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THE EFFECTS 0F NEW FIRM FORMATION ON REGIONAL DEVELOPMENT OVER

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THE EFFECTS 0F NEW FIRM FORMATION ON REGIONAL DEVELOPMENT OVER ...

THE EFFECTS OF NEW FIRM FORMATION ON REGIONAL

    DEVELOPMENT OVER TIME: THE CASE OF GREAT BRITAIN

Pamela Mueller,

    Max Planck Institute of Economics, Germany.

André van Stel,

    Erasmus University Rotterdam, EIM Business & Policy Research, Netherlands, and Max Planck Institute of Economics, Germany.

David J. Storey,

    CSME, Warwick Business School, University of Warwick, UK.

Paper submitted to Small Business Economics

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    1. INTRODUCTION This paper examines the link between new and small firms on the one hand, and

    economic development on the other. In principle it is clear that if a new firm is created

    and it employs, either as an owner or an employee, individuals who formerly were not

    employed, then this adds to aggregate employment in the economy. This arithmetic often

    provides a superficial attraction, particularly to politicians facing high levels of un-

    employment or under-employment. It suggests that raising new firm formation will lead

    subsequently to additional employment.

    This paper, however, makes it clear that this outcome is achieved only when certain key

    assumptions are made. The first is that it is possible for policy makers to take actions

    which do raise new firm formation. A second assumption is that macro economic

    circumstances remain unchanged. If this assumption is violated such that macro

    economic circumstances become either more or less benign then this will influence

    rates of new firm formation. On balance the evidence is that less benign macro-economic

    conditions lead to a rise in new firm formation. The third assumption is that it is new

    firm formation which causes increased employment and not vice versa. Often, increased

    employment is not the consequence but rather the cause of higher start-up rates. This is

    because local demand is likely to be higher in regions with employment increases, and

    therefore such regions are attractive locations to found new firms. As these two

    mechanisms differ greatly in their policy implications it is of vital importance to

    disentangle the correct direction of causality. Fourthly, as Fritsch & Mueller (2004) show,

    the creation of a new firm has both immediate and longer term consequences. As noted

    earlier, new firms have an easily identifiable short term direct effect in creating

    employment, but they also have two longer term consequences. The first is that new

    firms displace inefficient incumbents, leading to job losses. However, a second medium

    term consequence is that new firms enhance the competitiveness of firms that remain in

    1business, by exerting a powerful threat upon incumbent firms inducing improved

     1 Disney, Haskel and Hedon (2003) find that in the UK between 1980 and 1992 about half of productivity

    gain was because of internal factors such as introducing new technology and organisational changes. The

    remaining half was because of external factors most notably that the entrants were more productive than

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    performance from them. As Fritsch and Mueller (2004) show, the effect of new entrants is therefore threefold: the first effect is to increase employment, the second is to lower employment and the third is to increase employment. The total effect upon employment can therefore be either positive or negative and depends upon the magnitude of the three elements.

    This paper develops the Fritsch and Mueller (2004) findings for Germany by applying a broadly similar estimation procedure to data for Great Britain. It recognises that the net effect of new firm formation on subsequent employment can be either positive or negative. Furthermore, this study investigates whether there are circumstances in which the effects of new firm formation on subsequent employment change are more likely to be positive or more likely to be negative. In particular it assesses whether policies to raise new firm formation are more effective in geographical areas that already have high rates of new firm formation or whether they are more effective in low enterprise areas. To test this, the paper examines the effects of new firm formation on subsequent employment change between 1981 and 2003 for Great Britain, making a distinction between England on the one hand and Scotland and Wales on the other.

    Our broad key finding is that, for Great Britain as a whole and England in particular, the effect of new firm formation on subsequent employment growth is positive. Hence raising new firm formation, given that this is possible, will lead to subsequent increased employment in this country. However, we do not get the same results for Scotland and

    Wales. Here the impact of increased new firm formation is negative causing lower

    subsequent employment.

    Unfortunately both Scotland and Wales have, historically, had low rates of new firm formation. Believing this to be undesirable, both countries implemented policies, independent of those of England, which have sought to raise new firm formation. The evidence from this paper is that increased rates of new firm formation in Scotland and Wales lead to less, rather than more, employment. The paper therefore raises the question of whether it is possible to have „the wrong type of entrepreneurship‟ and if

    those exiting. However amongst single plant independent firms almost all the gains were attributable to external factors.

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public policy should focus on quantity or quality of new firms. In Scotland and Wales

    new firm formation appears to lead to fewer jobs whereas in England or at least parts of

    England it seems to lead to more jobs.

    2. POLICY CONTEXT

    This section discusses the changing enterprise policy context in Great Britain over the last

    three decades, which is vital for understanding the context of the paper. We use the

    categorisation of policy provided by Greene et al. (2004). They identify four separate

    policy periods. The first is the 1970s when enterprise policy defined as providing assistance and support for new and small firms hardly existed. The 1970s is therefore viewed as a “policy off” period.

    The arrival of Margaret Thatcher as Prime Minister in 1979 changed matters radically. A

    key tenet of the philosophy of her government was to move Britain away from what she

    saw as a dependency culture defined as one where individuals relied on the state. Her

    objective was for Britain to have an enterprise culture in which individuals relied on themselves rather than the state. Thatcher therefore saw enterprise creation as highly

    desirable in itself, but also as a direct mechanism for lowering unemployment levels. The

    1980s can therefore be considered as a decade characterised by support for new start-up

    businesses.

    The 1990s saw a shift in this policy, away from new firms and towards providing support

    2. For GB as a whole therefore, the mid to for existing small firms with growth potential

    late 1990s sees considerably less emphasis placed by policy makers upon new firms. The

    1990s can therefore be viewed as a decade in which the focus was on smaller firms with

    growth potential. Finally, following the election of a Labour government in 1997, the

    decade of 2000 sees a further change with policies being focussed more specifically on

    seeking to enhance productivity and increase social inclusion. In this period, both some

    3types of new firms and some types of growing firms are supported.

     2 For the reasons underlying this shift see Greene et al (2004). 3 These policies were formalised in Small Business Service (2004). This identified the so-called seven

    pillars: building an enterprise culture, encouraging a dynamic start up market, building the capability for

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Whilst these policies are being implemented in Great Britain and specifically in

    England different policies were being adopted in both Scotland and Wales, particularly

    in the 1990s. At a time when GB policies focussed upon “growth businesses”, Scottish

    policy makers became concerned that their new firm formation was much lower than that

    of England, as shown in Figure 1 below. In 1993 Scotland launched its Business Birth

    Rate Policy towards developing business start-ups and the development of

    entrepreneurship seeking to eliminate the difference between the two countries. This

    policy was recently reviewed and an overhaul took place. The new approach was

    launched in 2002 focusing on three priorities. Firstly, innovative high-growth start-ups

    20032003

    shall be encouraged to increase their number and value. Secondly, quality volume 20022002

    20012001business support services are offered to encourage more people to start businesses. 20002000

    Finally, the third focus is on entrepreneurship education. Other targets are to generate at 19991999

    19981998least 30 new starts that achieve the highest growth within three years, to achieve a 70 19971997

    19961996percent survival rate for start-ups over a three-year period, and to increase the number of 19951995start-ups by women and young people. 19941994

    19931993

    19921992

    4519911991Great BritainGreat BritainGreat BritainGreat Britain4519901990EnglandEnglandEnglandEngland1989198940ScotlandScotlandScotlandScotland1988198840WalesWalesWalesWales1987198735198619863519851985

    19841984301983198330

    1982198225198119812519801980

    20

    20VAT registration per 10,000 inhabitantsVAT registration per 10,000 inhabitants

    15

    15

Figure 1: VAT Registration per 10,000 inhabitants, 1980-2003

small business growth, improving access to finance for small businesses, encouraging more enterprise in

    disadvantaged communities and under-represented groups, improving small businesses‟ experience of

    government services and developing better regulation and policy

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Over the period 1980 to 2003, new firm formation rates measured as VAT Registrations

    per 10,000 inhabitants are consistently lower in Wales and Scotland than in England (Figure 1). The overall rate of Great Britain is very close to the England rate because

    England is the numerically dominant country. On average about 90 percent of the VAT

    registration in Great Britain take place in England. Wales counts for only about four

    percent of the registrations and Scotland consequently for six percent. Figure 1 also

    shows that there is a similar pattern over time in England, Scotland and Wales, with new

    firm formation rates rising in all three countries at least until 1989, then falling until

    1994-95 and subsequently being broadly stable. Hence, although the new firm formation

    rates greatly changed over time the distribution between the three regions is very constant

    over the period 1980 to 2003. The reason for the steep decrease at the beginning of the

    1990s and in 1994 is an increase of the VAT registration threshold of more than

    30 percent and 20 percent, respectively.

    Although the introduction of the Scottish Business Birth Rate Policy in 1993 seems to

    have resulted in realising higher new firm formation rates than Wales (Figure 1) it had

    little obvious impact upon new firm formation and it certainly did not appear to close the

    gap with England. In spite of the Scottish experience, Wales also sought to raise new

    firm formation. It introduced its Entrepreneurial Action Plan (EAP) in 2001 but any

    effect is difficult to identify given its short duration. Wales‟ Entrepreneurial Action Plan

    is built around three key objectives. The first target is to encourage more people to start

    or grow a firm by creating a greater awareness of the opportunities and benefits of

    entrepreneurship in order to develop an entrepreneurial culture. Secondly, the focus is on

    sustainable start-ups and to increase their number. Thirdly, the program is ought to

    increase the number of start-ups with growth potential and to create employment.

    3. LITERATURE REVIEW The lagged effects of new firm formation on employment growth already became

    apparent in the study of Audretsch and Fritsch (2002). They found that employment

    growth in the 1990s could not be explained by start-up rates in the 1990s but rather by

    start-up rates of the 1980s in West Germany. Fritsch and Muellers work on Germany,

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referred to above, formally showed the importance of time lags in examining the

    relationship between new firm formation and employment change. They theorised that

    new firm formation had three effects reflected in Figure 2 below.

    The first effect was the short term direct effect of employment created by the new firm.

    The second was the displacement effect of the entrant which causes some existing firms

    to go out of business, hence incurring job losses. Finally, there is a third effect of the

    entrant which is to stimulate better performance from surviving firms. This is called the

    induced effect.

    Applying this theory to German data Fritsch and Mueller (2004) find support for this

    three phase model. They concluded that the peak of positive impact of new firms on

    regional economic development was reached about eight years after entry, and

    disappeared after about a decade. Using a broadly similar approach, van Stel and Storey

    (2004) examined Great Britain for the period 1981 to 1998. Their conclusions were

    similar to those of Fritsch and Mueller. They found the employment impact of new firm

    4 formation was maximised in year five but had declined to zero by year nine.

     4 A disadvantage of their exercises was that they restricted the Almon lag polynomial to be of second

    degree while Fritsch and Mueller showed that a third degree polynomial may actually be more realistic.

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    direct effectdirect effect

    IIIIII

    induced effectinduced effectII00

    displacement effectdisplacement effect

    IIIIon employment changeon employment changeImpact of new business formationImpact of new business formation

    001122334455667788991010

    Lag (year)Lag (year)

    Figure 2: Schematic effects of new firm formation on employment change (according to

    Fritsch and Mueller, 2004)

    However, it is Van Stel and Storey‟s findings for „un-entrepreneurial areas‟ such as North-East England and Scotland, which is of greatest interest in the context of the

    current paper. Here they found that although there was, in the 1990s evidence that for

    England as a whole, new firm formation led to additional employment, this was not the

    case for all geographical areas. In areas with low rates of new firm formation such as

    Scotland and North East England, the overall impact of new firm formation on

    employment change was negative. This implied that policies to raise new firm formation

    in low enterprise areas could be counter-productive in terms of employment change.

    Rather than creating new employment opportunities, the new firms displace existing

    firms leading to employment losses or those new firms exit the market shortly after entry

    thereby degrading the employment just created.

    4. DATA SOURCES

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    The Van Stel and Storey (2004) analysis ended in 1998, and so there was insufficient time to examine the impact of the Scottish Business Birth Rate Policy. The Wales Entrepreneurial Action Plan (EAP) was not implemented until 2001 after the data set had ended. The current paper extends the time period examined up until 2003, which does enable the Scottish policy to be more effectively reviewed. The EAP is however too recent for any of its effects to be included.

    This paper formally merges the methodology of Van Stel and Storey, with that of Fritsch and Mueller. It has the specific objective of examining the impact of policy in the two low enterprise countries of Scotland and Wales, in comparison with high enterprise, England. As in the Van Stel and Storey (2004) paper, data on start-ups is taken from the UK Small Business Service. Start-ups have to exceed a turnover threshold in order to be registered for VAT purposes, for instance, a threshold of ?56,000.00 had to be exceeded in 2003. Businesses below this threshold may also choose to register, but this is optional and unlikely. While about 174,000 start-ups (including agriculture) registered in England, about 7,000 new firms registered in Wales and 12,000 in Scotland during the year 2003. Data on employment is taken from the Census of Employment and, from 1995 onwards, the Annual Employment Survey. Data are supplied by Nomis with the self-employed and unpaid family workers being excluded from the data. Furthermore, following Van Stel and Storey, hourly wages and population density were included as control variables. Wage data are derived from the New Earnings Survey Panel (NESP) Dataset and were changed into constant prices 2003. Data on population density were taken from the Office for National Statistics.

    The unit of analysis is 60 British regions 46 English Counties, 4 Welsh Regions and 10

    Scottish Local Authority Regions over the period 1981-2003. Because of missing (employment) data, the region Orkney/Shetland/Western Isles had to be excluded, therefore generating 59 observations. Different regional and sectoral classifications in the original data files meant some linking operations were performed to ensure uniformity for 19802003 (see Van Stel and Storey, 2004 for details). The agricultural sector is

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excluded as it is fundamentally different from the rest of the economy having, during this

    period, exceptionally low start-up and death rates.

    5. DATA ANALYSIS

    The regions in England and the regions in Scotland and Wales clearly show the same

    pattern regarding the correlation of new firm formation over time (see figure 3). Firstly,

    there is a strong correlation in the short term between start-up rates, but this correlation

    weakens over time. Secondly, there is a strong variation over space, while some regions

    count for only four start-ups per 100 employees, other regions had even more than 15

    registrations per 100 employees. Especially the English regions experience higher start-

    up rates. Most Scottish or Welsh regions cluster around lower values. Figure 3 plots the

    correlation of new firm formation for two time periods. The first is the relationship

    between start-ups in t and in t-1and the second is between t and t-5. A distinction is made New firm formation rate in t-5

    between the England, and Scotland and Wales data.

    2222

    1818

    1414

    1010

    New firm formation rate in t-166

    2226101418222610141822

    New firm formation rate in tNew firm formation rate in t

    Figure 3a: Correlation of new firm formation rates over time in England (per 1,000

    employees)

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