For many economists and politicians the accumulation of machinery is viewed as the prime determinant of superior productivity growth. In addition, small firms are seen as a source of new and innovative products and services. Therefore, it is not surprising that investment promotion, particularly for small businesses, is always high on the shopping lists of policy-makers. In Discussion Paper No. 1515, Christian Keuschnigg explains the nexus between business formation and medium-run growth, and compares the effectiveness of policies to promote small-business formation in a monopolistically competitive environment.

The paper identifies a failure by private investors to recognize that the spillovers from their own projects encourage others to invest. Because their external benefits are ignored, there are marginal projects which are not undertaken because they are unprofitable for a single firm, though worthwhile from a social perspective. As a mechanism for rewarding private investment for the external benefits it creates, the author compares a proportional investment-tax credit with an entry subsidy that favours small businesses. Evidence suggests that policies aimed at more extensive investment, e.g. increasing the number of workshop units for small business, are effective at generating medium-run growth. By operating with a lower scale, small businesses allow for more product variety and the externality raises the average productivity of intermediate inputs in building the capital stock. Hence capital becomes effectively cheaper, which further strengthens the incentives to invest. Policies favouring small-business formation, however, come at the cost of derationalization of production, and result in an inefficient trade-off between product variety and scale. Therefore, encouraging small business start-ups is a less desirable policy than a proportional investment subsidy.

Business Formation and Aggregate Investment
Christian Keuschnigg