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Creating Entrepreneurial Societies: Self-employment and regulations

27 January 2012


Independent Contractors Australia is interested in, and promotes policies that assist, self-employment in the community. We look for good research upon which good government policy toward self-employed people can be developed. We were alerted to the following publication released in August 2011 from the UK-based Institute of Economic Affairs. Although based on UK research, ICA believes that the messages contained in this publication hold true for global policies toward the self-employed and the encouragement of entrepreneurship.
Below are extracts from the publication that can be sourced at http://www.iea.org.uk/publications/research/self-employment-small-firms-and-enterprise

Extracts from
Self-employment, Small Firms and Enterprise
by Peter Urwin
The Institute of Economic Affairs

[NB: Headings have been added by ICA]

Regulations distort business behaviours
If economies were undistorted by regulation, we would expect to see the most efficient form of contractual relationships being used in a particular circumstance. Businesses and those who provide services would balance the advantages and disadvantages of taking on employees and contracting with the self-employed. Unfortunately, it is highly likely that government regulation does shape the economy and distorts people's decisions in undesirable ways.

Employment regulation encourages self-employment
Self-employment is made more attractive as a result of the cost of regulation. This arises especially, though not only, from employment protection regulation.

Self-employed people avoid employing
Regulation particularly affects small firms as it is often a fixed cost. This means that there can be a 'hollowing out' of the labour market: more people are self-employed (who would rather not be); at the same time, fewer of the self-employed take on employees and so there are relatively fewer employees working for small businesses. The average size of businesses with employees then rises.

Profile of self-employed people very different from people in large firms
According to Peter Urwin, author of this IEA monograph, this is precisely what is happening. Urwin's research also demonstrates how the social profile of those who are self-employed and those who work for smaller companies is quite different from that of those who work for larger companies.

If we damage employment in small businesses, we undermine opportunities for those who want flexible working arrangements and for those who find it difficult to persuade larger, more bureaucratic employers of their talents.

The nature of entrepreneurship
Other interesting findings from Urwin's research relate to the nature of entrepreneurship. Only a tiny proportion of today's small firms become tomorrow's large firms. More importantly, the nature of entrepreneurial discovery is such that we cannot predict those firms that will flourish in this way in advance. As such, any policy that involves picking winners or encouraging particular sectors is doomed to failure. Instead, it is important to remove general impediments to the self-employed taking on employees and to small firms growing. This also points in the direction of radical deregulation.

Employment regulation favours big business
Regulation to improve job security is always tempting for politicians. The costs of this regulation, however, are difficult for politicians to identify---they are reflected in the wealth creation opportunities that are lost and in reduced opportunities for many people with non-standard backgrounds and qualifications who do not fare well in the highly structured labour markets that are the recruiting ground for large firms.

  • Self-employment is a form of contractual relationship which, in certain circumstances, will have greater benefits to the parties involved than an employerÐemployee relationship. Government intervention, however, may make self-employment artificially more attractive by raising the costs of employment relationships.
  • Certain ethnic minority groups, older people and those without English as a first language tend to be over-represented among the self-employed. This is partly because of the flexibility the arrangement provides but also because self-employment offers a 'safety valve' for those who find it difficult to find employment in the formal labour market.
  • It is vital that businesses are not impeded from moving from a situation where the owner is self-employed without employees to a situation where the business has employees. There is evidence that businesses are impeded in this way. In just nine years to 2009, the proportion of micro-businesses with employees fell by almost one fifth. At the same time the proportion of self-employed with no employees rose rapidly.
  • Women, individuals from certain ethnic groups, those with young dependants, those with low or no qualifications, those for whom English is not a first language and those who have recently experienced unemployment make up a much greater proportion of the workforce of small firms. For example, whereas 11 per cent of employees of small firms had no qualifications, only 4 per cent of employees of large firms had no qualifications.
  • Some workers will prefer to work for small firms because of the greater flexibility they offer in their working practices. In many cases, however, small firms will employ people who are talented but who are not able to negotiate the more formal recruitment processes of larger firms. Micro-businesses therefore perform an important economic and social function---employing people who might be overlooked by larger employers.
  • Genuine entrepreneurial insight and discovery tends to come from small firms. Entrepreneurship is crucial for economic growth. The nature of entrepreneurial insight is such, however, that we have no idea where it will come from---not even in the most general terms. Probably only one in every thousand 'start-up' firms will become one of the large businesses of the future.
  • Policies to promote entrepreneurship must come in the form of removing impediments to business and should not involve the promotion of particular business activities. It is simply not possible for government intervention to pick this tiny number of winners. All government can do is create a climate in which entrepreneurship can thrive.
  • The smallest firms are a key driver of job creation. Businesses do not start big. One quarter of employees working in firms that were established ten years earlier are working for firms that started from a position of employing only one person.
  • The cost of regulation has grown enormously over the last fifteen years. This particularly affects small firms with employees because regulatory costs act like a 'poll tax'. Wide-ranging exemptions from employment regulation and the minimum wage would be appropriate for small firms. Such exemptions would have the additional advantage of allowing the government to 'experiment' with deregulation. Standard terms and conditions of employment could be drawn up which would ensure that employees clearly understood the exemptions. Radical reforms of the tax system would also assist small firms which experience much greater compliance costs than large firms.
  • Moves by the government to promote entrepreneurship through the state education system or provide specific tax exemptions and reliefs for particular forms of business activity are wasteful or counterproductive.
Preference for self-employment
Among citizens of the EU, evidence suggests that 45 per cent would prefer self-employment to alternatives if they could choose freely: in the UK this figure is almost identical.

Suspicion of self-employed people
The self-employed find themselves, however, at the centre of various key policy debates, with suggestions that they are essential to an entrepreneurial society often countered by concerns over employment security and suspicion from the tax authorities.

Unfortunately, however, evidence suggests that much of the regulation and legislation produced by government acts as a barrier to growth for self-employed small business owners.

Ageing workforces
... evidence that self-employment facilitates working into old age, as it allows greater independence and control over working hours and can therefore be seen as more flexible.

Motivation of tax authorities
The reason that this is so hotly debated is that, for any given set of activities, the employerÐ employee relationship provides greater revenue to the UK tax authorities. There is an incentive for employers and employees to define working relationships as contract for service and for HMRC to ensure that this is not simply a way of avoiding tax.

.... individuals wishing to register for tax purposes will find that there is no 'self-employed' category.

UK stats
  • 3.6 million enterprises with no employees;
  • just over one million 'micro' enterprises employing between one and nine employees;
  • just under 170,000 businesses employing between 10 and 49 employees;
  • approximately 36,000 businesses among the remaining medium-sized and large enterprises.
The proportion of firms without employees grows from 69.6 per cent of all firms in 2000 to 74.8 per cent in 2009.

Thus we have a rising number of self-employed individuals with no employees; a likely rise in the average size of micro-enterprises employing between one and nine employees; and a fall in the proportionate importance of the largest firms.

Small and medium-sized enterprises (SMEs) account for 60 per cent of all private sector employment and 49 per cent of all private sector turnover.

Small firms help the disadvantaged
Small firms have particular characteristics which lead them to employ those who are otherwise disadvantaged within the hierarchical labour markets of large firms.

Entrepreneurship and jobs come from small firms
This static picture of employment shares, however, hides an underlying dynamic of continual job creation and destruction.

... it is not that there is anything naturally 'second-rate' about small-firm jobs; their insecurity is a natural part of the entrepreneurial process without which no big firms would ever be created.

The evidence presented in this chapter suggests strongly that the growth of new firms is a crucial component of employment growth.

Young firms grow more rapidly and create and destroy more jobs than older firms. This jobs creation arises from a relatively small group within the new firm and small firm sector.

It is impossible to predict which firms will become successful.

We can deduce that the most effective way of ensuring that economic growth and job creation arise from the business sector is simply to make sure that the general conditions exist for businesses to flourish.

Picking winners is a non-starter; education and training will also not help, though policies in this area may be oriented towards other goals. Regulation does bear most heavily on small businesses, however, and may therefore inhibit job creation and the flourishing of potentially highly successful firms.

Only a small number out of the very large number of self-employed people are genuinely creating something new. For many self-employed, the process of contracting is not that different from the process of working for a firm.
    [ICA comment: This is a point with which we strongly disagree. It's a view that comes from having a partial understanding of what is entailed in self-employment. In particular, there is a failure to understand the nature of change in firms and a focus only on change that is 'big' and eye-catching, such as a new product or service. There is a failure to understand that change is constant, but small, in business---just as change is constant in markets. If firms are to operate in markets, they must always change and that's the nature of self-employment. It's also the nature of entrepreneurship]
Thus, the self-employed are not all predominantly entrepreneurs, even if they are considering price signals and working to arbitrage alternative opportunities.

Such entrepreneurial insight is spread very thinly among the self-employed.

Entrepreneurial skills will not be especially sought after by large firms. In a modern economy where education has evolved primarily to serve firms and government, entrepreneurship is unlikely to be valued or promoted in the same way as other skills.

For those whose abilities are primarily related to entrepreneurial insight, however, the educational qualifications system may not be an attractive proposition or a valid way of signalling skills.

This leaves self-employment as one of the few routes for the supply of entrepreneurial skills to the economy.

Policy Implications
The government cannot select winners or even develop schemes that will successfully nurture entrepreneurial skills. The government can, however, remove barriers to entrepreneurship. Regulation is a particularly important barrier because it bears most heavily on new, growing, small and entrepreneurial firms. Such policies of deregulation are important for other reasons too. They will particularly assist people who are otherwise at a disadvantage in heavily regulated labour markets and they will ensure that formal employment in small businesses is not artificially discouraged. More generally, a policy of stripping away regulations that affect small businesses will ensure that entrepreneurship---the engine of growth and the hub of a free economy---can thrive.

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