Thinking small misses the bigger productivity picture

European economic performance in recent years has been a disappointment. Since the end of the Great Recession, labour productivity – the single most important measure of economic vitality – has grown just 0.7pc annually for the 28 members of the EU. This is discouraging given the longer-term trend: in 1995, productivity in the 15 countries that made up the EU was 89pc of the US level. By 2013, productivity in the same EU-15 had sunk to 79pc of the US level. A recipe for stagnation and political unrest.

While many puzzle over the reasons for this poor economic performance, one surprising cause is consistently overlooked: Europe has too many small firms. On average, EU firms are much smaller than US firms – and smaller firms are generally much less productive than larger firms. Indeed, firms with 250 or more employees are 80pc more productive than firms with 10 or fewer employees, according to EU data covering 18 European nations.

Large technology firms are also more innovative. One study of European hi-tech firms concluded: “Their capacity for increasing the level of technological knowledge over time is dependent on their size: the larger the R&D investor, the higher its rate of technical progress.” Another study found that after controlling for firms’ age, large EU firms were about 14pc more likely to be involved in product or process innovation than small firms.

Defenders of small business will argue that they provide better jobs than corporate giants. But, in fact, small firms provide worse jobs. In looking at small firms in Germany, for example, economist Joachim Wagner found: “wages are lower, non-wage incomes (fringes) are lower, job security is lower, work organisation is less rigid, institutionalised possibilities for workers’ participation in decision making are weaker, and opportunities for skill enhancement are worse.”

But surely, with the increasing EU integration, firms must be getting bigger as they take advantage of larger markets and scale economies, right? In fact, average firm size declined from 7 workers per firm in 2005 to 6.2 in 2013. In contrast, average firm size in the US grew from 19.4 workers to 20.5.

You might think that given the clear economic and social advantages European officials would encourage firms to grow. In fact, the European Commission’s official policy is to favour small firms over larger ones. It states: “Being SME-friendly should become mainstream policy. To achieve this, the ‘Think Small First’ principle should be irreversibly anchored in policy making from regulation to public service.” As a practical matter, the Commission appears to be wary of large firms and determined to protect small and mid-sized firms from competition, as we see, for example, in the recent high-profile antitrust cases against tech companies like Google.

The Commission also allows governments to give direct aid to fishers, farmers, coal-mining companies, shipbuilders, steel companies, and synthetic fibre firms, but only if they are small.

It’s not just officials in Brussels who are perpetuating the myth that small business is best; most EU nations do, too. France, for example, offers more than 250 grants and subsidies for small business. And if you are lucky enough to have fewer than 50 employees, you are exempt from myriad regulations such as creating a works council and establishing a health and safety committee. Not surprisingly, many French firms stay under the 50-worker threshold. This distortion lowers French GDP by as much as 5pc, with workers bearing most of the cost in the form of lower wages.

France is not alone. In Portugal, the expansion of regulations that exempted small firms, combined with expanded subsidies, meant that the average firm size declined by almost 50pc from 1986 to 2009 – and growth stagnated.

Overall, if European firms had the same size distribution in terms of employment as their US counterparts, Europe would see a 12pc increase in productivity. A productivity bonus such as this would be an achievable goal if European policymakers were to embrace size-neutral economic policies. To start, this would entail redesigning tax codes to treat firms of different sizes alike. It would require repealing government procurement practices that favour small firms. Most small business subsidies should be eliminated. Most regulatory exemptions for small firms should be closed off. And most small business financing programs should cease.

There are two common criticisms of size-agnostic policies. The first is they would lead to fewer small businesses. But that is precisely the goal, because larger firms are more productive and innovative, and provide better jobs.

The second is that size-neutral policy would hurt new firms, even those that might have a chance to grow big. But size neutrality is not the same as age neutrality. To the extent there is a rationale for policy differentiation, it should be based on firms’ ages. Getting new firms off the ground can be difficult, as reflected by the fact that so many of them fail in their first five years. For this reason, European policy should accommodate new firms, but that is different to giving firms special favours in perpetuity just because they are small.

Europe’s economic challenge is multifaceted, but one simple step all European governments can take would be to stop “thinking small”.

Robert D Atkinson is president of the Information Technology and Innovation Foundation and co-author of “Big Is Beautiful: Debunking the Myth of Small Business”

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