Dear Mr. President:

It is a pleasure to present the U.S. Small Business Administration (SBA) Office of Advocacy’s 2008 edition of The Small Business Economy: A Report to the President. The American entrepreneurial spirit continues to be the strength of our economy. In the face of economic challenges, small businesses are developing new ideas, employing additional workers, and producing innovative products and services. 
	Over the past year, the Office of Advocacy has continued to conduct research documenting the importance of entrepreneurship to the American economy and highlighting policy issues of relevance to small firms. 
	Many Advocacy reports in 2007 affirmed the significance of the small business owner in the American economy. A report released in February by Donald Bruce, John Deskins, Brian Hill, and Jonathan Rork found that small business establishment births are the most important factor in growing gross state product, state personal income, and total state employment. They conclude their work with the following statement: "… our results indicate that the most fruitful policy option available to state governments is to establish and maintain a fertile environment for new establishment formation." Kathryn Kobe of Economic Consulting Services confirmed that the small business share of private, nonfarm gross domestic product remains around 50 percent, which is similar to the findings of previous reports on this topic.
	The Office of Advocacy released several studies that examined regional economic development issues. Whitney Peake and Maria Marshall wrote in January that certain state expenditures, particularly investments in human capital and roads, affected the number of new businesses. In March, Robert Fairlie examined entrepreneurship in the Silicon Valley relative to the rest of the United States. 
	The Office of Advocacy also benefited from the release of data from the U.S. Census Bureau’s Survey of Business Owners (SBO) for 2002. In April, the office released "Minorities in Business: A Demographic Review of Minority Business Ownership," a follow-up to the August 2006 release of a report on women-owned businesses. The 2007 edition of "The Small Business Economy" featured a long-awaited discussion of veteran and service-disabled veteran business ownership by Jules Lichtenstein and Joseph Sobota. These reports relied heavily on the 2002 SBO data and other sources. 
	Other reports also dealt with owner demographics. In January, Open Blue Solutions examined self-employment trends among veterans and service-disabled veterans, and I wrote a working paper in December finding that the self-employed tend to have attained higher levels of education, to own their own home, and to have served in the military. The study also confirmed that the self-employed are more likely to be older, white, married, Internet-savvy, and rural. Erin Kepler and Scott Shane in September observed that among nascent entrepreneurs, gender did not affect new venture performance; however, several factors-—such as differing expectations, reasons for starting a business, motivations, and opportunities sought and types of businesses-—varied across men- and women-owned businesses.
	Other studies released in 2007 are worthy of mention. Karl Wennberg, Timothy Folta, and Frederic Delmar, in a working paper released in June, found that many people enter into self-employment gradually, and Brian Headd and Bruce Kirchhoff observed various "stylized facts" from the U.S. Census Bureau’s firm size data, including the conclusion that growing firms are generally a constant share of the economy. Two papers focused on employment benefits-—one by Econometrica and the other by John Hope and Patrick Mackin of SAG Corporation. Both found that small businesses are less likely to offer benefits to their workers, and the offering of such benefits improves employee retention.
	Larry Plummer, at the University of Colorado at Boulder, found that new business entrants provide long-term benefits to the local economy; the increased competition might be painful in the short term, but with time, collaborative efforts accrue to everyone’s betterment. These and other studies can be found on the Office of Advocacy’s research page at http://www.sba.gov/advo/research.
	This edition of The Small Business Economy features chapters on small businesses in international trade and their training of the work force. Contributors Donald Bruce and Paul Reynolds focus, respectively, on tax issues of concern to small business and groundbreaking new data on small business creation. 
	This report also summarizes the economic and small business financial climate in 2007 and examines small business procurement. The Office of Advocacy, through its implementation of the Regulatory Flexibility Act of 1980 and Executive Order 13272, has helped to reduce the regulatory compliance costs of proposed rules and this year began a Regulatory Review and Reform (r3) initiative to begin addressing the cumulative burden of regulation.
	In sum, the 27 million small businesses in the United States play a vital role in the economic well-being of our nation. The Office of Advocacy’s research contributes to the understanding of the importance of small businesses and the entrepreneurial spirit in generating economic growth, hiring and training new workers, and creating innovative products and services that will strengthen America’s competitiveness in an increasingly global economy.

Chad Moutray
Chief Economist and 
Director of Economic Research

Executive Summary

"The Small Business Economy for Data Year 2007" reviews how small firms fared in the economy, the financial markets, and the federal procurement marketplace in 2007. The report provides new information about small businesses in international trade and small firm uses of formal and informal training. Donald Bruce reviews upcoming tax issues for small businesses at the federal, state, and local levels. Paul Reynolds provides an in-depth look at business creation using data from the Panel Study of Entrepreneurial Dynamics. The SBA Office of Advocacy continued its oversight of Regulatory Flexibility Act implementation and introduced the r3 initiative in fiscal year 2007. Appendices provide additional data on small businesses, summaries of small business research from the Office of Advocacy, and background documents on the Regulatory Flexibility Act.

The State of Small Business, 2007

Small businesses, which provide half of the nation’s nonfarm, private real gross domestic product (GDP) weather the same storms as the rest of the economy, and in 2007, they faced an economic slowdown. The economy experienced solid growth in the first and fourth quarters, but began and ended the year with real GDP up only slightly. Housing starts, which had increased rapidly since 1990, dropped to 1 million homes by December 2007-—a 56.4 percent decline. The price of gasoline passed $100 a barrel near year’s end. 
	In the midst of the economic challenges, exporting was among the stronger positive factors. Aided by a weaker dollar, American goods and services were more competitive than in previous years. The U.S. trade deficit was down in 2007; real exports rose 8.1 percent, while real imports increased by 1.9 percent. 
	Increases in service sector employment more than offset declines in the goods-producing sectors. The economy generated 1.1 million net new jobs in 2007. In the first quarter of 2007, 74 percent of the net new jobs were in small firms with fewer than 500 employees and 22 percent were in firms with fewer than 20 employees. Third quarter data showed declining net employment change in all firm size classes.
	Self-employment trends were mixed. Incorporated self-employment rose from 5.5 million in 2006 to 5.8 million in 2007, while unincorporated self-employment averages fell from 10.6 million to 10.4 million over the period. 
	Inflationary trends were modest, especially core inflation, which excludes energy and fuel costs. Nonetheless, with consumer prices rising between 2 and 3 percent, the Federal Reserve was free to aggressively lower interest rates to spur economic growth. The Economic Stimulus Act of 2008 was proposed and debated in the final months of 2007 before being signed into law by President Bush in February 2008.

Small Business Financing

The effects of a decelerating housing market and increasing energy prices were felt to some extent in the financial markets of 2007. Total net borrowing grew at a slower rate than in the previous year. Large declines in home mortgage borrowing were offset by increased borrowing by governments and nonfinancial businesses. 
	Credit conditions remained supportive for most small business financing. Interest rates in all small business loan size categories declined. Small business lending activity strengthened for all loan sizes through June 2007, particularly for loans of $100,000 to $1 million. Large lending institutions with assets of $10 billion or more continued to dominate the small business loan market, accounting for more than half of loans under $100,000, as well as two-thirds of total business loans and three-quarters of the domestic assets of U.S. depository institutions. 
	The number and value of new initial public offering (IPO) issues were up in 2007 as the IPO market continued to recover. Angel investing was also up—by 12 percent, as more than 57,000 entrepreneurial ventures received angel funding in 2007.

Federal Procurement from Small Firms

In FY 2007, the SBA’s Office of Government Contracting reported that of more than $378.5 billion in small-business-eligible federal contracts, small businesses received a total of $83 billion in prime contract awards and about $64 billion in subcontracts. Women-owned small firms received 3.4 percent of the available contract dollars, and small disadvantaged businesses received almost 6.6 percent. Service-disabled veteran-owned businesses were recipients of $3.81 billion, or 1.01 percent, and historically underutilized business zones were awarded $8.5 billion, or 2.2 percent. A total of more than $23 billion has been awarded in the 25 years of the Small Business Innovation Research program.

Profile of Small Businesses and 
International Trade

A bright spot in the U.S. economy of 2007 was the increase in U.S. real exports, up by 7.9 percent over the 2006–2007 period, compared with a 2.2 percent increase in real GDP. Although most U.S. exporting firms are small (because most U.S. firms are small), the level of small business exporting has considerable room for growth. Small businesses with fewer than 500 employees constitute 97.3 percent of identified U.S. exporting companies. The total known value of their exports has increased, while their share has declined from 31.1 percent of the $500.7 billion in total known 1996 exports to 28.9 percent of $910.5 billion in 2006. 
	Behind these numbers is the portrait of U.S. competitiveness on world markets. In the short term, the fall in the dollar’s value relative to other currencies made American exports more competitive on world markets and contributed to a declining net trade deficit in 2007. Longer term, U.S. competitiveness has benefited from investments in research and development and other aspects of the American economy that contribute to quality and innovation. The Global Competitiveness Index notes that the United States is among countries at the highest stages of development that are competitive only when they can innovate and produce new and different goods using the most sophisticated production processes. Small firms play a particular role in U.S. innovation. 
	The chapter also highlights challenges and opportunities for small firms interested in exporting.
 
Small Business Training and Development

As well as being primary job generators in the U.S. economy, small businesses are major trainers of American employees, and give many workers their first job training. The small firm work force includes more young and entry-level workers, and the training offered in small firms tends to be more general, informal, and flexible than that provided by large firms. Small firms provide as much total training—formal and informal together—as large firms, and when they provide on-the-job training, it is often as extensive. 
	Evidence from the 1996, 2001, and 2004 Surveys of Income and Program Participation (SIPP) shows decreases in employer-provided training between 1996 and 2004. Training for workers in firms with fewer than 100 employees dropped 6.1 percentage points, while that for workers in larger firms with 100 or more employees fell 11.6 percentage points. 
	The SIPP also indicates that almost one-third of the owners of U.S. businesses had received training in the last ten years and almost 15 percent had received job skills training in the past year.

A Tax Policy Update for America’s Small Businesses
 
Taxes are perennially listed as a significant concern of America’s small businesses, and advances in data availability and econometric models have spawned a growing body of knowledge about the effects of tax policies on small firms. Small businesses face several prominent federal, state, and local tax issues. Leaving aside the revenue impacts, it is critical to be able to discuss possible changes to the tax landscape. 
	At the federal level, the individual income tax, the alternative minimum tax (AMT), the corporate income tax, and the estate tax are all concerns. Policy issues include the possible extensions of the 2001 and 2003 federal income tax rates, solutions to the burgeoning AMT filing population, depreciation rules, health insurance costs, and carried interest. 
	At the state and local levels, a number of nonrate tax issues are under discussion, including the taxation of variants of gross receipts instead of net business profit, streamlining of state sales tax rules leading toward more efficient multi-state sales taxes, decoupling of states from federal rules, and the determination of “nexus” from multi-state tax purposes.
	Emerging themes include the aging of the population, rapidly expanding technology for tax planning, and increasing environmentally conscious tax policies.

Business Creation in the United States
 
The Panel Study of Entrepreneurial Dynamics (PSED) offers a unique capacity to explore the initial stages of the business creation process, as well as the outcomes—new firms. The firm creation process is complex—many distinct activities are involved. In 2005, more than 12 million people were involved in trying to start new firms.
	For 90 percent of these beginning or “nascent” entrepreneurs, it takes more than five years after the process has begun for an outcome to be determined. By that time, about one-third have implemented a new firm, one-third have disengaged from the process, and one-third are continuing in the startup mode.
	Nascent entrepreneurs devoted a significant amount of unpaid time working on their startup firms—an amount that was equal to about 2.1 percent of all U.S. hours worked in 1999 and about 2.7 percent in 2005.  It was close to one-half the total work time of self-employed workers.
	All kinds of individuals start new firms. Those likely to be more active in the process are men, 24–54 years old, with full- or part-time work or self-employment, African American or Hispanic, and with a high school diploma. When it comes to succeeding, though, individual backgrounds and personal attributes are less significant. The most important factors associated with successful completion of the business creation process are related to knowing the industry and aggressively pursuing the opportunity.
	In cross-national comparisons, the U.S. prevalence rates for "total entrepreneurial activity" are the highest on the chart. The United States is more than holding its own with respect to the emergence of growth-oriented entrepreneurs, according to this assessment.

The Regulatory Flexibility Act in Fiscal Year 2007

Enacted in 1980, the Regulatory Flexibility Act (RFA) requires federal agencies to determine the impact of their rules on small entities, consider alternatives that minimize small entity impacts, and make their analyses available for public comment. President Bush’s Executive Order 13272, signed in August 2002, gave agencies new incentives to improve their compliance with the RFA. The SBA’s Office of Advocacy oversees implementation of the law. 
	Advocacy efforts helped result in FY 2007 savings to small entities of $2.6 billion in regulatory costs. These figures are just one important measure of the effectiveness of the law’s implementation, but they do not capture the totality of Advocacy’s efforts. Often, confidential preproposal communications are where the greatest benefits are achieved in agency compliance with the RFA and in the choice of alternatives that reduce a rule’s impact on small firms. To further enhance implementation of Section 610 of the RFA, which requires review of the cumulative burden of regulations, the Office of Advocacy introduced the Regulatory Review and Reform (r3) initiative in 2007. 
	Since 2002 in response to Advocacy’s model state legislation initiative, 23 states had implemented regulatory flexibility by executive order or legislation as of 2007. All told, including those with previously passed provisions, 42 states had full or partial regulatory flexibility initiatives in effect. Thirteen states introduced regulatory flexibility legislation in 2007. Bills were signed into law in Arkansas, Hawaii, Maine, Tennessee, Texas, and Washington. The importance of state regulatory flexibility for small businesses is demonstrated in a real-life example from Puerto Rico, which has an active regulatory flexibility statute. There, businesses and government worked together, revising onerous regulations to allow ice manufacturers to legally place their logo on an ice bag and still allow enough visible surface to ensure the cleanliness of the bag’s contents.