Which State Policies Lead to U.S. Firm Exits? Analysis with the Economic Freedom Index

This research investigates the relationship between public policy and firm deaths in the U.S. states. Policies that promote firm births may increase or decrease firm deaths. We use components of the Economic Freedom of North America index as a metric to evaluate the relationship between increased government size and firm deaths for the 50 states during 1989-2004. Elements of economic freedom are significantly related to firm deaths but in conflicting directions. We find that in the relevant range, some increases in state policy lead to firm death more than others. The paper also discusses our results and the implications for both future academic research and public policy. Introduction Entrepreneurship and the role of new businesses have a strong role in economic development in the United States (e.g., Sherman and Chappell 1998). Thousands of new businesses are started every month in each of the U.S, states (U.S. Small Business Administration 2008). However, thousands of firms also cease to exist every month. The Small Business Administration (SBA) estimates that 649,700 new firms were created in the states in 2006 but also estimates 564,900 firms closed and 19,695 firms filed bankruptcy (U.S. Small Business Administration 2008). A great deal of the entreprcneurship literature has focused on the creation of new ventures, including research into the effect of public policy institutions on new venture creation (Gohmann, Hobbs, and McCrickard 2008; Sobel 2008). Relatively fewer studies have focused specifically on the causes of firm deaths, especially how public policy influences firm deaths rates. In times of economic uncertainty and economic slowdown, this is a significant issue to address. How might public policies influence the deaths rate of firms? The impact of new ventures on the economy and the prospect of new ventures improving a community's fortunes leads many governments (at all levels of governance) to emphasize firm creation as a matter of public policy. However, as the evidence deafly shows, firm launches are often accompanied by firm deaths. This observation raises the question of whether public policy is also related to firm deaths. Do public policies intended to foster new firm creation have any unintended consequences regarding firm deaths? Or, as may be, does the process of venture creation--mediated by public policy--also create the "raw materials" for firm deaths as a by-product of the benefits the new ventures create? We consider these research questions by investigating the relationship between firm deaths and a widely used index of state public policy settings and outcomes, the Economic Freedom of North America (SFNA) index (Karabegovic, McMahon, and Mitchell 2005). Karabegovic, McMahon, and Mitchell (2005) measure "economic freedom" as a combination of political policies and outcomes related to the "size" of government, taxation, and government influence in labor markets. Research demonstrates that the bundle of policies and outcomes summarized by the EFNA affect a state's income (Karabegovic, McMahon, and Mitchell 2005), population growth (Ashby 2007), and business formation (Campbell and Rogers 2007; Kreft and Sobel 2005). Karabegovic, McMahon, and Mitchell (2005) group 10 variables--usually expressed as ratios of gross domestic product (GDP)--into three categories: size of government; takings and discriminatorry taxation; and labor market freedom. Karabegovie, McMahon, and Mitchell (2005) argue economic freedom consists of smaller governments, with lower taxes, and less public employment. Campbell and Rogers (2007) and Kreft and Sobel (2005) argue that more economic freedom (higher values of the freedom index)--so-called by the EFNA--spurs more entrepreneurial activity and more new venture creation. Armchair economics might seem to indicate that states with more economic freedom should also experience fewer firm deaths: having a smaller, less intrusive government would result in smaller tax and regulatory burdens for a small business, and firms facing less "competition" in markets from the government itself. …