Here's the truth about employment growth--and how the government can stop hindering it and start helping.
Every four years about this time, political pandering reaches a crescendo, and this year no constituency has been pandered to more than small business. As different as the two candidates’ economic philosophies may be, both President Barack Obama and former Governor Mitt Romney agree that job creation is one of the central issues of the campaign, that small businesses are the biggest job creators, and that federal policy should be geared toward helping them. “They are the anchors of our main streets,” says the President in a video on his campaign website, which notes that small businesses are responsible for two out of every three new jobs in the United States. “Small business, entrepreneurs and innovators, mom and pop businesses, little shops and stores—they’ve always created most of the jobs in this country and they will again,” said Lou Dobbs in a recent Fox News special, nicely summing up the conventional wisdom.
A Political Half-Truth
The problem is, this conventional wisdom is wrong. Or rather it’s only half-right: Small businesses may create the majority of jobs, but they also lose most of the jobs. What counts is not job creation, but net job generation. And if you were to group together the vast majority of small companies, their net job generation would add up to zero. For economists and policymakers who research job creation, this is not a major news flash. No one who has done a serious study of the subject in the past 15 years believes that small companies as a whole generate the 60 to 70 percent of the net new jobs they are credited with by, among others, the Small Business Administration. Indeed, the claim has been debunked so often by so many people of all political persuasions that I’d be piling on to debunk it yet again. It survives by virtue of repetition, the SBA, and the Tip O’Neill Rule that all politics is local. When members of Congress want to check on the economic climate back home, or raise money for their campaigns, the people they talk to are business owners. Supporting small business is thus a guaranteed political winner. And you might ask, “Where’s the harm in that?” Job generation aside, we know that small businesses play a vital role in our economy and our society. They form the backbone of communities from Barrow, Alaska, to Key West, Florida. They also employ between 60 million and 95 million people (depending on who’s counting), or 50 percent to 65 percent of the workforce. So what if they don’t add a lot of new jobs to the economy every year? Shouldn’t the government be doing all it can to help them anyway? There’s an interesting debate to be had on that subject. But it would be a distraction from the policy discussion we should be having—particularly now, when jobs are in such short supply. That’s actually where the myth of small-business job generation has done its harm: It has diverted our attention from the most important questions we face when it comes to economic growth. There are three of them: Which companies really are the job creators? What can be done to enhance their ability to survive and prosper? And how can we get more of them? The search for answers to all three begins with one word: gazelles.
A Little Bit of History
For most of the 20th century, everyone believed that big companies created almost all new jobs. Then, in the late 1970s, a researcher at the Massachusetts Institute of Technology, David L. Birch, made a remarkable discovery. He’d come to MIT from Harvard to work in the Center for Urban Studies and there had developed a particular interest in jobs—how they were created, why they moved from place to place, what role they played in regional development. The government databases weren’t much help in his research, since they didn’t break out employment at individual companies and therefore didn’t allow him to track changes in the numbers and locations of jobs over time. So he hit on the idea of using data from Dun & Bradstreet, which recorded the job numbers and locations of specific firms and establishments in the course of preparing its annual credit reports. He got hold of the complete D&B files for four years—1969, 1972, 1974, and 1976. When he examined the data, he was surprised to find that, in that period, businesses with fewer than 20 workers created four times as many new jobs as companies with more than 500 employees. In 1979, Birch published the results of his research in a 52-page report titled The Job Generation Process. Appearing as it did just as entrepreneurs were beginning to remake the economy, the report had a huge impact on policymakers. Equally important, it demonstrated the need to study job creation and destruction on the micro level, thereby opening up a whole new field of research. To be sure, not everyone accepted Birch’s findings. One research team tried to duplicate his results using D&B data from different years and found that small companies grew no faster than large ones. Others claimed he’d made statistical errors that had skewed the results and invalidated his conclusions. Still others argued that Birch’s conclusions were beside the point: Jobs in small companies were worse than those in big companies in terms of working conditions, compensation, fringe benefits, and employment security, and therefore it was no great shakes to have more of them. But Birch also had defenders who conducted independent studies that produced similar results—not only for the United States, but for other countries, including Canada, the United Kingdom, Holland, and Greece. Over the next decade, Birch continued his research into the job-generation process. (Some of his findings were presented in columns he wrote for Inc.) As time went along, he developed new insights into where jobs came from. In 1994, he co-authored an essay with one of his chief critics, Harvard professor James Medoff, for a book called Labor Markets, Employment Policy, and Job Creation. The idea was to see what they could agree on. The title of the essay was "Gazelles."
The Role of Gazelles
"Gazelles" is a term Birch coined to describe the small percentage of companies that accounted for virtually all the net job growth he had observed in his research. As such, the concept represented a significant shift in his thinking. In an interview many years later, he said that he needed “a simple, almost naïve way of explaining what was going on in the economy.” His solution was a business taxonomy consisting of elephants, mice, and gazelles. “The big companies, elephants, are slow and not very innovative,” he said. “Then there are a large number of very small firms—mice—that run around but fail to develop. And then the gazelles...small firms that grow quickly and create employment.” He defined gazelles as companies that, beginning with at least $100,000 in sales, grow 20 percent or more annually for four years, at least doubling their revenue in the process. In the period the essay covered—1989 to 1992—there were about 350,000 of them, or just 4 percent of all firms, and yet they accounted for about 60 percent of the net new jobs in the economy. (Of the remaining 40 percent, about half came from start-ups, and half from large companies.) The following year, Birch doubled down on his analysis. In a paper published by his consulting firm, Cognetics, he and two colleagues presented the results of a study they’d done using their D&B-based dataset to analyze job generation from 1990 to 1994. They concluded that gazelles were responsible for all net job generation during that time. They also added a significant twist. At the beginning of the period, some 82 percent of the gazelles had had fewer than 19 employees, while just 3.6 percent had had 100 or more. That contingent of larger companies proved to be “superstars,” generating 53 percent of the net new jobs created by the entire group during the five years studied. Some of the superstars were already Fortune 500 companies in 1990. Others would join that list later. These findings turned Birch’s earlier conclusions upside down. He was now saying, in effect, that size didn’t matter. Although most gazelles were small companies, only a tiny percentage of small companies were gazelles, and the most prolific job-creators among them weren’t particularly small at all. The private sector got the message: Birch’s firm did a booming business helping companies identify and market to gazelles. But these startling findings had no discernible effect on elected officials and policy makers, who continued to promote as enthusiastically as ever the myth that small businesses as a group created the lion’s share of new jobs.
The Problem With Myths
That was 17 years ago. Since then, the study of job creation has blossomed. Today there are more researchers than ever, and they have a raft of new tools at their disposal, including new and improved sources of information and vastly superior technology with which to analyze it. You might think that, as a result, we know a great deal more about what it takes to create a business environment conducive to the growth and proliferation of gazelles. But we don’t—and the myth of small-business job generation is at least partly to blame. It is so deeply embedded in the consciousness of policy makers, politicians, and the general public that leading researchers feel compelled to keep debunking it. John Haltiwanger of the University of Maryland is one of them. In 2010, he and two colleagues released a major study showing that the age of firms was a more important factor than size in identifying the job creators. “Mature” small companies lose more jobs than they create, while start-ups and young firms create most jobs but are “inherently volatile with a high exit rate.” His conclusion: Policies that target small companies without regard to age “will likely have limited success in improving net job creation.” The Ewing Marion Kauffman Foundation subsequently published a series of studies making the same point, though with a stronger emphasis on start-ups and an explicit goal of influencing policy. “The politics have always been about small,” says Robert Litan who, until recently, was the foundation’s vice-president for research and policy. “But when you show that new jobs are actually coming from young companies, rather than small companies, that implies a whole different set of policies. It implies things like the Startup Act.” And indeed Litan and the Kauffman Foundation have worked hard to shift the government’s focus from small companies to start-ups. They were deeply involved in crafting the bipartisan Startup Act 2.0, which would make it easier for highly skilled immigrants, including entrepreneurs, to stay in the country; would exempt individual start-up investors from the capital gains tax; would accelerate the commercialization of federally funded research; and would reduce the regulatory burden on start-ups. Congress has yet to act on that bill but did pass, and the President signed, the Jumpstart Our Business Startups (or JOBS) Act earlier this year, intended to improve startups’ access to capital. The JOBS Act grew out of the President’s Startup America Initiative, launched with Kauffman’s help. To the extent that such legislation removes ill-conceived obstacles to starting and growing companies, the economy should benefit from its passage. You can also make a case that the easier it is for people to go into business, the better off our society will be, and not just for economic reasons. That said, it’s far from clear how government policies favoring start-ups are any more likely to promote significant job generation than policies favoring small companies. To begin with, the argument for both is based on a logical fallacy: Because a lot of the job creators are young (or small), we’ll have more of them if we have more young (or small) companies. In addition, some of the data is suspect. The jobs created by start-ups, in particular, can be deceptive, since their mortality rate is so high. If you look just at the number of jobs that start-ups create in the year they’re born and then you keep adding jobs created by start-ups in subsequent years, it will appear that start-ups account for all net new job creation. As researcher Tim Kane concluded in one widely cited Kauffman study, “…start-ups aren’t everything when it comes to job growth. They’re the only thing.” But Kane’s methodology exemplifies what Mark Twain had in mind when he wrote about “lies, damned lies, and statistics.” Using his approach, every start-up could go out of business in its second year and it would still appear that start-ups had created more jobs than existing businesses. (In the second year, the previous year’s start-ups become “existing businesses,” and thus the jobs lost by those former start-ups are deducted from the latter’s total.) Nevertheless, there’s ample evidence that companies aged one to five account for a large percentage of the net new jobs each year—almost two-thirds of them in 2007, according to another, more solid Kauffman report, Where Will the Jobs Come From?, by Litan and Dane Stangler. The question is, so what? Young companies don’t create jobs because they’re young, any more than small companies create jobs because they’re small. Moreover, as Birch demonstrated back in 1994, and as has been repeatedly corroborated in the years since, a relative handful of small companies or young companies—the gazelles—are responsible for the great majority of net new jobs created by each group, and the companies that create the most new jobs aren’t necessarily either small or young. What we don’t know is why one company becomes a gazelle and another doesn’t, or why some gazelles keep creating jobs and others stop. Nor do we know the obstacles that are common to gazelles and impede their growth. Worse, we don’t know the reason for the most troubling element in the entire job picture: Why the percentage of growing companies has fallen over the last ten years. And we’re just beginning to learn what new government policies could improve the situation—and what current policies are making matters worse. Statistics and theory can’t help with these questions. They require boots on the ground.
The Study of Gazelles
One pair of boots belongs to Gary Kunkle, founder and CEO of Outlier and research fellow of the Edward Lowe Foundation’s Institute for Exceptional Growth Companies. His specialty is economic development and firm growth, a field he’s been working in since 1988. In 2005, he was hired by Pennsylvania—whose governor at the time was Ed Rendell, a liberal Democrat—to investigate the role of high-growth companies (or “higros,” as he calls them) in job generation. The program has since been expanded by Rendell’s successor, Tom Corbett, a conservative Republican. In the meantime, Kunkle has been hired to put together similar projects for Louisiana and Indiana. Along the way, he has done hands-on research into more than 600 high-growth companies and come to some interesting conclusions. Among other things, Kunkle has found that many existing government programs are counter-productive. “The policy makers don’t understand what’s going on at ground level,” he says. “They don’t know the causal factors for growth, and so they pursue wrong-headed strategies left and right.” He cites direct financial assistance as a prime example. “When we make cheap capital available to companies, we’re actually doing three very negative things. One, we’re taking away their incentive to monitor utilization rates, and so they wind up with too much capacity, which can come back to haunt them. Second, the cheap capital distorts the process by which the market screens out bad ideas and shifts capital to better ideas, and so bad ideas get overfunded. Third, the companies get saddled with more debt than they’ll be able to handle, which increases the chance of them going bankrupt.” A case in point: Solyndra, the best-known of the Obama administration’s failed green energy initiatives. “It’s a huge issue. Cheap capital is the main policy tool of both state and federal governments, but all it does is create an unsustainable growth spurt while destroying capital stocks and putting employees and taxpayers in a worse position afterwards.” To be sure, it would come as a surprise to owners of fast-growing companies that having too much cheap capital could actually be a problem. After all, they’re more likely to go out of business due to insufficient capital, as has been documented by Doug Tatum, the author of No Man’s Land and co-founder of professional services firm Tatum, which—during his tenure as CEO and chairman—focused on providing financial expertise to high-growth companies. Through his work there, he came to see that one of the greatest threats to gazelles is the capital gap they run into when they reach the stage of being too big to receive loans secured by personal guarantees and too small to be profitable investments for banks or private equity firms. “Lack of capital is one of the biggest problems, maybe the biggest problem, these companies face,” Tatum says. But he doesn’t dispute Kunkel’s main point. “Cheap capital is a problem when it’s the government, rather than the market, deciding who gets it.”
How the Government Can Help
So is there any positive role that government can play in the job generation process? The answer is yes, although it’s different from what small business advocates typically push for. For one thing, they tend to focus on programs at the federal or state level, while the government that matters most to gazelles is usually local. “When you get down to ground level and see how they operate, you may find some things with implications for federal policy,” says Kunkle, “but a lot more issues have to do with the local environment—the local facilities they’re in, the local employment pool they draw on, the local government agencies they deal with.” There are, indeed, some initiatives already under way that hold promise, while others could be implemented to address the documented needs of gazelles. For example:
1. Offer the right kind of job training.
This is another area in which Kunkle sees misguided government policy at work. “In most cases, government-sponsored job training is actually a social program” aimed at preparing people for entry-level jobs, he says. “But companies that grow and create jobs can usually find the entry-level people they need. Growth begins to stall when they can’t find supervisors to manage all those entry-level employees.” If we want to help gazelles create jobs, he argues, it makes more sense to train hourly people to become supervisors, rather than programs to train unemployed people to become entry-level employees. “By giving people the ability to rise up in a company through hard work and aptitude, you create social equity and solve a big problem of growing companies at the same time.”
2. Build existing local businesses rather than trying to attract new ones.
The “economic gardening” approach to economic development was pioneered by the city of Littleton, Colorado, beginning in the late 1980s, and has since been adopted by communities nationwide. The concept grew out of a severe recession during which thousands of Littleton’s citizens were laid off by its principal employer, Martin Marietta. Fed up with being at the mercy of giant out-of-state corporations, the city council directed that Littleton’s economic development department should henceforth “work with local businesses to develop good jobs.” Between 1987 and 1989 members of the department searched, studied, experimented, learned, and eventually produced a wide variety of programs that are still supporting its gazelles today.
Among other things, it provides local companies with information on marketing, competitive intelligence, and industry trends. It offers training and seminars in advanced management techniques. It has developed a telecommunication curriculum and an e-commerce course with the local community college and helped local businesses connect with trade associations, academic institutions, and other companies in the same industry. The list goes on. Have such efforts paid off? In 20 years, the number of jobs in the city doubled, while sales tax revenue tripled, without a dime being spent on recruiting outside employers, according to Chris Gibbons, now with the National Center for Economic Gardening, who led the effort.
3. Help entrepreneurs negotiate the bureaucracy.
Kunkle notes that high-growth companies are four times more likely to relocate than other businesses, but that nine times out of 10 they relocate within the same area. They aren’t looking for tax havens or government perks. They simply run out of space. Yet their searches are often hit-or-miss because they aren’t plugged into local economic development agencies, which tend to be the best sources of information about available spaces. After moving a couple of times, a company’s owners may decide it’s easier to buy a facility and add space as needed—at which point they run into state and local ordinances about having adequate storm water drainage, or wide enough stairs, or sufficient parking space. The permitting process can take months, during which the company’s growth is put on hold and its hiring delayed. In the Pittsburgh region, an alliance of private- and public-sector leaders and economic development professionals recognized the problem and created the Pittsburgh Impact Initiative, which Kunkle describes as a “concierge service” for high-growth companies. “Someone from Impact can take them to the front of the line at the clerk’s office and say, ‘We need to expedite these permits now so that they can get busy hiring people.’”
4. Find new ways to get universities involved.
While a debate rages on the subject of technology transfer and the commercialization of federally funded university research, policy-makers and academic institutions alike are largely oblivious to the type of academic support that would be most likely to foster significant job generation. More than cutting-edge technology out of a university or government lab, gazelles need help with things like cost accounting, pricing, and product design. “One of the most problematic questions for a growing company is, How do you allocate costs so you can price accurately?” says Kunkle. “Or how do you do ergonomic design, which has made American manufacturers more competitive in the world? We have this knowledge in our academic institutions, and yet we don’t do anything to get it to the growing companies that need it the most—not even out of community colleges. It’s about process transfer, not technology transfer.”
5. Change the tax code to facilitate self-funding.
High-growth CEOs have an aversion to debt financing, preferring to grow with retained earnings, Kunkle has found. The problem is, if they wait beyond the end of the year to invest, their earnings are taxed, and the company is left with just 50 cents on the dollar to invest. As a result, gazelles tend to invest the earnings in small chunks before the year-end. Kunkle’s idea is to create tax-deferred savings accounts—corporate IRAs, he calls them—in which companies can collect retained earnings to be used for certain specified purposes, such as investing in capital equipment or making payroll during a market downturn. That idea is similar to the Bridge Act long championed by Tatum. It would address the capital gap by allowing companies to defer taxes, putting the money instead into a bank account they could borrow against to finance their growth. The bill currently languishes in Congress despite having strong bipartisan support. And there, I suppose, can be found a silver lining. Kunkle says his efforts have also garnered strong bipartisan support in all the states where he has worked. “The Republicans like the emphasis on the power of the entrepreneur and the limited role government can play,” he says. “The Democrats like the social equity aspect. These companies are in all industries and all locations, and they’re bringing people in with all levels of experience. The benefits aren’t just for microbiologists in Philadelphia. They’re for people in all places, in all careers, in all levels of job training. It also helps that minority and women-owned businesses are slightly overrepresented among the higros. So both sides like what we’re doing. Hopefully that means it’s pragmatic.” Given the tenor of the current Presidential campaign, that seems like very good news indeed.
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