Public Policy, Economics and Entrepreneurship: February 2009 Archives

I am at a blogger forum in Kansas City today hosted by the Kauffman Foundation.  It was organized by Tim Kane who blogs at Kauffman's Growthology blog.

There were several great sessions.

One that was particularly interesting was a forum of economics bloggers.  Paul Kedrosky expressed his concerns that the President is over-focusing his attention on VCs as the means to stimulate the entrepreneurial sector.  He pointed out, and I agree, that although important, this is not the main driver of the entrepreneurial economy.  It is small businesses being bootstrapped and self-financed.  The President's focus on increasing marginal tax rates will only stifle this part of the entrepreneurial equation.

Arnold Kling told us that he has been considering four scenarios using a two dimensional matrix -- shallow recession versus deep recession on one dimension and capitalism lives as we know versus capitalism dies as we know it on the other dimension.  He limited his remarks to the scenario of a long and deep recession with capitalism still being alive and well.  He said that we may face years and even decades of weak economic conditions.  Eventually a strong economy will emerge, but it will be fundamentally restructured from what we know now.  Kind of depressing, but a real possibility to many in the room.

He believes that there will be three dominant forces in the new economy -- healthcare, education, and leisure.

Also had some interesting discussions with Mish Shedlock (Global Economic Trends), Sramana Mitra, Mark Thoma (Economist's View), and Charles Johnson (student blogger from Claremont McKenna College).

It was a great chance to finally put some faces with some really great bloggers.

sub-si-dy [suhb-si-dee]  -noun. 1. a direct pecuniary aid furnished by a government to a private industrial undertaking, a charity organization, or the like.  2. a sum paid, often in accordance with a treaty, by one government to another to secure some service in return.
3. a grant or contribution of money.

We now need to add "income tax deduction" to this definition.  Part of the tax increase plan coming from the President includes limiting mortgage interest tax deductions for higher income earners.  Here's how Thomas F. Schaller at the Baltimore Sun described it this morning (emphasis added):

The mortgage interest deduction subsidizes homeownership. Unlike rent subsidies for the poor or seniors, we tend not to call this form of redistribution "welfare." But in the broadest sense, it is a form of welfare that largely benefits middle- and upper-class Americans, including this columnist.

A subsidy means transferring money from the government to private parties.  So this subtle shift in the language signals another erosion of property rights.  Tax deductions are no longer ways to allow us to keep our own money -- they are now in the same category as grants given to us from the government.

Our money and our property are beginning to become mere subsidies given to us through the generosity and benevolence of the federal government.  While this change in language may seem inconsequential, mark my word that this is a highly calculated change meant to let us know who ultimately owns property in this country under the new rules coming out of Washington.

A Zogby Interactive survey was released yesterday that shows nearly two-thirds of Americans (63%) are putting their trust in small businesses and entrepreneurs to lead the U.S. to a better future. Fifty-two percent of surveyors said they would rely on the fields of science and technology and only thirty-one percent surveyed said leadership from government is where a better future is likely to come from.  Americans think leadership toward a better future is more likely to come from family and friends (38%), non-profit groups (32%), or even themselves (36%).

Rep. Sam Graves of the House Small Business Committee responded to the Zogby poll by saying, "Americans understand that to improve our economy and brighten our future, small businesses will lead the way. The poll released today is further proof that Americans do not believe bigger government will bring us prosperity."

If you want to see some of these attitudes up close and personal, read the comments at this post about the President's economic plans at Independent Street.  Here is just one sample comment posted:

We discussed tax policy and entrepreneurial activity last night in my MBA entrepreneurship seminar. 

We examined the results of a 2005 study from the SBA Office of Advocacy in which it was reported that a 1% increase in marginal income tax rates led to a 1.42% drop in the probability of single filing tax payers starting a business and a 2.0% drop in married filers.  Marginal tax rates are a powerful predictor of entrepreneurial start-up activity.  Higher tax rates are a disincentive to start a business.

The current administration in Washington plans to let the tax cuts expire, which leads to a 4% increase in the marginal tax rate.

That suggests that we can expect almost a 6% drop in the probability of those filing a single tax return starting businesses and an 8% for those married citizens filing a joint return.

The President's speech last night gave lip service to the need for entrepreneurs to pull us out of the recession.  However, his action of letting the tax cut expire leading to a 4% increase in marginal rates will be like throwing a bucket of cold water on this sector of our economy.

Maybe he is right that we might face years and even a decade of economic hardship.  I hope not, but his tax policies will clearly help fulfill his predictions.

Last week we launched our first Business Plan Boot Camp here at Belmont.  It is a three evening program for people who are new entrepreneurs and for entrepreneurs that have started businesses, but need some help getting their venture moving ahead. 

Programs like this are popping up all over the country, with more and more accidental entrepreneurs.

The Kauffman Foundation announced that they are rolling out their FastTrac LaunchPad program in cities across the country to help give an entrepreneurial boost to the economy.

"Entrepreneurs will be the foundation of our nation's economic recovery because they start and grow businesses that create jobs," said Carl Schramm, Kauffman Foundation president and CEO.

Although education is one of the key elements to fostering entrepreneurship, lower tax rates, reducing regulation and protecting property rights all play a major role in spurring the creation of new businesses.

So what are we doing to cut taxes to encourage more business formation?  Nothing.  The President's new budget to be released this week will seek to raise tax rates.  From the San Francisco Chronicle:

Obama also seeks to increase tax collections, primarily by making good on his promise to eliminate the temporary tax cuts enacted in 2001 and 2003 for wealthy taxpayers, whom Obama defined during the campaign as those earning more than $250,000 a year. Those tax breaks would be permitted to expire on schedule for the 2011 tax year, when the top tax rate would rise from 35 percent to more than 39 percent.

And what about protecting property rights?  Well, Sen. Dodd is advocating nationalizing banks and the President's auto task force is aggressively moving to take control of the strategic direction of America's car companies.

Ever feel like you are trying to put out a forest fire with a garden hose?

Elizabeth Milito, senior executive counsel of the NFIB, reports that the IRS and DOJ are planning to crack down on businesses with unpaid employment taxes. 

Here is her report:
 
The head of the U.S. Justice Department's Tax Division has warned a group of tax attorneys that the IRS and DOJ will aggressively pursue unpaid employment taxes. The DOJ claims some employers are ripping off the IRS, using unsophisticated schemes that make them easy targets for enforcement. In addition to civil methods to recover unpaid employment taxes, DOJ indicated it will ramp up criminal enforcement as well.
 
Employers should not disregard these taxes or devise ways to avoid paying them. More information on employment taxes and penalties is provided below.
 
Employment Tax Basics

Employers are required by law to withhold federal income, Social Security and Medicare taxes through the Federal Insurance Contributions Act (FICA), and federal unemployment taxes through the Federal Unemployment Tax Act (FUTA). These are pay-as-you-go taxes; this means employers cannot fall behind on payments.
 
Avoid the Following Schemes

The IRS has pledged to actively investigate and prosecute the following schemes:
 
-  Pyramiding, a practice in which a business withholds taxes from employees, but intentionally fails to remit them to the IRS. The business files for bankruptcy to discharge liabilities and then starts a new business under a new name.
-  Paying employees in cash.
-  Misclassifying an employee as an independent contractor. Employers are not responsible for withholding taxes for independent contractors, but this is likely to be a major point of emphasis by the IRS.  (Many small business owners don't really who can be treated as an independent contractor.  See this past post for more information).
-  Employment leasing, a legal but abused practice in which an employer contracts with an outside business to handle all administrative, personnel and payroll concerns, but the employer does not pay collected employment taxes to the IRS.
-  Following frivolous arguments. Don't be fooled into believing that an interpretation of the tax code allows an employer to avoid withholding employment taxes.
-  Filing false payroll tax returns or failing to file payroll tax returns.
 
Don't Ignore IRS Demands

Don't overlook a letter from the IRS.The issue will not go away. You should ensure that all your tax records are available and organized. Next, you should talk to someone knowledgeable about tax laws, such as your accountant, tax attorney or an enrolled agent. A professional can help negotiate a settlement that may allow you to avoid the worst penalties.
 
Stiff Penalties Include Criminal Sanctions

It's a felony to willfully fail to collect or pay taxes to the IRS, punishable by fines up to $250,000 for individuals and/or jail time up to five years. Willfulness is a voluntary or intentional violation of the law, which can be inferred by facts or circumstances that show conduct likely to mislead or conceal. Financial difficulties may not be a reasonable cause for not paying employment taxes.
 
Lesser felony and misdemeanor penalties are also possible for willful failure to file a return or supply information. In fiscal year 2008, there were 42 convictions for failing to collect or pay employment taxes, with an average sentence of 29 months. The incarceration rate was 81 percent.
 
A Final Warning

Employment taxes affect nearly every small business. The burden can be overwhelming at times, but employers should not ignore these taxes. The government is taking tax evasion--particularly employment tax evasion--more seriously than ever before. Whereas most investigations sought civil sanctions, the threat of criminal sanctions shows the IRS means business.

It seems that scammers agree with Rahm Emanuel, White House chief of staff, who uttered the now famous quote, "You never want a serious crisis to go to waste."  Scammers are playing on people's desperation and the promise of government pork for everyone coming from the "We Are All Socialists Now" Act of 2009.

Phishing scammers are sending e-mails that look like they come from the IRS.  The e-mail claims that the recipient has a tax rebate coming.  When you click through it then sends you to a rather authentic looking website set up to get personal financial information that can then be used to pilfer the accounts of its victims.

The U.S. Small Business Administration issued a scam alert to small businesses, warning them not to respond to letters falsely claiming to have been sent by the SBA asking for bank account information in order to qualify them for federal tax rebates.

The fraudulent letters were sent out with what appears to be an SBA letterhead to small businesses across the country, advising recipients that they may be eligible for a tax rebate under the Economic Stimulus Act, and that SBA is assessing their eligibility for such a rebate.  The letter asks the small business to provide the name of its bank and account number. 

The SBA is working with the SBA Office of Inspector General to investigate this matter. The Office of Inspector General asks that anyone who receives such a letter report it to the OIG Fraud Line at 1 (800) 767-0385, or e-mail at OIGHotline@sba.gov. 

Professor Scott Shane of Case Western University is at it yet again.  He made waves last year for assailing entrepreneurship education, particularly if they have anything to do with small business, or what he calls "marginal businesses" that he asserts actually hurt employment in the economy.  I refuted his analysis here and here at this site. 

Now he is questioning if we really have an entrepreneurial culture in the US in a column at US News.  The same Scott Shane who previously trivialized the importance of small business is now using self-employment statistics to make his point that the US culture is becoming less entrepreneurial.  He looks at self-employment rates over the past ten years.

First, always question those who shift definitions to suit their agendas.  He wants us to only focus on high growth ventures and R and D as the relevant forms of entrepreneurship, but now is using self-employment as his definition of entrepreneurship in our culture.  Why doesn't he look at LLC and S-corp formation over time, employment in entrepreneurial ventures over time, and the percent of innovation in small ventures over time?  All of these are readily available, and all show the entrepreneurial nature of our culture and our economy.

Second, to look at cultural trends we need to look at more than a ten year snap shot. 

Third, if we are looking at the behavioral part of entrepreneurial cultures, we need to look at comparative rates of business formation across economies.

Finally, a true measure of culture must look at both behaviors and shared values, as pointed out by Dawn Rivers Baker in her counter point to Prof. Scott also published at US News:

Compared to other places on the planet, the United States is very forgiving, culturally, of risk and even of failure.

That is what makes us entrepreneurial.... 

In looking at Prof. Shane's writings it is clear to me that what he wants is more government directed economic policies toward business formation giving preference only to high growth, high potential entrepreneurship and innovation.  

This is what I call socialized entrepreneurship, which sadly seems to be where the US is headed at the same time that we are socializing healthcare and banking. 

The movement toward socialized entrepreneurship is the one trend that may squash our entrepreneurial culture in this country and it will ruin any hope that entrepreneurship will be the spark to create a new age of economic growth.

There is one bit of good news that we can take from history about recessions and even depressions.  They tend to be a time of major transformations due to the typically high levels Schumpeterian creative destruction active in the economy. 

Consider the following brief list of examples:

• GE was founded during the Great Economic Panic of 1873 
• Disney was founded during the Recession of 1923 
• The Great Depression saw the founding of both HP and Polaroid
• Trader Joe's was founded during the 1958 recession 
• During the 1975 recession Microsoft was founded
• CNN and MTV both were launched during the 1981 recession 
• And in the 2001 recession iPod launched and Google finally got its market footing and emerged from its start-up phase

Innovations like these helped create ripples of new ventures and other innovations that were the major force in reviving the economy.

So why aren't we finding ways to help spur entrepreneurship in our economy instead of being consumed with bailing out failing businesses and declining industries? 

I am blogging this morning from my father's house in southern Florida where the recession seems to have hit particularly hard.

The NFIB has released an early summary of the job creation portion of their monthly survey summary due out this week, and it is also not very promising for the short-term employment outlook.

Seasonally adjusted, there was a decline in average employment per firm of 0.74 workers reported by small business owners in January, the second largest monthly decline in survey history (December was the largest at -0.86 workers per firm). Eight percent of the owners increased employment by an average of 3.3 workers per firm, but 23 percent reduced employment at average of 4.1 workers per firm (seasonally adjusted). The private sector is very weak, with the only job growth coming from education, healthcare and government.

Over the next three months, 9 percent of small business owners plan to create new jobs (up 1 point), and 14 percent plan workforce reductions (down 5 points), yielding a seasonally adjusted net negative 6 percent of owners planning to create new jobs, the third lowest reading in survey history and unchanged from December. Lower readings occurred only in the 1974-5 and the 1980-82 recession periods. Not seasonally adjusted, job creation plans were positive in all the service sectors, but negative in manufacturing and construction, retail and wholesale. Of the nine census regions, only in the Mountain states did more owners plan to increase employment than planned to reduce employment.

With reports of sales and profit declines more frequent than at any time in the past 35 years, firms have little choice but to reduce costs to survive, and for small firms, the major cost is labor (about 80 percent). Consumer spending didn't revive, so employment adjustments must now be larger, since hoped-for gains in sales did not materialize. Firms are now cutting hours faster than sales are falling, a rare event. This will raise productivity (sales per hour) and mitigate the rise in unit labor costs. 

There is a bit of a silver lining in their findings this month.  It looks like firms are making adjustments quickly now, which the NFIB believes should bring the economy to a bottom sooner rather than later. The service sector seems to be finding its legs.

This week I showed the video Demographic Winter to both my undergraduate and graduate students. 

The video documents a chilling demographic trend that is not getting enough attention -- the declining fertility rate that is occurring in about 70% of the countries around the world.

Here is a part of the synopsis of the film from their website:

One of the most ominous events of modern history is quietly unfolding.  Social scientists and economists agree - we are headed toward a demographic winter which threatens to have catastrophic social and economic consequences.  The effects will be severe and long lasting and are already becoming manifest in much of Europe.

A groundbreaking film, Demographic Winter: Decline of the Human Family, reveals in chilling soberness how societies with diminished family influence are now grimly seen as being in social and economic jeopardy.

Demographic Winter draws upon experts from all around the world - demographers, economists, sociologists, psychologists, civic and religious leaders, parliamentarians and diplomats.  Together, they reveal the dangers facing society and the world's economies, dangers far more imminent than global warming and at least as severe. 

We had a rich discussion in both of my classes. 

We talked about the impact of declining populations on the future of the US and world economies.  The data presented in the film seems to paint a fairly bleak picture for the US and other western economies over the coming decades due to population decline.  Japan and much of Europe are already feeling the negative economic effects of declining fertility rates.  The US is expected to begin this slow economic decline beginning around 2010 -- when Baby Boomers reach their peak spending age.

The graduate students, mostly Generation X, were stunned.  Our program is an evening MBA degree, so most of the students are working full-time.  They were concerned about their careers, their children's futures, and their outlook for retirement.

My undergraduate students, who are mostly Generation Y, seemed to take it more in stride.  They reminded me that this is part of the reason why they are studying entrepreneurship, after all.  They understand that our economy will never look like it did even a decade ago.  They already know that it is up to them to create their own way in the world -- the corporate career path of the past century is at a dead end in their minds. 

What is increasingly clear to me is that our post recovery economy will probably not be very robust.  The timing of this recession just at the time that Baby Boomers are reaching peak spending age is like, to use the words of one of my students, "the perfect storm."  I believe the recovery will be slow, but that the long term will be a general decline over the coming decades.

Will there be opportunity in this world?  You bet.  But, you will need to be highly skilled at identifying more scarce market niches and a much more nimble manager as your business grows.  We will not see times when any fool can make money as an entrepreneur.  With softer markets only the best will thrive.

The film suggests that much of the boom of the past twenty years is attributable to one main cause -- the Boomers reaching their peak consumption age.  Those times are over, and there is every indication that a long-term booming economy will not come again in the US for generations -- if ever.

ADP Small Business Report for Janaury 2009 was released today.  It shows that the recession has deepened on Main Street.

• Total small business employment: -175,000

• Goods-producing sector: -74,000 small business jobs

• Service-providing sector: -101,000 small business jobs

This marks the third consecutive month of decline in the small-size business sector.  Although January's number shows fewer job losses than December, the recession continues to have an impact on this space.  Although job declines have consistently been interpreted as mostly affecting larger corporations, businesses with fewer than 500 employees lost 430,000 jobs in the month of January.

It continues to be alarming how little Washington is paying attention to small business in their policy decisions.