Can government spending encourage entrepreneurship?

A fairly robust finding is that total government spending is negatively correlated with entrepreneurship. The proposed rationale for this relationship falls under either one of two categories. The first is that government spending is a proxy for government size. Under this scenario high level of government spending implies high levels of government involvement both in terms of burdensome regulations and crowding out of the private sector; both factors considered to be detrimental towards entrepreneurship. The second hypothesis is that total government spending goes hand in hand with high levels of social welfare spending. High levels of welfare spending may provide safety nets for potential entrepreneurs, effectively raising the opportunity cost of entrepreneurship, thus discouraging entrepreneurship.

It is this latter explanation that sparked my curiosity. Here was a directly testable hypothesis – what is the association between government social spending and entrepreneurship? Perhaps the relationship between government spending is more nuanced? Maybe certain types of government spending encourage entrepreneurship while others crowd out private enterprise? The fact of the matter is that quantifying the relationship between total aggregate government spending and entrepreneurship makes one rather important and naïve assumption that all government spending is equivalent. Explicitly, a dollar increase in government spending due to an increase in defense spending is assumed to be equivalent to a dollar increase in government spending due to education spending, or even health spending for that matter. One way to relax this assumption is to explore the relationship between the composition of government spending and entrepreneurship. In other words, holding total government spending (and thus to an extent tax rates) fixed, does a shifting of government spending towards social and public goods such as health, education, social welfare, infrastructure and R &D from other types of spending increase entrepreneurship?

In fact there are several potential reasons why one would expect this to be the case. Increases in the stock of human capital have been shown to have positive effects on entrepreneurship. Increased spending in health and education would have direct positive effects on human capital formation. Increased welfare spending may actually loosen credit constraints encouraging individuals to invest in human capital, especially under imperfect credit markets. A critical assumption of the existing literature is that there are no credit market failures. Finally increases in the share of social and public good spending could come at the cost of private subsidies (e.g. energy, agriculture) where there is a general consensus about their harmful effects.

Given the difficulty in ascertaining which mechanisms dominate, the relationship between public and social government and entrepreneurship lends itself to an empirical investigation. In a recent study I empirically explore this relationship (forthcoming, World Development). In the study I draw data from two sources over the 2001-2009 time periods. The Global Enterprise Monitor survey (GEM) covers at least 2,000 individuals annually in each country. The individual level data (approximately 650,000 usable observations) are generated through surveys. Government spending data is obtained from the IMF’s Government Financial Statistics database (GFS).

I use the standard definition of entrepreneurship or nascent entrepreneurs, with the additional requirement that they expect to create ten jobs or more within the next five years. An individual is considered to be a nascent entrepreneur if he or she is between the ages of 18 and 64 and has taken some action towards starting a business in the last year, and expects to own or share the business they are starting that  must not have paid any wages of salaries for more than 3 months.

The results are interesting. I find that when social and public good spending is increased at the cost of other spending such as private subsidies, there is an increase in entrepreneurial activity. These results are robust to a variety of individual and economy-wide controls, as well as different time period lags of the government spending variables. Further disaggregation of social and public good spending shows positive associations between all the components of social and public good spending and entrepreneurship although only health and education spending is statistically significant.

While the findings of the study are pretty positive towards the engagement of the government in certain sectors, there are limitations to the policy implications. I identify a specific financing source of the social and public good spending – which is private subsidies and other types of spending such as defense. I cannot say with certainty that the same effects will prevail when increased taxes or government debt is used to finance such expenditures. Second, while the study does provide explicit policy recommendations, in practice such policies may be difficult to carry out. Eliminating certain private subsidies or defense spending is likely to be political unfavorable thus making a spending compositional change policy hard to implement. Regardless, the results presented are insightful and should encourage further debate on the nexus between government intervention and entrepreneurship outcomes.

This post first appeared on The World Bank Let’s Talk Development Blog. Publication does not imply endorsement of views by the World Economic Forum. 

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Author: Asif Islam is a Consultant with the Enterprise Analysis Unit at the World Bank Group.

Image: Businessmen and visitors enjoy the good weather on the stairs under the Arche de la Defense in the financial district of la Defense near Paris.   REUTERS/Charles Platiau