement, and effective limits on government’s ability
to transfer wealth through taxation and regulation, cre-
ative individuals are more likely to engage in productive
market entrepreneurship—activities that create wealth
(e.g. product innovation). In areas without strong insti-
tutions, these same individuals are instead more likely
to engage in attempts to manipulate the political or le-
gal process to capture transfers of existing wealth through
unproductive political and legal entrepreneurship—ac-
tivities that destroy wealth (e.g. lobbying and lawsuits).
This reallocation of effort occurs because the institutional
structure largely determines the relative personal and fi-
5. Productive versus Unproductive
Entrepreneurship
Figure 3. Economic Freedom and Entrepreneurship in OECD Countries, 2002
Sources: Global Entrepreneurship Monitor (2004) and Economic Freedom of the World: 2004 Annual Report (2004).
0
2
4
6
8
10
12
14
16
6.0 6.5 7.0 7.5 8.0 8.5
Economic Freedom Index (EFW)
)
A
E
T
(
x
e
d
n
I
y
t
i
v
i
t
c
A
l
a
i
r
u
e
n
e
r
p
e
r
t
n
E
13
structure as measured by economic freedom, however,
which promotes productive, wealth-generating entrepre-
neurial activity which is the source of economic growth
(Ovaska and Sobel 2005; Kreft and Sobel 2005).
The strength of this relationship between economic free-
dom and entrepreneurship is illustrated in Figures 3 and
4. Figure 3 shows the relationship, for OECD countries,
between their levels of economic freedom and entrepre-
neurship (as measured by the Global Entrepreneurship
Monitor score for Total Entrepreneurial Activity, TEA).
In Figure 3, it is clear that those countries with the most
broadly constrained and limited governments (those with
the highest freedom scores) have the most entrepreneur-
ship. In those nations where governments are involved
to the greatest extent through taxes, subsidies, property
takings, and regulations, entrepreneurship is lowest. This
relationship also holds among the U.S. states as is illus-
trated in Figure 4.
nancial rewards to investing entrepreneurial energies into
productive market activities versus investing those same
energies instead into unproductive political and legal
activities. For example, a steel entrepreneur might react
to competition by trying to either find a better way of
producing steel (productive entrepreneurship), or by lob-
bying for subsidies, tariff protection, or filing anti-trust
lawsuits against competitors (unproductive entrepreneur-
ship).
The index of economic freedom measures precisely those
institutional structures that should lower the return to
unproductive entrepreneurship, promoting productive
entrepreneurship over unproductive entrepreneurship.
Thus, underlying economic freedoms generate economic
growth because they more heavily promote productive en-
trepreneurial activity, which is the source of economic
growth. Both sets of literature are indeed correct, eco-
nomic freedom and entrepreneurship are both highly
correlated with economic growth. It is the institutional
Figure 4. State Economic Freedom and Growth of Entrepreneurial Activity
Sources: State and Local Area Data (2006) and Economic Freedom of North America: 2002 Annual Report (2002).
0%
5%
10%
15%
20%
25%
30%
5.5 6.0 6.5 7.0 7.5 8.0
Economic Freedom Index
S
o
l
e
P
r
o
p
r
i
e
t
o
r
s
h
i
p
G
r
o
w
t
h
R
a
t
e
14
While this area of research on how good institutions
channel entrepreneurial energies into productive wealth-
enhancing activities is relatively new, it has found some
interesting results. For example, while government
funded entrepreneurial education programs in K-12 edu-
cation have almost all been discontinued or cut due to
their lack of proven success, Sobel and King (2005) have
found that the adoption of school choice programs, that
reduce government involvement in schooling, are hav-
ing a large positive impact on increasing youth entrepre-
neurship, simply because young adults are going to
school each day in an environment that is more entre-
preneurial and competitive than traditional public
schools. Witnessing their teachers and school adminis-
trators being more innovative and entrepreneurial on an
every day basis seems to have a large impact on students’
likelihood of becoming entrepreneurs.
To grow richer, states and nations need more productive
entrepreneurship and less unproductive entrepreneur-
ship. The specific reforms necessary are those that: (a)
increase the relative reward to productive market entre-
preneurship, and/or (b) decrease the relative reward to
unproductive political and legal entrepreneurship. A
reduction in state corporate income taxes or a reduction
in regulatory barriers for new entrepreneurs would be
ways to accomplish (a). The reward to unproductive
entrepreneurship can be reduced through reforms that
increase the security of private property rights, create a
fairer and more balanced judicial and liability system,
strengthen contract enforcement, lessen government
“pork-barrel” spending, and more effectively limit
government’s ability to transfer wealth through taxation,
regulation, and subsidies. Here is a list of specific pro-
grammatic reforms, based on Baumol’s theory of produc-
tive and unproductive entrepreneurship, which could
accomplish these goals. All of these reforms either lower
the reward to political/legal entrepreneurship or increase
the reward to productive market entrepreneurship. Those
that are also explicitly part of the Economic Freedom of
North America Index calculation are denoted by
[EFNA]. Thus, reform-minded policymakers could:
reduce state corporate income taxes [EFNA];
reduce state personal income taxes [EFNA];
eliminate state turnover, business, or occupation
taxes [EFNA];
reform workers compensation through
privatization or tougher rule enforcement
[EFNA];
reform medical malpractice;
reform the judicial system to minimize the ef-
fect of politics and electoral pressures;
eliminate state minimum and maximum price
and wage limits and restrictions [EFNA];
enact constitutional limits on public land tak-
ings such as eminent domain;
reduce occupational licensing requirements;
reduce government employment and public
ownership of resources (such as land holdings),
freeing these resources to be employed in the
private sector [EFNA];
simplify the tax code to reduce the ability of (and
incentive for) groups to lobby for exemptions
and credits;
and, reduce the returns to lobbying through leg-
islative reform that makes it more difficult to
pass pork-barrel legislation.
As one will notice by looking at this list, the real contri-
bution of recent economic theory, as presented in Fig-
ure 1, which depicts the entire entrepreneurial process,
is that it shifts attention toward institutional reform as
the way to promote entrepreneurship. This is a rather
large change in thinking given the conventional wisdom
in the 1990s, which advocated promoting entrepreneur-
ship through enacting additional public sector education
programs, subsidies, and interventions in venture capi-
tal markets. Given the ever continuing search for new
ways to promote entrepreneurship, institutional theory
and its policy implications could potentially form the
foundation of 21
st
century economic development policy.
After all, good institutional reforms have already allowed
countries such as Ireland to greatly increase its rate of
economic growth, and as well as some of the former
Soviet republics such as Estonia. At the same time, states
15
like West Virginia, whose economic freedom ranks lower
than that of Estonia, have struggled economically and
will continue to do so without significant institutional
reform.
The policy implications are clear; rather than focusing
on expanding government programs like subsidized
loans, workforce education, or programs aimed at in-
creasing ‘entrepreneurial inputs’ as a way to foster entre-
preneurship, the better path is through institutional
reform that increases the return to productive entrepre-
neurship and lowers the return to unproductive entre-
preneurship. Government-sponsored programs too often
encourage entrepreneurial individuals to devote effort
toward figuring out how to obtain public funds and
transfer payments, rather than devoting those efforts to-
ward satisfying consumers and creating wealth.
6. Conclusion
The importance of entrepreneurship to job creation and
economic growth is clearly not lost on policymakers. The
rise in state venture capital programs, targeted small busi-
ness subsidies, and other forms of aid to those interested
in starting new businesses is abundant evidence that
policymakers understand the importance of entrepre-
neurship to economic development. An increasing
amount of economic evidence, however, indicates that
such an ad hoc programmatic approach to promoting
entrepreneurship is not effective. Policymakers can cre-
ate more success for their stakeholders if they instead
focus on institutional reforms that increase economic
freedom and the relative return to productive entrepre-
neurship.
This paper has presented a framework for thinking about
the process of entrepreneurship and the role of public
policy in that process. The amount of positive-sum en-
trepreneurship such as new business creations or patent
activity is dependent on the rules of the game created by
policymakers. Policies consistent with economic freedom
keep the payoffs to positive-sum entrepreneurial activ-
ity high and discourage investment in activities that do
not lead to mutually-beneficial exchange. Or, as Adam
Smith ([1776] 1998) said: “Little else is requisite to carry
a state to the highest degree of opulence from the lowest
barbarism, but peace, easy taxes, and a tolerable admin-
istration of justice; all the rest being brought about by
the natural course of things.”
16
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18
Center for Applied Economics
University of Kansas School of Business
Summerfield Hall, 1300 Sunnyside Avenue
Lawrence, KS 66045-7585
www.cae.business.ku.edu
(785) 864-5134
doc_680484225.pdf
This brief elucidation explores public policy and entrepreneurship joshua c. hall.
T H E C E N T E R F O R
APPLIED ECONOMICS
PUBLIC POLICY
AND
ENTREPRENEURSHIP
SCHOOL OF
BUSINESS
The University of Kansas
Suppor ti ng Regi onal Economi c Development thr ough Analysi s and Educati on
TECHNICAL REPORT 06-0717
July 2006
Joshua C. Hall
H.B. Earhart Fellow
Department of Economics
West Virginia University
Russell S. Sobel
Professor and
James Clark Coffman Distinguished Chair
Department of Economics
West Virginia University
About The Authors
Russell S. Sobel, Ph.D., is Professor of Economics and James Clark Coffman Distinguished Chair in
Entrepreneurial Studies at West Virginia University. He has authored or coauthored over 50 academic
books and articles, including a best-selling collegiate principles of economics textbook. Joshua C. Hall
is an H.B. Earhart Fellow in Economics at West Virginia University. A former staff economist for the U.S.
House’s Joint Economic Committee, he is author or co-author of several journal articles and over a
dozen policy reports.
About The Center for Applied Economics
The KU School of Business established the Center for Applied Economics in February of 2004. The
mission of the Center for Applied Economics is to help advance the economic development of the state
and region by offering economic analysis and economic education relevant for policy makers, commu-
nity leaders, and other interested citizens. The stakeholders in the Center want to increase the amount
of credible economic analysis available to decision makers in both the state and region. When policy
makers, community leaders, and citizens discuss issues that may have an impact on the economic
development potential of the state or region, they can benefit from a wide array of perspectives. The
Center focuses on the contributions that markets and economic institutions can make to economic
development. Because credibility is, in part, a function of economic literacy, the Center also promotes
economics education.
Abstract
Entrepreneurship is a primary catalyst for economic growth and regional development. Recognizing its
importance, state and local policymakers are now devoting considerable resources to fostering entre-
preneurship. After a brief discussion of the data and theories of entrepreneurship, this paper presents
a framework for thinking about government’s role in the entrepreneurial process. We then examine the
research on macro-level determinants of entrepreneurial activity and find that policies broadly consis-
tent with economic freedom, such as secure property rights, low taxes, and low regulations lead to a
robust entrepreneurial environment.
i
Table of Contents
1. Introduction ........................................................................................................... 1
2. The Definition and Measurement of Entrepreneurship ....................................... 2
2.1 What is an Entrepreneur?.............................................................................. 2
2.2 Entrepreneurial Success and Failure ............................................................. 2
2.3 Entrepreneurs and Wealth-Creation ............................................................. 3
2.4 Theories of Entrepreneurship........................................................................ 4
3. Inputs, Institutions, and Entrepreneurship ......................................................... 5
3.1 A Framework for Understanding the Entrepreneurial Process .................... 5
3.2 Entrepreneurship and Economic Growth ..................................................... 5
4. Factors Affecting Entrepreneurship...................................................................... 7
4.1 The Questionable Relevance of Liquidity Constraints .................................. 7
4.2 Government Loan Programs are Generally Ineffective ................................. 8
4.3 Regulation Limits Entrepreneurial Opportunities ........................................ 9
4.4 Taxes Distort the Decision to become an Entrepreneur ............................. 10
4.5 Institutional Quality and Economic Freedom Matter for Entrepreneurship11
5. Productive versus Unproductive Entrepreneurship ............................................ 12
6. Conclusion ............................................................................................................ 16
References .................................................................................................................. 17
ii
1
Some areas simply have more of this spirit channeled
toward wealth-enhancing private-sector entrepreneurship
than others. The central question then becomes identi-
fying what policies and incentives explain this difference
in the way entrepreneurial energies are channeled.
We begin first by providing an overview of the varying
definitions and theories of entrepreneurship, and discuss-
ing some of the issues involved in actually measuring the
rate of entrepreneurship. We then discuss the role of the
entrepreneur in economic development and growth, pro-
viding some estimates of the magnitude of this relation-
ship. Finally, we summarize the research on the factors
influencing the rate of entrepreneurship within a soci-
ety, making a distinction between entrepreneurial inputs
(like venture capital) and the policy environment (or
‘rules of the game’ like taxes and regulations).
Public Policy and Entrepreneurship
1. Introduction
Over the past two decades the focus of economic devel-
opment policy, and even of collegiate business programs,
has shifted more heavily toward entrepreneurship. This
increased interest in the entrepreneur’s role in the
economy has led to a growing body of research attempt-
ing to identify the factors that promote entrepreneurship.
This research has important implications for public
policy. Some theories of entrepreneurship, for example,
are based on the premise that there exists an “entrepre-
neurial spirit” that waxes and wanes for exogenous rea-
sons. If differences in “entrepreneurial spirit” are the
source of differences in entrepreneurship levels between
areas, then public policy can do little to foster it. Fortu-
nately, the evidence is clear that entrepreneurship is an
omnipresent feature of human nature. What differs
across areas is thus not the degree of underlying entre-
preneurial spirit but instead how that spirit is channeled.
2
2.1 What is an Entrepreneur?
One definition of an entrepreneur is someone who dis-
covers, evaluates, and exploits opportunities to create new
goods and services (Shane and Venkatamaran, 2000).
While few would disagree with such a general definition,
it is unclear if a person who opens an antique store should
be counted the same as someone like Sam Walton or Bill
Gates. If not, how do we draw a distinction? The lit-
erature has attempted to deal with this by differentiat-
ing between ‘lifestyle’ entrepreneurs and ‘gazelle’ (or ‘high
growth’) entrepreneurs. Lifestyle entrepreneurs open
their own businesses primarily for the non-monetary
benefits associated with being their own bosses and set-
ting their own schedules. Gazelle entrepreneurs often
move from one start-up business to another, with a well-
defined growth plan and exit strategy. While this dis-
tinction seems conceptually obvious, empirically
separating these two groups is difficult when we can’t
observe individual motives
Most applied economic research on entrepreneurship
uses the number of nonfarm self-employed individuals
as a share of the labor force as a measure of entrepreneur-
ship. This definition clearly includes the lifestyle entre-
preneurs too, as well as some individuals who do
part-time work outside their regular jobs. As an alter-
native, some research has used measures of the number
of new business firms, or patent activity, to isolate only
gazelle entrepreneurs.
2.2 Entrepreneurial Success and
Failure
Entrepreneurship is important because it is the competi-
tive behavior of entrepreneurs that drives the market
process and thereby leads to economic progress (Kirzner
1973). Entrepreneurs are always in search of new pos-
sible combinations of resources. A vibrant entrepreneur-
ial climate maximizes the number of new combinations
attempted. Some of these combinations will, however,
not be good ideas. In a market economy, it is the profit
and loss system that is used to sort through these new
resource combinations discovered by entrepreneurs, dis-
carding bad ideas through losses and rewarding good
ones through profits. A growing, vibrant economy thus
depends not only on entrepreneurs discovering, evalu-
ating, and exploiting opportunities to create new goods
and services but also on the speed at which ideas are la-
beled as failures or successes. Economics has long held
that business failure has a positive side, as it gets rid of
the bad ideas and frees up those productive resources for
use by other entrepreneurs. A vibrant economy will have
both a lot of new business start-ups and a lot of business
failures. Minimizing business failures should not be a
goal of public policy. If we are to maximize the number
of new combinations attempted, we will witness lots of
failures. This is a simple result of the uncertainty in-
volved in knowing whether a new idea will meet the
market test or not.
A point worth clarifying is that it is much better to have
a decentralized profit and loss system sorting through
these combinations than a public sector decision-mak-
ing process. The reason why is that the incentives facing
public officials are very different than the incentives fac-
ing venture capitalists and entrepreneurs. While each
venture capitalist and entrepreneur brings different mo-
tivations to the table, ultimately their success or failure
is determined by whether their idea generates wealth. The
same is not true for public officials in charge of handing
out tax incentives or low-interest loans as they may have
other concerns beyond creating wealth. For example,
officials have incentives to be concerned about where a
new business is located in order to maximize political
support.
The distortions associated with government intervention
into entrepreneurial decisions are not trivial. The eco-
nomic analysis of public decision-making suggests
policymakers will choose courses of actions that have
clearly defined benefits with little regard to the long-run
costs or benefits (Buchanan and Tullock, 1962; Weingast,
Shepsle and Johnsen, 1981). One example is that press
releases are issued triumphing the number of new jobs
2. The Definition and Measurement of
Entrepreneurship
3
created when tax incentives are granted but rarely does
anyone follow up to see if the jobs are ever created. When
outside observers do, they usually find that the results
have no effect on growth. Gabe and Kraybill (2002)
studied the impact of tax incentives offered through the
Ohio Department of Development and found, after con-
trolling for other factors, that firms receiving tax incen-
tives to expand actually had 10.8 fewer jobs at the end
of two years. In addition to concluding that tax incen-
tives do not lead to employment growth, they find that
tax incentives do have a positive effect on announced job
growth. They suggest that firms drastically overestimated
future job growth in an effort to win tax incentives and
that public officials did little to verify the accuracy of
estimated employment growth since they benefited from
increased “bragging rights.”
This does not mean that venture capitalists and entre-
preneurs do not err. Obviously they do. For example,
Ken Olson, president, chairman and founder of Digital
Equipment Corporation, who was at the forefront of
computer technology in 1977, stated: “There is no rea-
son anyone would want a computer in their home.”
Today that sounds funny simply because we all have com-
puters in our homes, but even those in the infant com-
puter industry didn’t see this coming. An even better
example might be the story of Fred Smith, the founder
of Federal Express Corporation. He actually wrote the
business plan for FedEx as his senior project for his stra-
tegic management class at Yale. While we all know what
eventually happened in retrospect, the Yale professor, one
of the leading experts on business strategy wrote on his
paper: “The concept is interesting and well-formed, but
in order to earn better than a ‘C,’ the idea must be fea-
sible.”
The point? Even smart professors, business leaders, and
government officials cannot possibly pre-evaluate busi-
ness ideas and pick those that will be most successful from
those that will fail. A thriving economy depends on the
ability of individual entrepreneurs to try their own ideas,
without approval from anyone else, and then let the profit
and loss mechanisms of the marketplace answer this
question once the product is developed.
2.3 Entrepreneurs and Wealth-
Creation
It is important to recognize that from society’s perspec-
tive the profits earned by entrepreneurs represent gains
to society as a whole. Because entrepreneurs must bid
resources away from alternative uses, production costs
reflect the value of those resources to society in their
alternative uses. Thus, profit is only earned when an en-
trepreneur takes a set of resources and produces some-
thing worth more to consumers than the other goods that
could have been produced with those resources. A loss
happens when an entrepreneur produces something that
consumers do not value as highly as the other goods that
could have been produced with those same resources. For
example, an entrepreneur who takes the resources nec-
essary to produce a fleece blanket sold for $50 and in-
stead turns them into a pullover that sells for $60 has
earned a $10 profit. Since the price of the resources used
by entrepreneurs reflect the opportunity cost of their
employment in other uses, the $10 profit generated by
the entrepreneur reflects the amount by which they have
increased the value of those resources. By increasing the
value created by our limited resources, entrepreneurs
increase the overall level of wealth.
Successful entrepreneurship thus expands the size of the
economic pie by allowing us to generate more wealth
from our limited resources. Sam Walton, the founder
of Wal-Mart, was an innovator in distribution warehouse
centers and inventory control. His innovations in these
areas are what allowed Wal-Mart to grow from one store
in Arkansas to the largest retail chain in the world in fewer
than thirty years. Consumers benefit in numerous ways
from his innovations including lower prices and increased
product variety. However, the business failures that re-
sult from Wal-Mart’s better ability to please consumers
also result in net gains to society. The resources they
consumed are now freed up to go into other new entre-
preneurial businesses. Many downtown retail areas rav-
aged by Wal-Mart store openings subsequently turn into
thriving cultural districts, with coffee shops, art galler-
ies, and other types of businesses that could have never
have competed for that downtown retail space with the
general retail stores that used to need to locate there. The
4
entrepreneurial efforts of Walton and other entrepreneurs
such as Microsoft’s Bill Gates, CNN’s Ted Turner, and
McDonald’s Ray Kroc have improved the quality of life
for billions of people all over the world.
2.4 Theories of Entrepreneurship
1
The word entrepreneur originates from a 13
th
-century
French verb, entreprendre, meaning “to do something”
or “to undertake.” By the 16th century, the noun form,
entrepreneur, was being used to refer to someone who
undertakes a business venture. The first academic use
of the word by an economist was in 1730 by Richard
Cantillon, who identified the willingness to bear the
personal financial risk of a business venture as the defin-
ing characteristic of an entrepreneur. In the early 1800s,
economists Jean Baptiste Say and John Stuart Mill fur-
ther popularized the academic usage of the word “entre-
preneur.” Say stressed the role of the entrepreneur in
creating value by moving resources out of less produc-
tive areas and into more productive ones. Mill used the
term “entrepreneur” in his popular 1848 book, Principles
of Political Economy, to refer to a person who assumes
both the risk and management of a business. In this
manner, Mill provided a clearer distinction than
Cantillon between an entrepreneur and other business
owners (such as shareholders of a corporation) who as-
sume financial risk, but do not actively participate in the
day-to-day operations or management of the firm.
Building on Cantillon and Mill, Frank Knight (1921)
emphasized that entrepreneurs deal with uncertainty
about the future, not with risk. Probabilities can be esti-
mated for risky activities and thus are insurable. Entre-
preneurs, however, are dealing with uncertainty about the
profitability of their new combinations of resources.
Since entrepreneurs cannot insure against the probabil-
ity that new goods and services will not be liked, entre-
preneurs bear the burden of the uncertainty associated
with the market process. While Knight makes some im-
portant points with respect to the bearing of uncertainty,
his work has been overshadowed by the research of two
other economists, Joseph Schumpeter and Israel Kirzner
who greatly advanced our understanding of the role of
the entrepreneur.
Schumpeter ([1911] 1934) stressed the role of the en-
trepreneur as an innovator. To Schumpeter, an entrepre-
neur is someone who carries out new combinations of
resources to create products that did not exist previously.
The result of these new combinations would be entirely
new industries that open up considerable opportunities
for economic advancement. From a Schumpeterian view,
the entrepreneur is a disruptive force in an economy
because the introduction of these new combinations leads
to the obsolescence of others, a process he terms ‘creative
destruction’. The introduction of the compact disc, and
the corresponding disappearance of the vinyl record,
is just one of many examples of this process. Cars, elec-
tricity, aircraft, and personal computers are others.
Schumpeter viewed this disequilibration as a beneficial
byproduct of innovation.
Kirzner’s (1973) view of entrepreneurship stands in stark
contrast to Schumpeter’s. Instead of focusing on the
disequilibrating role of innovation, Kirzner views entre-
preneurship as an equilibrating force in which entrepre-
neurs discover previously unnoticed profit opportunities
and act on them. Thus Kirzner’s entrepreneur initiates
changes that move markets towards equilibrium. An ex-
ample of such an entrepreneur would be someone in a
college town who discovers that a profit opportunity has
arisen in renovating houses and turning them into rental
apartments because of a recent increase in college enroll-
ment.
Entrepreneurship encompasses all of these functions.
Entrepreneurs take on risk, they innovate, but they also
engage in mundane activities such as arbitraging between
areas of high and low demand. The thing that all entre-
preneurs have in common is the desire to discover and
exploit profit opportunities.
1
This section draws heavily from Russell S. Sobel, “Entrepreneurship,” in David R. Henderson (ed), The Concise Encyclopedia
of Economics, Indianapolis, Indiana: Liberty Fund, Inc., forthcoming.
5
3.1 A Framework for
Understanding the
Entrepreneurial Process
To begin to think more carefully about how might be
the best ways for government policy to foster entrepre-
neurship, it is important to understand the process by
which entrepreneurial outcomes are generated. This is
illustrated in Figure 1.
Figure 1 helps to categorize our thinking on the process
of entrepreneurship. Economic inputs and resources,
such as venture capital and resource availability, are con-
verted into entrepreneurial outcomes (new businesses
created or patents issued). However, the amount of en-
trepreneurial outcomes generated from a given amount
of economic inputs depends primarily on the rules of the
game, or public policies, under which entrepreneurs
operate. This model makes it clear that increasing en-
trepreneurship can be accomplished either by increasing
the inputs into the process, or by improving the rules of
the game for entrepreneurs. It is important to note, how-
ever, that when the rules of the game are unfavorable,
increasing inputs might have little impact on the amount
of entrepreneurial outcomes.
3.2 Entrepreneurship and
Economic Growth
Entrepreneurship is important because it is a key factor
contributing to economic growth, the ultimate outcome
of entrepreneurial efforts. Figure 2 shows the strength of
3. Inputs, Institutions, and Entrepreneurship
Figure 1. The Entrepreneurial Process
Examples:
Venture Capital Availability
Skilled Labor Force
Technology & Infrastructure
Resource Availability
Examples:
Tax Burdens
Business Regulations
Legal/Judicial System
Economic Freedom
Examples:
New Business Formation
Patents Issued
New Goods and Services
6
this relationship across countries taken from the Global
Entrepreneurship Monitor.
Empirical research finds that a substantial portion of the
variation in economic growth rates can be explained by
differing rates of entrepreneurship. Reynolds, Hay, and
Camp (1999), for example, show that different rates of
entrepreneurship account for one-third of the difference
in national economic growth rates, while Zacharakis,
Bygrave, and Shepherd (2000) find that it can explain
approximately half of the difference. This relationship
has held up to testing both among subsets of, and inter-
nally within, these countries as well. Ovaska and Sobel
(2005) find that differing rates of entrepreneurship ex-
plain the divergent economic paths followed by the
former Soviet republics. Berkowitz and DeJong (2005)
find a strong relationship between economic growth
within a country over time and the rate of entrepreneur-
ial activity within that country. Kreft and Sobel (2005)
find this relationship to be true across U.S. states, and
Henderson (2002) finds it to hold at the local level within
the United States.
Figure 2. Entrepreneurship and Economic Growth: International GEM Findings
Source: Figure 6 from Global Entrepreneurship Monitor (2004).
R = 0.37
0.000
5.000
10.000
15.000
20.000
25.000
30.000
35.000
-4.0 -2.0 0.0 2.0 4.0 6.0 8.0 10.0
PERCENT GROWTH IN GDP, LOCAL CURRENCY, CONSTANT PRICES
T
E
A
I
N
D
E
X
(
#
/
1
0
0
P
E
R
S
O
N
S
1
8
-
6
4
Y
R
S
O
L
D
)
7
Clearly entrepreneurship is vital for economic growth.
But what can government policy do to promote it? This
section reviews the existing literature on how both eco-
nomic inputs and public policy impact entrepreneurial
outcomes in a society.
4.1 The Questionable Relevance of
Liquidity Constraints
One factor impacting an individual’s decision on whether
or not to become an entrepreneur might be the availabil-
ity of funding to implement their vision. In our frame-
work, this would be one of the economic inputs to the
entrepreneurial process. While some individuals may
have enough personal wealth to start their own business,
most must secure outside financing. The issue, however,
is that many entrepreneurs may lack the ability to secure
this outside financing, even in cases where the venture
would be highly successful. Thus worthwhile projects
may not get undertaken solely because of these ‘liquid-
ity constraints’. While it is easy to think of theoretical
reasons why individuals may face liquidity constraints
even in well-functioning markets (Stiglitz and Weiss
1981), it is ultimately an empirical question if liquidity
constraints are actually a binding constraint holding back
entrepreneurship.
The issue of liquidity constraints is very important be-
cause much of current entrepreneurship policy is predi-
cated on the idea that potential entrepreneurs face
significant liquidity constraints. The justification for the
Small Business Administration, for example, is that po-
tential entrepreneurs face barriers to capital and that
government grants and subsidies can spur socially pro-
ductive entrepreneurship.
A large number of studies have tested for the presence
of liquidity constraints and the results have been some-
what mixed. One of the most prominent studies on li-
quidity constraints is Holtz-Eakin, Joulfaian and Rosen
(1994b). Because every sole proprietor files a “Schedule
C” on their tax return, they use data from the Internal
Revenue Service to examine who became a sole propri-
etor between 1981 and 1985. To test the importance of
liquidity constraints on the decision to become an en-
trepreneur they looked at the role of inheritances on the
decision to become an entrepreneur. The idea is if indi-
viduals are liquidity constrained, the influx of capital
from an inheritance should increase their propensity to
become an entrepreneur, other things being equal. They
find an inheritance of $100,000 would increase the prob-
ability of an individual transitioning to entrepreneurship
from 19.3 percent to 22.6 percent. An important fea-
ture of their data that they were able to separate out those
individuals who become entrepreneurs because they in-
herit businesses from those who become entrepreneurs
because the inheritance helps them to overcome a liquid-
ity constraint. Their research is clearly consistent with
the presence of liquidity constraints, although it says
nothing about the quality of the entrepreneurial activi-
ties undertaken by the liquidity constrained versus those
who were not liquidity constrained. After all, maybe the
individuals with the least access to capital are those whose
ideas have the lowest probability of future payoff.
Holtz-Eakin and Rosen (2005) find that both U.S. and
German entrepreneurs face liquidity constraints and that
lower access to capital in Germany explains a significant
portion of the difference in observed self-employment
rates between the countries. Evans and Jovanovic (1989)
discuss how inadequate access to capital deters individu-
als from pursuing self-employment. From their data set
they estimate that liquidity constraints deter about 1.3
percent of the population from pursuing self-employ-
ment during the period studied. This is significant con-
sidering that the percentage of the population becoming
self-employed in their study was only 3.8 percent. The
implication is that removal of the liquidity constraints
facing would-be entrepreneurs would increase the rate
of entrepreneurship by about one-third.
In an important recent paper, Hurst and Lusardi (2004)
find that inheritances are more than a proxy for liquid-
ity. They find evidence that future inheritances predict
past entrepreneurship, meaning that inheritances are
probably a proxy for something other than liquidity con-
straints that is related to the probability of self-employ-
4. Factors Affecting Entrepreneurship
8
ment. Thus inheritances are probably a poor instrument
to test liquidity constraints. Instead they suggest using
gains in housing value as an instrument for increases in
liquidity, since housing appreciation varies by region and
affects a larger segment of the wealth distribution. This
link should be strong as the vast majority of new small
businesses are opened with bank financing secured by the
entrepreneur through loans against the value of their
house. Hurst and Lusardi find that households in areas
with strong housing appreciation are no more likely to
start businesses than households in areas with no hous-
ing appreciation. Thus, they argue, the relationship be-
tween wealth and entrepreneurship is flat over most of
the wealth distribution and only increases at the high end.
Hurst and Lusardi argue that business ownership is a
luxury good and that wealthy individuals start business
to gain power and flexibility over their work schedules
and activities. This is consistent with research by
Hamilton (2000) showing the non-pecuniary returns to
business ownership are high. More importantly, Hurst
and Lusardi conclude that:
…even if some households that want to start
small businesses are currently constrained in
their borrowing, such constraints are not empiri-
cally important in deterring the majority of
small business formation in the United States.
This may simply reflect the fact that the start-
ing capital required for most businesses is suffi-
ciently small. We provide evidence to this effect
throughout the paper. Alternatively, even if the
required starting capital for some small busi-
nesses is high, existing institutions and lending
markets in the United States appear to work
sufficiently well at funneling funds to house-
holds with worthy entrepreneurial projects. (p.
321-322)
Thus, they argue that liquidity constraints are not a major
deterrent to entrepreneurship, although their data does
not allow them to test whether or not business start-ups
are insufficiently capitalized due to liquidity constraints.
There are two important things to come out of the Hurst
and Lusardi (2004) paper. First, it provides a reason why
the relationship observed between wealth and the prob-
ability of self-employment found in many studies (Evans
and Jovanovic 1989; Evans and Leighton 1989; Fairlie
1999; Gentry and Hubbard 2001) might not be evidence
of liquidity constraints but instead could reflect self-
employment as a luxury good. Second, this paper dem-
onstrates why using inheritances to test for the presence
of liquidity constraints, as Holtz-Eakin, Joufainin and
Rosen (1994a, 1994b) do, may be problematic. More
research is needed on the presence of liquidity con-
straints, but Hurst and Lusardi (2004) provide some rea-
son to think that liquidity constraints are not a relevant
impediment to starting a new business.
4.2 Government Loan Programs
are Generally Ineffective
The experience with government subsidized loan pro-
grams also suggests that liquidity constraints are not a
significant impediment to entrepreneurial activity (Taub
2004). In addition, these programs can create a host of
other problems and are generally subject to manipula-
tion by powerful politicians and lobby groups. Lerner
(1999) finds that the presence of Small Business Inno-
vation Research (SBIR) funding alone had little relation-
ship with sales and employment growth except in a few
small geographic areas already dominated by private ven-
ture capital and a thriving high-tech sector. In the vast
majority of other areas he concludes that distortions in
the award process may have led to the selection of firms
that really could not benefit from the funds. In addi-
tion, firms receiving multiple awards, or large awards,
actually performed worse than other firms. He con-
cludes, “additional awards appear to have had minimal
positive benefits, and the pursuit of these awards may
even have had detrimental effects on the firms.” (Lerner
1999, pp. 312).
A Micrometrics (2002) evaluation of the Oklahoma Pro-
gram for State-sponsored Venture Investing, for example,
finds that the fund not only has high administrative costs,
but it was also ineffective in drawing additional private
equity and venture capital into the state, showed a re-
turn significantly less than half of the national average
for private venture funds, and generated relatively little
investment capital for startups in the state. Studies of
the effectiveness of particular state venture funds are far
9
and few between primarily because, according to Bartik
and Bingham (1997), program administrators fear the
political consequences of a negative evaluation, and by
not doing an evaluation it is easier to claim success. A
study of the economic development programs of the Il-
linois Department of Commerce and Community Af-
fairs (DCCA) in 1989 by the Illinois Auditor General
showed widespread poor management of loan and grant
programs and also found that officials with these pro-
grams had vastly overstated the true impact of the pro-
grams in their internal reports.
One explanation for the ineffectiveness of government
loan programs comes from Taub (2004) who shows that
state subsidized business loan programs simply cannot
provide the managerial and technical support entrepre-
neurial companies need. Private venture funds on the
other hand, not only provide this support but frequently
require the firm to take this support as a condition of
receiving private venture funding. Yet another explana-
tion for the ineffectiveness of government loan programs
comes from Cohen and Noll (1991) and Wallsten (2000)
who conclude that government funding agencies tend to
select firms based on their likelihood of success, regard-
less of whether government funds are needed, simply so
they can claim credit for the firm’s eventual success.
Eisinger (1998) points out that under such programs,
firms actively devote efforts to securing subsidies that
directly increase their profits, but have no impact on
eventual business success. With government agencies
continually pressured to show successes to receive future
funding, they too often invest in firms who would have
been successful without government funding.
Studies such as Lerner (1999) and Carsey, Rundquist,
and Fox (1997) additionally show that public officials
put significant pressure on SBIR and other government
grant-making agencies to fund companies in their dis-
trict, and attempt to ensure loans to particular areas to
secure congressional support on legislation. Even the
government’s own evaluations of these loan programs
(US GAO 1992) suggests that a few large companies
capture a disproportionate share of awards each and ev-
ery year. Many of these “SBIR mills,” as they are known,
have staffs in Washington that focus on helping to se-
cure the political support for the grants, and studies show
that these firms appear to commercialize projects at a
significantly lower rate than other firms who don’t re-
ceive government funding (Lerner 1999). The large share
of funds going to these few politically connected firms
even led to the passage of new federal legislation attempt-
ing to put additional criteria on funding for firms who
had received awards in the past (Lerner 1999).
Other studies, such as Levy and Terleckyj (1983), Irwin
and Klenow (1996) and Wallsten (2000) have also found
that firms receiving government funds respond by reduc-
ing their own private R&D spending, leading many to
question whether government funds have any positive
impact at all on overall total R&D spending. Wallsten
(2000), for example, finds that SBIR grants simply crowd
out firm-financed R&D spending dollar for dollar. Per-
haps the most striking evidence is that the U.S. states with
the largest levels and increases in SBIR grants have shown
little improvement in their rates of entrepreneurial ac-
tivity.
Government loan programs, or attempts to create pub-
lic venture funds are generally ineffective because they
tend to put ‘the cart before the horse.’ Recent research
by Kreft and Sobel (2005) tests for the direction of cau-
sality between venture capital and entrepreneurial activ-
ity. Their results show that exogenous increases in venture
capital within a state do not increase the overall rate of
entrepreneurship, but rather it is those states with the
highest underlying entrepreneurial activity that attract the
most venture capital. Thus, new ideas easily draw ven-
ture funding. Because capital is significantly more mo-
bile than labor, and because venture capital firms spend
enormous resources hunting out potential new ventures
to invest in, there simply are very few cases where prof-
itable entrepreneurial ventures go unfunded. Venture
capital will naturally and automatically flow to those areas
with more entrepreneurial ideas.
4.3 Regulation Limits
Entrepreneurial Opportunities
We now turn to the impact of government imposed regu-
lations on the level of entrepreneurship, a shift from fo-
cusing on entrepreneurial inputs to focusing on the rules
of the game set by government policy. While it is diffi-
cult empirically to determine the effect of regulation on
10
the decision to become an entrepreneur, there is some
evidence that certain types of regulation inhibit entre-
preneurship. Holtz-Eakin and Rosen (2005) find
evidence that at least part of the difference in entrepre-
neurship rates between Germany and the United States
can be explained by differences in regulatory environ-
ment that discourage individuals from transitioning from
wage to self-employment.
Kanniainen and Vesala (2005), using panel data on
OECD countries, find that labor market regulations
explain differences in the rate of enterprise formation
between countries. They utilize several different defini-
tions of labor market regulations and find that all of them
have a negative impact on the self-employment rate in a
country. For example, high unemployment compensa-
tion increases the opportunity costs of becoming self-
employed. Their measures of labor market regulations
include measures of unemployment compensation, em-
ployee protection, labor union power, trade union den-
sity, the bargaining coverage rate, and the centralization
of wage bargaining in the country.
Benson (2004) notes how regulations introduce errors
into markets because they divert entrepreneurial energy
toward circumventing new regulations and away from
society-benefiting innovations that might have otherwise
occurred. Another type of labor market regulation is
minimum wage laws. Garrett and Wall (2005) find evi-
dence that minimum wage laws deter entrepreneurship.
Minimum wage laws affect the probability to start a small
business because the majority of small businesses rely
heavily on low-wage workers. Thus mandated minimum
wages might make some types of new small businesses
artificially unprofitable.
One reason why entrepreneurship is stifled in develop-
ing countries is because often starting a new business
requires navigating a several-year long process that in-
volves layers of government officials who must think that
the idea is worthwhile before an entrepreneur can get the
go ahead to open their new business (de Soto 2000).
Although far less onerous, regulations throughout the
United States prevent entrepreneurs from satisfying con-
sumer wants. A recent study on the barriers to entrepre-
neurship in Minnesota highlights the extent to which
regulations prevent potential entrepreneurs from realiz-
ing their goals (Dranias 2006). In Minneapolis, for ex-
ample, it is illegal to hang signs without a license and
licenses can take from one to twelve months to receive,
if granted at all. Potential manicurists have to undergo
350 hours of training to receive a license, nearly double
the training required of paramedics in the state. Barbers,
plumbers, and taxi cab drivers are other potential entre-
preneurial occupations where onerous regulations above
minimal safety requirements protect incumbent interests
at the expense of consumers. The pattern documented
in Minnesota by Dranias (2006) exists throughout the
United States and regulations such as these stifle produc-
tive entrepreneurial efforts, and instead encourage
individuals to spend time simply attempting to get per-
missions, satisfy regulations, and filling out onerous gov-
ernment paperwork.
4.4 Taxes Distort the Decision to
become an Entrepreneur
Taxation matters for entrepreneurship because it lowers
the reward earned by entrepreneurs from opening a new
business venture. In this manner, higher taxes unambigu-
ously deter entrepreneurship. This relationship, however,
is virtually impossible to quantify because self-employ-
ment is one of the best ways to avoid or evade taxation.
Areas with high taxes generally have higher rates of self-
employment, not because taxes encourage entrepreneur-
ship per se, but rather because of the flexibility in realizing
or hiding income that self-employment affords individu-
als. Also, income taxes could artificially stimulate
entrepreneurship as individuals shift away from wage
work, which is taxed, to self-employment that also pro-
vides significant personal non-pecuniary returns (like
more flexible working hours, etc.) which are untaxed
(Hamilton 2000).
Research on the effect of taxes on self-employment gen-
erally finds that the evasion effect dominates in the em-
pirical data. Higher taxes drive a large number of people
into self-employment as a way of avoiding high taxes on
wages and salaries (Bruce 2000, Schuetze 2000, Bruce
2002). However, it is important to note that this avenue
through which taxes increase entrepreneurship is strictly
welfare reducing for society as a whole.
11
4.5 Institutional Quality and
Economic Freedom Matter
for Entrepreneurship
The publication of the Economic Freedom of the World
index, by James Gwartney and Robert Lawson (2004),
has significantly advanced our understanding about the
continuum of ‘economic freedom’ that exists around the
world. They derive a single index measure for each coun-
try that places them on a spectrum from zero to ten,
in which ten represents the highest degree of ‘economic
freedom’, or reliance on laissez-fare capitalism. Because
state and local policies also impact the degree of ‘eco-
nomic freedom’, authors Amela Karabegovic and Fred
McMahon (2002) released their Economic Freedom of
North America, ranking U.S. states and Canadian prov-
inces with respect to each other in terms of their degree
of free-market orientation. Generally these indexes at-
tempt to condense into a single number the degree of
economic freedom individuals have in a geographic area
in several key categories such as taxation, regulation, and
property rights. Studies using these indices such as Farr,
Lord, and Wolfenbarger (1998) and Gwartney, Lawson,
and Holcombe (1999) have consistently shown that
countries with higher economic freedom scores not only
have larger per capita incomes, but also tend to have
higher rates of economic growth.
12
One strand of literature suggests that entrepreneurship
causes the majority of economic growth, while the other
suggests that the quality of prevailing institutions causes
the majority of economic growth. Can these two seem-
ingly separate ‘fundamental’ explanations for economic
growth be synthesized? Baumol’s (1990) theory of ‘pro-
ductive and unproductive entrepreneurship’ provides the
answer. His theory is founded in the idea that the level
of underlying entrepreneurial spirit is fairly constant
across people and regions. This multitude of entrepre-
neurs, however, exploits profit opportunities not only
within private markets but also within the political and
legal arenas. Thus, differences in measured rates of pri-
vate sector entrepreneurship are due to the different di-
rections entrepreneurial energies are channeled by
prevailing economic and political institutions, through
the rewards and incentive structures they create for en-
trepreneurial individuals.
In areas with institutions providing secure property
rights, a fair and balanced judicial system, contract en-
forcement, and effective limits on government’s ability
to transfer wealth through taxation and regulation, cre-
ative individuals are more likely to engage in productive
market entrepreneurship—activities that create wealth
(e.g. product innovation). In areas without strong insti-
tutions, these same individuals are instead more likely
to engage in attempts to manipulate the political or le-
gal process to capture transfers of existing wealth through
unproductive political and legal entrepreneurship—ac-
tivities that destroy wealth (e.g. lobbying and lawsuits).
This reallocation of effort occurs because the institutional
structure largely determines the relative personal and fi-
5. Productive versus Unproductive
Entrepreneurship
Figure 3. Economic Freedom and Entrepreneurship in OECD Countries, 2002
Sources: Global Entrepreneurship Monitor (2004) and Economic Freedom of the World: 2004 Annual Report (2004).
0
2
4
6
8
10
12
14
16
6.0 6.5 7.0 7.5 8.0 8.5
Economic Freedom Index (EFW)
)
A
E
T
(
x
e
d
n
I
y
t
i
v
i
t
c
A
l
a
i
r
u
e
n
e
r
p
e
r
t
n
E
13
structure as measured by economic freedom, however,
which promotes productive, wealth-generating entrepre-
neurial activity which is the source of economic growth
(Ovaska and Sobel 2005; Kreft and Sobel 2005).
The strength of this relationship between economic free-
dom and entrepreneurship is illustrated in Figures 3 and
4. Figure 3 shows the relationship, for OECD countries,
between their levels of economic freedom and entrepre-
neurship (as measured by the Global Entrepreneurship
Monitor score for Total Entrepreneurial Activity, TEA).
In Figure 3, it is clear that those countries with the most
broadly constrained and limited governments (those with
the highest freedom scores) have the most entrepreneur-
ship. In those nations where governments are involved
to the greatest extent through taxes, subsidies, property
takings, and regulations, entrepreneurship is lowest. This
relationship also holds among the U.S. states as is illus-
trated in Figure 4.
nancial rewards to investing entrepreneurial energies into
productive market activities versus investing those same
energies instead into unproductive political and legal
activities. For example, a steel entrepreneur might react
to competition by trying to either find a better way of
producing steel (productive entrepreneurship), or by lob-
bying for subsidies, tariff protection, or filing anti-trust
lawsuits against competitors (unproductive entrepreneur-
ship).
The index of economic freedom measures precisely those
institutional structures that should lower the return to
unproductive entrepreneurship, promoting productive
entrepreneurship over unproductive entrepreneurship.
Thus, underlying economic freedoms generate economic
growth because they more heavily promote productive en-
trepreneurial activity, which is the source of economic
growth. Both sets of literature are indeed correct, eco-
nomic freedom and entrepreneurship are both highly
correlated with economic growth. It is the institutional
Figure 4. State Economic Freedom and Growth of Entrepreneurial Activity
Sources: State and Local Area Data (2006) and Economic Freedom of North America: 2002 Annual Report (2002).
0%
5%
10%
15%
20%
25%
30%
5.5 6.0 6.5 7.0 7.5 8.0
Economic Freedom Index
S
o
l
e
P
r
o
p
r
i
e
t
o
r
s
h
i
p
G
r
o
w
t
h
R
a
t
e
14
While this area of research on how good institutions
channel entrepreneurial energies into productive wealth-
enhancing activities is relatively new, it has found some
interesting results. For example, while government
funded entrepreneurial education programs in K-12 edu-
cation have almost all been discontinued or cut due to
their lack of proven success, Sobel and King (2005) have
found that the adoption of school choice programs, that
reduce government involvement in schooling, are hav-
ing a large positive impact on increasing youth entrepre-
neurship, simply because young adults are going to
school each day in an environment that is more entre-
preneurial and competitive than traditional public
schools. Witnessing their teachers and school adminis-
trators being more innovative and entrepreneurial on an
every day basis seems to have a large impact on students’
likelihood of becoming entrepreneurs.
To grow richer, states and nations need more productive
entrepreneurship and less unproductive entrepreneur-
ship. The specific reforms necessary are those that: (a)
increase the relative reward to productive market entre-
preneurship, and/or (b) decrease the relative reward to
unproductive political and legal entrepreneurship. A
reduction in state corporate income taxes or a reduction
in regulatory barriers for new entrepreneurs would be
ways to accomplish (a). The reward to unproductive
entrepreneurship can be reduced through reforms that
increase the security of private property rights, create a
fairer and more balanced judicial and liability system,
strengthen contract enforcement, lessen government
“pork-barrel” spending, and more effectively limit
government’s ability to transfer wealth through taxation,
regulation, and subsidies. Here is a list of specific pro-
grammatic reforms, based on Baumol’s theory of produc-
tive and unproductive entrepreneurship, which could
accomplish these goals. All of these reforms either lower
the reward to political/legal entrepreneurship or increase
the reward to productive market entrepreneurship. Those
that are also explicitly part of the Economic Freedom of
North America Index calculation are denoted by
[EFNA]. Thus, reform-minded policymakers could:
reduce state corporate income taxes [EFNA];
reduce state personal income taxes [EFNA];
eliminate state turnover, business, or occupation
taxes [EFNA];
reform workers compensation through
privatization or tougher rule enforcement
[EFNA];
reform medical malpractice;
reform the judicial system to minimize the ef-
fect of politics and electoral pressures;
eliminate state minimum and maximum price
and wage limits and restrictions [EFNA];
enact constitutional limits on public land tak-
ings such as eminent domain;
reduce occupational licensing requirements;
reduce government employment and public
ownership of resources (such as land holdings),
freeing these resources to be employed in the
private sector [EFNA];
simplify the tax code to reduce the ability of (and
incentive for) groups to lobby for exemptions
and credits;
and, reduce the returns to lobbying through leg-
islative reform that makes it more difficult to
pass pork-barrel legislation.
As one will notice by looking at this list, the real contri-
bution of recent economic theory, as presented in Fig-
ure 1, which depicts the entire entrepreneurial process,
is that it shifts attention toward institutional reform as
the way to promote entrepreneurship. This is a rather
large change in thinking given the conventional wisdom
in the 1990s, which advocated promoting entrepreneur-
ship through enacting additional public sector education
programs, subsidies, and interventions in venture capi-
tal markets. Given the ever continuing search for new
ways to promote entrepreneurship, institutional theory
and its policy implications could potentially form the
foundation of 21
st
century economic development policy.
After all, good institutional reforms have already allowed
countries such as Ireland to greatly increase its rate of
economic growth, and as well as some of the former
Soviet republics such as Estonia. At the same time, states
15
like West Virginia, whose economic freedom ranks lower
than that of Estonia, have struggled economically and
will continue to do so without significant institutional
reform.
The policy implications are clear; rather than focusing
on expanding government programs like subsidized
loans, workforce education, or programs aimed at in-
creasing ‘entrepreneurial inputs’ as a way to foster entre-
preneurship, the better path is through institutional
reform that increases the return to productive entrepre-
neurship and lowers the return to unproductive entre-
preneurship. Government-sponsored programs too often
encourage entrepreneurial individuals to devote effort
toward figuring out how to obtain public funds and
transfer payments, rather than devoting those efforts to-
ward satisfying consumers and creating wealth.
6. Conclusion
The importance of entrepreneurship to job creation and
economic growth is clearly not lost on policymakers. The
rise in state venture capital programs, targeted small busi-
ness subsidies, and other forms of aid to those interested
in starting new businesses is abundant evidence that
policymakers understand the importance of entrepre-
neurship to economic development. An increasing
amount of economic evidence, however, indicates that
such an ad hoc programmatic approach to promoting
entrepreneurship is not effective. Policymakers can cre-
ate more success for their stakeholders if they instead
focus on institutional reforms that increase economic
freedom and the relative return to productive entrepre-
neurship.
This paper has presented a framework for thinking about
the process of entrepreneurship and the role of public
policy in that process. The amount of positive-sum en-
trepreneurship such as new business creations or patent
activity is dependent on the rules of the game created by
policymakers. Policies consistent with economic freedom
keep the payoffs to positive-sum entrepreneurial activ-
ity high and discourage investment in activities that do
not lead to mutually-beneficial exchange. Or, as Adam
Smith ([1776] 1998) said: “Little else is requisite to carry
a state to the highest degree of opulence from the lowest
barbarism, but peace, easy taxes, and a tolerable admin-
istration of justice; all the rest being brought about by
the natural course of things.”
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Center for Applied Economics
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