Economy & Budget

Washington must reduce policy uncertainty for small businesses

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The U.S. economy is still on its way back from the 2008 financial crisis. While conventional measures such as real gross domestic product (GDP) per capita have surpassed their pre-crisis peak, a number of weaknesses remains. Some of these are plausibly the result of the long and deep recession the country went through: think of the number of long-term unemployed workers, which is still significantly above its pre-crisis level.

Longer-term weaknesses are arguably more worrisome, as there is no reason to believe that they will, with enough time, disappear. For example, levels of concentration in most industries have been increasing for decades now. Perhaps as a consequence, or maybe as a cause, entry by new firms has been on the decline for quite some time as well.

{mosads}During this same period something else happened: uncertainty surrounding economic policy has been elevated compared to the preceding decades, in particular after the financial crisis. Widely discussed in the popular news amidst analyses of the impact of Federal Reserve policy, healthcare reform, the rise of the Tea Party movement, debt ceiling disputes and spending levels, such uncertainty also received significant attention from researchers looking into its possible effects on the U.S. economy.


While the foundations for believing that policy uncertainty can have negative effects on the broader economy had existed in the economics literature for quite some time, the more recent research introduced new ways to measure indicators of uncertainty, opening the door for serious empirical work.

Scott Baker of Northwestern, Nick Bloom of Stanford, and Steve Davis of the University of Chicago have developed a method for measuring policy uncertainty based on newspaper coverage, expiring tax provisions, and economic forecaster disagreement. They have used this to demonstrate the negative impact policy uncertainty has on firm performance as well as aggregate output measures like industrial production.

Daniel Shoag of Harvard and I have sought to explain the cross-section of labor market outcomes within the U.S. by studying policy uncertainty at the state level. We found that increases in local uncertainty were strongly correlated with the effects of the recession, a finding that is highly robust across alternate measures.

Our baseline results suggest that if uncertainty levels in all states had been the same as those of the five states facing the lowest levels of uncertainty, the national unemployment rate would have been 1 percentage point lower. Importantly, increases in local uncertainty are partially driven by preexisting state institutions. Our results show that well-designed institutions and resilient public-sector operations can reduce policy uncertainty and produce better macroeconomic outcomes.

Reducing policy uncertainty is, if anything, of even more importance to small businesses. While economists often model firms as risk-neutral, owned by a large number of shareholders with fully diversified portfolios, that is obviously not the case for the overwhelming majority of small businesses. As a consequence, small-business owners are likely to be more vulnerable to the risk induced by uncertain business environments.

A number of the initiatives of the new Congress will be helpful in creating more certainty about the business environment. The Small Business Regulatory Flexibility Improvements Act requires more careful consideration before new rules and regulations and demands that their impact on small business be considered. The Helping Angels Lead Our Startups Act (HALOS) is helpful on the other side of the ledger: by making it easier for startup firms to connect with angel investors, the negative impact from heightened policy uncertainty will be somewhat dampened. Despite measures like this, levels of policy uncertainty appear to have spiked in the last few months, at least according to the Baker-Bloom-Davis measure.

Some of this can be attributed to the fact that we just recently had an election. Other uncertainty indicators — the VIX, for example — paint a different picture. But there are real concerns about upcoming legislative and executive activity. While repeal of the Affordable Care Act has long been a priority for Republicans, individuals and small businesses worry about what will come next.

Changes in immigration policy may affect the ability of startups to hire skilled employees. The recent executive order that imposed a travel ban on citizens of a number of Muslim-majority countries, including at least initially green-card holders, has left the more than 10 million legal permanent residents in the country wondering about their true status. Corporate tax reform, while long overdue and with the potential to improve the investment climate, will create winners as well as losers.

The new administration, and Congress, should strive to avoid generating unnecessary uncertainty, and focus first on not doing harm.

Stan Veuger, Ph.D., is an economist and resident scholar at the American Enterprise Institute. This article draws heavily from his recent testimony on the state of the small business economy before the House Financial Services Subcommittee on Small Business.

The views expressed by contributors are their own and are not the views of The Hill.

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