Banking on Job Growth

|
Posted: Dec 21, 2009 12:01 AM

President Obama is zeroing in on the culprit holding back employment growth. It just might be the banks. After his bankers’ summit at the White House earlier this week, the president said, “The way I see it, having recovered with the help of the American government and the American taxpayers, our banks now have a greater obligation to the goal of a wider recovery, a more stable system, and more broadly shared prosperity.” However, he added a comment that muddied the picture: “I urged these institutions here today to go back and take a third and fourth look about how they are operating when it comes to small-business and medium-sized business lending.”

Going Rogue by Sarah Palin FREE

The latter comment indicates that the president is actually on to the fact that “the banks” are not the problem when it comes to job growth. Indeed, it indicates that he has learned a lesson that has penetrated deep in the economics literature over the years. Namely, that small business is responsible for nearly all job creation in this country. The most a large employer employing hundreds of thousands (and enjoying a cushy relationship with the banks) – an IBM, say – is going to do, even in the best of years, is add 10% to its workforce. The big firm’s task will then revert to cutting fat and getting nimble, the perennial challenge facing corporate behemoths.

Small businesses, on the other hand, may double, triple, quadruple their workforces if a boom is on the horizon and the niche they are exploiting looks promising. Studies have shown that small businesses can create jobs at twenty times the rate of the Fortune 500. Indeed, when job creation is really robust, firms in the Fortune 500 quickly get replaced by hugely successful startups. A Kauffman Foundation study of last June showed that most of the companies currently in the Fortune 500 were, in fact, founded during periods of recession or a bear market.

Another conclusion drawn in the Kauffman study should give President Obama pause as he steps toward bullying the banks: “Many new firms don’t rely on external financing in their earlystages[, and] a suppressed financial climate may be less immediately relevant to aperson’s propensity to found a new company….” In other words, banks don’t finance startups and small businesses. Individuals do – breakaway engineers taking out mortgages on their homes, venture capitalists looking for the next big thing, and successful garage entrepreneurs plowing a good year’s profit into financing the next year’s operations.

Therefore, the secret to unlocking job growth at the moment is not recapitalizing the banks, let alone steering their lending practices, but getting entrepreneurs and their angel investors to do their thing. This is done not through financial but tax policy. The marginal rate of the income tax, the capital gains rate, and the inheritance tax, not the lending propensities of Citigroup, are the things fateful for small businesses. If the marginal tax rate is high, a small firm doing well one year has little money left over to help through a bad year. If the capital gains rate goes up, startup profits are siphoned off to the government. And an estate tax scheduled to rise to 55% in 2011 will scare venture capitalists from striving to finance the next business phenom into economically inert tax shelters.

Events thus are cornering the Obama administration into holding the line on taxes – even recognizing that real tax cuts, on top income, capital gains, and estates (and not rebates and other one-time deals), are becoming urgently necessary. Pleading with the banks to sniff out what’s going on in entrepreneurs’ garages will not work, because the most banks ever really do with startups is provide a short-term credit facility, not real capital. At any rate, the Obama administration wants banks to get “risky” assets off their books. This means not financing untried small businesses and instead stocking up on the $1.8 trillion in treasury bonds the U.S. is going to produce this year, thanks to the budget deficit.

That leaves tax policy as the one and only lever the administration has to jump-start a non-jobless recovery. “For the next year or two, priority No. 1 - certainly this year, priority No. 1 has to be job creation,” administration economics majordomo Larry Summers said on television over the weekend. The sooner he informs the president that it’s time to cut taxes, the sooner that priority will be addressed.