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Economic SYNOPSES
short essays and reports on the economic issues of the day
2004 ■ Number 12

Entrepreneurship
Rubén Hernández-Murillo
he U.S. economy’s remarkable resilience in the face of
shocks arguably owes to an array of institutions and
policies that reward entrepreneurial activity. A competitive market system, a sound legal framework that secures
property rights, a robust financial system, monetary stability,
low inflation, and generally flexible labor markets encourage
new business start-ups. Together these ingredients act as an
engine for sustainable long-run economic growth. In such an
environment, entrepreneurs have strong incentives to develop
new products and new technologies and to discover profit
opportunities that ultimately direct society’s resources toward
the most productive activities.
In the United States, entrepreneurship fosters small business growth. Firms with fewer than 500 employees represent
about 99.7 percent of all firms and account for about half of
all private nonfarm output and employment. As one would
expect, the turnover among small firms is very high. In 2002,
for example, 550,100 new firms were created and 584,500 firms
closed down. Between 1999 and 2000, job creation by new or
expanding establishments of small firms amounted to about
10.8 million employees, while job destruction at establishments
that downsized or closed totaled about 8.3 million employees.
The net change of 2.5 million employees in small firms, however, represented 75 percent of the net nonfarm employment
change in the United States.1
Economists Steven Kreft and Russell Sobel argue that the
key link between economic freedom—the combination of
favorable legal institutions and tax and regulatory policies—
and economic growth is entrepreneurial activity.2 While several
studies have found that nations with higher economic freedom
tend to have larger per capita income and higher rates of economic growth, Kreft and Sobel analyze entrepreneurial activity
across the 50 U.S. states as a function of political, legal, and regulatory factors. They find a statistically significant and positive
relationship between the growth of entrepreneurial activity—
measured by the annual growth rate of sole proprietorships—
and states’ scores on an index of economic freedom.
Their results suggest that a state’s economic freedom is an
essential factor in the state’s ability to create and attract entrepreneurial activity. The economic freedom index is a composite
measure of three areas of state policies: size of government,

T

discriminatory taxation, and labor-market flexibility.3 The
table illustrates the positive relationship between the economic
freedom score in 1996 and the growth in entrepreneurial
activity in the period 1996-2001. The five states with the highest freedom scores experienced, on average, higher growth in
the rate of entrepreneurship—measured as the number of
nonfarm sole proprietors divided by the population between
25 and 64 years of age—than did the five states with the lowest
freedom scores.
These analyses, Kreft and Sobel insist, strongly suggest
that political and economic liberties do not work individually
to promote economic growth, but rather they exert influence
as a complementary group through their incentive effect on
entrepreneurial activity. ■
1

United States Small Business Administration, http://www.sba.gov/advo/stats/.

2

Kreft, Steven F. and Sobel, Russell S. “Public Policy, Entrepreneurship, and
Economic Growth.” Unpublished manuscript, West Virginia University, 2003.
3

Karabegović, Amela; McMahon, Fred; Samida, Dexter; with Mitchell, Glenn.
“Economic Freedom of North America 2004 Annual Report.” The Fraser Institute
(Canada), 2004.

Economic
Freedom Score
1996 (0-10)

Growth of
Entrepreneurship
1996-2001 (%)

Five highest scores
Delaware
Colorado
Wyoming
South Dakota
Georgia
Average

7.7
7.4
7.4
7.3
7.2
7.4

12.2
7.9
4.6
5.5
7.2
7.5

Five lowest scores
Washington
Maine
Rhode Island
West Virginia
Montana
Average

6.0
5.7
5.7
5.7
5.6
5.7

0.5
6.8
6.0
8.2
5.0
5.3

SOURCES: Sole proprietorships: Bureau of Economic Analysis.
Population: intercensal estimates of population, Bureau of the
Census. Economic Freedom Index: The Fraser Institute.

Views expressed do not necessarily reflect official positions of the Federal Reserve System.

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