Small Business Is Not a Job Engine - Bloomberg (Part One)

(Part One of Two)

The most productive small businesses might be crushed as part of the "solution" to the "Fiscal Cliff" debates in Washington. For a year, our leaders have known the debt ceiling, sequestration, and other major economic nightmares — all self-inflicted wounds — were set to crash down upon us as the calendar changed.

Raising taxes on "the rich" is a crusade for President Obama and many Democrats. Even more than a few Republicans have tacitly joined the march towards raising tax rates. I'd rather we simplify the tax system, before raising rates, but that's not the topic of this post. The president and some influential voices are dismissing the potential harm caused by narrowly focusing on "the rich" at a level that includes many small and growing businesses.

Bloomberg News, of all places, published an editorial that conflates arguments about growing small businesses and small business in general. It is a rhetorical trick, a slight of hand meant to convince the public (voters) that small business isn't so special — and, even if small enterprises were special, they won't be harmed by the mismanagement of our federal coffers.

Let me explore the pre-election editorial from "The Editors" of Bloomberg, part of a campaign to push through higher tax rates without sufficient cuts or meaningful tax reforms.

Small Business Is Not a Job Engine

[link http://mobile.bloomberg.com/news/2012-10-04/time-to-debunk-the-myth-of-small-business-as-job-engine.html]
Bloomberg
by The Editors
October 04, 2012 6:45 PM EDT

[To] portray small businesses as the engine of job growth is to vastly overstate their role. The argument that raising tax rates on upper-income individuals would harm entrepreneurs is likewise flawed. We love small business as much as anyone. But with the U.S. facing unsustainable budget deficits that will require many Americans to pay higher taxes, it's worth separating fact from fiction.

Sorry, but stating that you "love small business" is a red flag. And anytime someone offers to separate "fact from fiction" always ask which selective facts will be used and which fictions are being challenged. Expect fallacious arguments aplenty in taxation debates.

Let's get to the core of the Bloomberg nonsense.

First, small businesses destroy almost as many jobs as they create. Second, only about 3 percent of small-business owners fall into the upper-income tax brackets that would increase if, as Obama has proposed, the Bush tax cuts are allowed to expire. And third, many businesses counted as small aren't engaged in traditional small-business activity. Instead, they are partners in hedge funds, law firms and private-equity shops, or they are highly paid actors, athletes, speakers and authors.

1. Small Businesses are Job Destroyers

Small businesses destroy jobs? Sorry, but that's a misreading of several studies. Small businesses earn less and pay less per employee, so they do have a smaller effect on economic activity than medium and large enterprises. Yet to assume they "destroy jobs" is to assume the jobs created by small businesses would be shifted to larger firms, magically. More likely, the owners and employees of many small businesses would be unemployed or underemployed. Small businesses take chances and fill niches larger firms tend to ignore.

[Once] most startups pass the five-year mark, they destroy more jobs than they create.

University of Maryland economist John Haltiwanger found, for example, that small mature businesses have "negative net job creation" and that the bigger contributors to job growth are startups, which account for roughly 3 percent of employment in most years.

Alan Viard, a resident scholar at the American Enterprise Institute, says the argument that small business creates jobs "does not stand up under scrutiny."

The Bloomberg editors apparently didn't read the Haltiwanger report closely. As the Wall Street Journal clarified:

The paper—co-authored by University of Maryland economist John Haltiwanger and two Census Bureau economists—confirmed that small businesses create more net new jobs, per employee, than do bigger businesses.
— http://online.wsj.com/article/SB10001424052970203914304576630973840478808.html

Consider a simple example: There is still a market for saddles, but not a large market. Horses are used by the military, police forces, ranchers, and athletes. There isn't a huge market for equestrian supplies, yet there is a market. A large global conglomerate is unlikely to replace a small business specializing in saddles and other equipment. The small business making saddles might not fill a huge need, and it might not create millionaires, but it offers a job and a living wage to its owners and any employees.

How many small businesses are unlikely to be replaced by larger firms? Many service industries, for example, resist being "corporatized" beyond franchises and cooperatives. Hair stylists, tutors, yoga instructors, dog walkers, and many others are not going to merge their small businesses into massive corporations. Some businesses are small, often one or two people, and they will remain small. It is also true that such businesses do not create jobs for many additional employees. These are sole-proprietorships that give purpose to many individuals. That is part of capitalism: being free to choose a path, defining "success" for yourself.

While many small businesses will never expand to employ hundreds or thousands of people, the companies that eventually do employ large numbers and generate significant revenues begin as small firms.

The Editors offer a non-sequitur of sorts, arguing that small businesses don't create jobs, yet the businesses that do create jobs are generally smaller. Yes, not every small business is growing, but most growing businesses are small — so by definition most dynamic growth is within the ranks of small enterprises.

[Recent] economic research shows that small companies play no greater role in job creation than large ones do. What matters more is age: New businesses account for the biggest share of job gains. Those companies tend to be small yet unprofitable. They would be largely unaffected by an upper-income tax increase.

Nobody founds a 2000-employee company, at least not since the Industrial Revolution. Today's new businesses are likely to be knowledge-based firms, such as tech start-ups and specialty engineering firms. You don't need more than a dozen or so people to create software or plans for a new product. Labor-intensive manufacturing tends to be outsourced, especially by smaller companies that focus on new ideas.

Coming up with new ideas, or serving shrinking markets, is risky. You have to be the best of the best. Larger firms don't like such risks. Of course, there is a price to taking chances and many, if not most, small businesses do fail. The entrepreneurs I know have founded many small businesses, with some failing and others growing. If the Bloomberg editors consider such "churning" destructive, they are reflecting a serious distrust or misunderstanding of a basic underpinning of our free market system. Creative destruction allows the market to discover which new ideas will grow and become the foundations for big business in the future.

Small businesses are the great places of experimentation and creativity. That's Capitalism 101.

[Many] don't last long. For instance, employers with fewer than four workers have accounted for roughly 5% of all private-sector workers since 1992, but 15% of all job creation and 15% of job destruction in the private sector in that period, according to BLS.
— http://online.wsj.com/article/SB10001424052970203914304576630973840478808.html

Small businesses with fewer than four workers are only five percent of the labor market. Some of those firms will grow and employ dozens or hundreds. Others will fail. The smallest of new businesses matter because the handful that do find the sweet spot in the marketplace will become medium to large companies.

2. Only Three Percent of Small Business Owners are Upper-Income

So what? Those three percent are the job creators. They are the innovators.

Once you suggest "only" a small group will be affected, and those are "the rich" anyway, the populist rhetoric red flag waves. This is the president's argument that most small business owners aren't rich, and won't be affected by any higher taxes. We can dislike the rich, while not disliking business owners (until they are too successful).

New businesses are more likely to be unprofitable, yet they also tend to jump from "nothing to something" instead of climbing steadily through the income brackets. The new businesses also tend to experience much greater swings in revenue and net incomes than larger firms, since a few thousand dollars is a lot of money to a sole-proprietor. New enterprises are experiments, with all the unpredictability that entails. You search for good ideas, testing many things to build a successful firm.

The early years of most businesses are lousy. They are sleepless. And yet,

A friend of mine helped create a smartphone application. The app was popular for a time, creating a windfall. And then, almost as quickly, the app slipped off the best-seller charts. Some products are prone to trends: you either catch the wave or not, and the wave ends. Another acquaintance in the software industry wisely understood the trend-based nature of industry. He is always looking for the "next big thing" in online gaming. Earnings from one success are used to invest in a half-dozen other ideas, and most of those do not succeed. Boom. Bust.

I am an entrepreneur by nature, compelled to try one idea after another, working non-stop to discover that one idea that will elevate us into the ranks of the rich. I'm not about to apologize for wanting to have a successful idea.

My wife and I have co-owned a computer store, a bookstore, and our little freelance business. The computer industry changed. The publishing industry changed. Entrepreneurs are always racing to stay ahead of trends. We are always hoping to be ahead of the trends, working and worrying constantly. I've met few entrepreneurs who "relax" easily. They are people always on edge, optimists with a sense of impending doom. Most small firms don't survive, yet entrepreneurs keep at it.

Small businesses are always one event, one bad moment, from failure. Even established small businesses experience volatile incomes. Consultants and freelancers have great years, and bad years. Farmers know the boom-and-bust cycles better than most business owners. For these business owners, a year over $250,000 can be followed by a year of losses. Ideally, you hire an accountant and exploit any and all tax provisions that allow you to shift losses and expenses. You do all you can as a small business owner to reduce "net income" — something larger corporations employ armies of tax attorneys and accountants to do.

Being self-employed means accepting that the tax code, like most laws and regulations, are stacked in favor of the larger corporations. Yet, there is something about taking responsibility for yourself that makes proprietorship attractive to some of us. It is that legal standing as "sole-proprietorships" and "subchapter S corporations" that causes small business owners heartburn during the current tax "fairness" debates. When you are a business of one, you tend to file taxes in a way that treats the entire business as "personal" income and expenses. This is done to avoid the costs of forming a complex corporation and then paying yourself a salary. In effect, business incomes "pass-through" the personal tax filings of entrepreneurs.

At least Bloomberg's editors understand this basic fact of life for small business owners.

Two recent reports by Ernst & Young LLP… concluded that pass-through companies accounted for almost 95 percent of all business entities in 2008 and employed 54 percent of the private-sector workforce.

Read the above several times. Ninety-five percent of businesses file taxes as individuals, either as sole-proprietorships or subchapter S corporations. Medium and large businesses, which employ 40 to 46 percent of workers, are only five percent of all business entities in the U.S. tax system. All but five percent of businesses are small businesses and file taxes in a way that leaves them vulnerable to oddities in the tax code.

From my earlier points, recall that most small businesses have no or few employees and are destined to remain "small" by choice. There are also regional differences in what the self-employed can earn: a consultant in New York, Chicago, or Los Angeles must charge (and earn) more than a similar consultant in a rural town. I recently compared hourly computer repair fees where we live in Western Pennsylvania to fees in Los Angeles, trying to set my own consulting rates to the market. I can charge about half the rate of a "big city" consultant, it seems.

But, I certainly do want to be in that top three percent. I'd love to establish a clientele that recognizes my value as a technologist. If I do someday earn $250,000 a year, I certainly will have employees and seek to expand in some way. My desire is to create a growing and respected business — with some financial payoff. Building a business means making a lot of sacrifices. It also means "bouncing back" from the various failures of the past. Success in business is seldom easy and rarely unearned.

Financial success results from planning, hard work, and a bit of fortune. It takes a special character to build a businesses, enduring any number of personal and professional challenges. I've written about what makes the successful different before: they really do work more hours and take more chances than others. So why do we punish the very people that might create the best ideas?

At least the Bloomberg editors admit that the three percent includes the entrepreneurs creating the jobs. You create a good idea, you create a growing business. That business, in turn, creates jobs and economic growth. No, those jobs won't pay more than jobs at larger corporations — and there is always the chance of sudden failure — but these are the jobs that drive capitalism.

True, most small-business wealth is accumulated at the top. The 3 percent of filers with pass-through income in the upper brackets account for half of all pass-through income. Owners of small businesses that employ workers are also more concentrated in the top two brackets — accounting for 10 percent of owners — supporting the argument that a tax increase would cost jobs.

Consider the above facts carefully: the top employers are concentrated in the top two tax brackets. Of course they are, since you need profits and growth to pay employees. The men and women with the best new business ideas are rewarded by the free market. Increasing taxes on productive entrepreneurs will reduce the amounts they invest in employees, materials, and other costs associated with expansion.

3. Many Small Businesses Aren't Really Businesses

Recall that The Editors dismissed many small businesses as not being sufficiently bound to traditional perceptions of small business:

And third, many businesses counted as small aren't engaged in traditional small-business activity. Instead, they are partners in hedge funds, law firms and private-equity shops, or they are highly paid actors, athletes, speakers and authors.

Some of them are very profitable, but a large number aren't what most of us would consider a small business, such as a dry cleaner or coffee shop.

I'm a freelance writer. I'm a public speaker. I'm a computer consultant. While my wife and I have had small retail businesses, my current endeavors don't require retail rent or employees — at least at this moment. Does that mean my "small business" doesn't contribute to the economy?

Just 20 million of the 34.7 million filers reporting pass-through income qualified as a small business, Treasury said. Of those, about one-fifth qualified as an employer.

To be clear, the editors at Bloomberg complain that "just" 58 percent of pass-through businesses, those sole-proprietors and subchapter S corporations, are truly "small businesses" by one definition. Worse, horror of horrors, most small businesses — mine included — have no employees!

As a writer and a tech consultant, I need a computer. Actually, my wife and I have three laptops, two desktop computers, and a tablet. We have a network router, five or six switches, two laser printers, and much more. Our work requires "tools" and those tools were purchased from companies that employ other people. Even a business of one or two people creates economic activity, and therefore supports jobs.

Profits I earn are likely to be spent on services and products that employ other people. Simply because I do not have employees does not mean that my wife and I do not hire any number of specialists to provide services. Our spending supports jobs, including those of other small business owners and their employees. And, as I've stated, I'd love to have an idea that takes off and ends up requiring a growing staff of employees.

I would rather not be hiring the services of accountants, lawyers, and tax specialists. It often seems that Washington tax policies are meant to stimulate jobs for the tax-avoidance industry.

My wife and I are in the top 10 percent, and I darn well hope we eventually land in the top one percent. We've worked hard and we've endured a great deal. When we've failed, we've picked up ourselves and started over on the path towards whatever we could achieve. We didn't give up when we had nothing: we set about becoming "something" again. Having nothing, being truly poor, was miserable — and that is part of what drives me to keep searching for new ideas.

That is what makes "small business" special: the people behind those businesses. We are driven. We don't give up and settle. We take risks, even after failing. We are a job engine simply because we work, almost no matter what we have to do to earn the next opportunity. If we have to work seven days a week, we do. If we have to skip vacations, we do. We are producers — and consumers.

That consumption might be curtailed, thanks to Washington's ineptitude. Like most entrepreneurs, I'm going to be cautious in the new year. I'm going to take fewer risks and I'm going to divert more funds into various tax-sheltered savings options. If I don't take risks, I'm less likely to stumble into an idea that will propel us towards needing employees.

Concluding Thoughts

The U.S. faces a serious financial shortfall that will require many Americans, including the wealthiest, to pay higher taxes. Republicans can argue against tax increases for many reasons, but hampering small business isn't one of them.
— http://mobile.bloomberg.com/news/2012-10-04/time-to-debunk-the-myth-of-small-business-as-job-engine.html

If you want the wealthiest, which includes many entrepreneurs, to pay more in taxes, first demonstrate some serious spending restraint. I fear that any new tax revenues will simply become new spending… and that new spending will outstrip new revenues as has happened repeatedly over my lifetime. Government projections will prove wrong (as usual) and yet more revenues will be demanded of the people most likely to create jobs.

Bloomberg's editors are right that most small businesses do not create the majority of jobs. But, the handful of small businesses that are new, innovative, and successful are the engine of job growth. That one-in-ten small business with the right idea behind it might become the next Apple, which has been "near-death" more than once.

It should not matter if only a fraction of small businesses create the new jobs — what matters is that we do everything possible to encourage entrepreneurial thinking and risk taking.