Small Business

Why Small Businesses Aren’t Innovative

Everyone says small businesses are dynamic, market-shaking, job creators. But new evidence suggests that’s not true.

Small businesses often sell familiar products to existing customer bases rather than innovating

A year ago, President Barack Obama approved the Small Business Jobs Act, which cut taxes and expanded loan programs for tens of thousands of small companies. Signing the bill into law, he gave a speech that could have come out of the mouth of any Washington politician: lauding the country’s “entrepreneurs,” the “basement inventor[s]” designing revolutionary new products and creating most of the country’s new jobs.

The stereotype of the small-businessperson as a start-up innovator is pervasive. But it’s not true, according to a new study. Scupper the image of Mark Zuckerberg handcrafting a new service to revolutionize how we socialize and adding thousands of jobs to the economy. Replace it with the image of a gas-station owner, servicing a crowded market, happy to be able to make his kid’s soccer games without a boss breathing down his neck, and more wary of innovation than eager for it.

In a new paper, “What Do Small Businesses Do?,” Erik Hurst and Benjamin Wild Pugsley of the University of Chicago say innovative whizzes and small-business owners are very different breeds. For politicians and policymakers eager to bolster job creation and foster American competitiveness, Hurst and Pugsley’s analysis could have important ramifications.

The study notes that small-business owners, innovators, and entrepreneurs get lumped together not just in Washington’s rhetoric, but also in the academic literature. Decades of economic theory “usually considers entrepreneurs” as people who “innovate and render aging technologies obsolete” and “take economic risks,” they note. But it does not always do a good job sussing out who is really innovating, who is taking risks, and whose businesses are really growing, they say.

The researchers attempt to figure that out by surveying entrepreneurs, asking why they decided to start their own companies and what they hope to achieve. The bottom line? “Few small businesses intend to bring a new idea to market,” they write. “Instead, most intend to provide an existing service to an existing customer base.” And a relatively small proportion of small businesses have aspirations to get any bigger, either.

Indeed, the new business owners responding to the survey were lawyers, plumbers, doctors, shopkeepers, real estate agents, and the like—common village professionals. Fewer than half started a business because they “had a good business idea.” Many chose to start a business for “non-pecuniary” benefits, like being your own boss and keeping flexible hours.

The bulk of small businesses being created, in short, are not particularly innovative ones. Few spend any money on research or development, getting a patent, or otherwise trademarking a new idea. Most simply help provide already-crowded markets with familiar goods such as legal work or gas or nearby groceries. Nor are they growing businesses either. “[M]ost surviving small businesses do not grow by any significant margin,” the economists write. “Most firms start small and stay small throughout their entire lifecycle.”

This is not to pooh-pooh new small-business owners, of course. People need their teeth cleaned, their taxes filed, and their gas tank filled. But it does offer valuable perspective on how and why government should aid small business. Programs aimed at helping small businesses are not generally going to reach growing businesses, or innovating businesses, or new businesses. And with Washington spending billions to help small businesses and desperately seeking job creation, that matters.

The paper’s authors argue that Washington policymakers and academic economists need to focus on the minority of entrepreneurial and growing small firms, as opposed to small firms, full stop. So how to separate the Zuckerbergs from the gas-station owners? Often they separate themselves. Companies that seek venture capital funding, for instance, tend to innovate and create jobs. Thus, a tax break for a company in receipt of VC funding might get more bang for its buck than a tax break for all firms with fewer than 20 employees.

Even easier, Washington could ensure that it subsidizes growing firms, not just small firms. “Often subsidies targeted at increasing innovative risk taking and overcoming financing constraints are focused on small businesses,” the academics write. “We believe that these targets are better reached through lowering the costs of expansion, so they are taken up by the much smaller share of small businesses aspiring to grow and innovate.” The (admittedly obvious) takeaway? Give tax breaks or other incentives to firms hiring new employees if you want to juice employment at small companies.

One thing is not in dispute: Young companies—which tend to be small—create the bulk of new jobs. Of late, they have been starting with smaller staffs and adding fewer employees, which helps explain the current economic malaise. Washington is desperate to support small businesses and to help them add jobs, to help the overall economic picture. But first Washington should take the time to understand which small businesses really do innovate and grow.