What do we know about firm support policies?

In October 2022, the Reimagining the Economy project convened 20 economists and political scientists for a workshop on firm support policies. The goal of the workshop was to take stock of what we have learned from empirical work about policies aimed at promoting dynamism, entrepreneurship, and productivity among smaller and medium-sized firms. While much of public support to firms involves tax incentives and fiscal subsidies, the workshop was more focused on policies that target specific constraints, such as training, management quality, market access, technology, supplier relationships, and regulatory barriers.

We organized the discussion around three sessions:

• Policies for management, entrepreneurship, private sector development and innovation in developing countries
• Employment, investment, and innovation effects of tax incentives and subsidies
• Entrepreneurial ecosystems, public/private partnerships, and institutional factors that enable SME growth

Here are some of our main takeaways from the workshop:

• Industrial policies can be impactful in supporting distressed areas, but they must be used with caution

Economists have generally been skeptical of industrial policies due to policymakers having limited information, past failures from these policies, and market distortions that they can create. However, recent empirical evidence and changes in modern-day capitalism demonstrate that industrial policies that focus on investment subsidies, innovation policies, and diffusion of best practices can be helpful in increasing employment and welfare at large.

As policymakers and practitioners draft such policies, they should (1) not replicate what the market currently provides, (2) leverage existing mission-oriented policies, (3) allow expertise and independence between institutions such that policies do not constantly need to be updated, and (4) consider evidence-based approaches that enable further learning. Further research needs to be conducted by economists to better understand the synergies that exist among different policies as these policies can interact in a myriad of different ways.

• Even though states spend an incredible amount of money on tax breaks and subsidies to improve their local economic conditions, the efficacy of such policies is not well understood

States often provide incentive packages to firms in the hopes of developing or attracting new firms. These incentives are believed to have a positive impact when they are used to attract large investments by the firm. Moreover, firms relocating to distressed communities can have spillover effects that increase growth in the region. Distressed communities, however, are the least likely to attract relocating firms even though these areas are willing to pay more for these firms.

While many governments cite job creation as the primary reason for providing incentives, there are also political considerations as governors who are up for reelection are more likely to give larger subsidies. The lack of transparency in these deals have made research in this field limited, but there are ample opportunities to make progress in understanding how incentives shape the local economy. Questions on changes in worker conditions, the best way to structure incentive deals, and supplementary partnerships and programs are all points of future research.

• Targeting firms with industrial policies requires caution because of skewed firm size distribution and heterogeneity in firm performance

For policymakers, two things about firms are worth noting. First, several developing countries have very skewed firm size distribution. For example, in Madagascar and Tanzania, the vast majority of manufacturing and trade firms have less than 10 employees. The number of manufacturing and trade firms with 100+ employees is nearly zero. Second, enormous heterogeneity exists in the performance of firms of different sizes. According to World Bank Enterprise Surveys, in several developing countries, the coefficient of variation (CV) of sales ranges from 1.5 to 9.6 for firms with less than ten employees. The CV of sales ranges from 0.9 to 5.0 for firms with 100+ employees. Therefore, it brings us to the question of what types of policies to apply to these firms in huge heterogeneity. All of this is compounded when governments seek to hit too many policy targets with a single instrument.

• High-growth entrepreneurship is missing in developing countries

High-growth entrepreneurship takes the form of young firms in the top 1-5 percentiles of growth, that have an outsized contribution to the economy, are more likely to raise equity, are few in number, and have a high failure rate. However, high-growth entrepreneurship is missing in developing countries. This is a function of insufficient capabilities to prioritize and experiment with innovative ideas, scale in non-traditional scale channels, fundraise from VCs, and build business connections.

In part, this is due to developing countries lacking opportunities to “learn by doing.” To address this issue, developing countries have been implementing initiatives such as business accelerators. These are essentially “schools for entrepreneurs” – fixed-term, cohort-based programs that provide competitively selected entrepreneurs with capability-building opportunities (e.g., training, mentoring, and networking) and sometimes funding opportunities. However, growing evidence has shown that the impacts of business accelerators on participants are heterogenous, and it is still unclear which capabilities matter.  Besides, business accelerators also affect non-participants in that they act as ecosystem builders and help attract VC and talents to regions. However, the outcomes of business accelerators are still mixed in developing countries.

• Building an entrepreneurial ecosystem through industrial policy is a complex process

It involves consideration of a range of factors, including the key ecosystem elements that spur entrepreneurship, the institutional factors that enable SME growth, and the role of public-private partnership. What drives the entrepreneurial success of a region isn’t as simple as the amount of funding that can be allocated toward investments. For instance, while having the proper functions, resources, and spatial configuration are important to an effective entrepreneurial ecosystem, people matter when it comes infusing the creativity and culture that can change a region. North Carolina’s Research Triangle Park from the 1990s is a fitting example of this.

• Institutional coordination between workforce development and economic development

Small and medium-sized enterprises (SMEs) in the U.S. are major contributors to income and wage but are not as well-funded due to policy loopholes and exceptions. By enforcing equal funding for all firms regardless of size, policymakers could help SMEs escape their perpetual cycle of stagnated growth. In addition, current interactions between government institutions that support firm growth are not well-documented, and more research is needed to support and understand the effects of institutional coordination. As an example, while economic development and workforce development may seem to already have strong institutional alliances, they are in fact quite siloed. Ultimately, by investing in the hidden talents of all workers, more integrated institutional systems have been able to foster more innovation and inclusion.

Across the board, the coordination required among different institutions, and the complementarities that could emerge from considering workforce training, management, and preconditions of an investment location seemed at least as important, if not more so, than financial flows.

• Governments can also spark more business formation by investing in venture capital (VC) firms themselves

Josh Lerner cited the 19th Century French-American venture capitalist Georges Doriot’s vision that neither banks nor public markets would be able to fully support the kinds of companies that were created during WWII. This thinking rings true to the present, as VCs create a larger per-dollar impact than more traditional funding sources and consequently spur more innovation. However, when it comes to translating this type of investment into top-down decisions, policymakers should carefully consider potential incentive distortions caused by matched funding, preconditions of the investment location, and timelines that are tractable. As a case study, China leans heavily into funding VCs, constituting 50% of the country’s total VC funding post 2015. This public source of funding has its merits. Jing Lin mentions that while government-funded VCs are largely outperformed 30-50% by private VCs, the former seems more resistant to market cycle failures. In the case of China, public funding has been altered to shape the local legislative landscape, with more implementation at the local level, more focus on manufacturing and production industries, and more investments into early-stage companies that are otherwise less funded.