The Start-Up Act: Blueprint for an Innovation Recovery

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Entrepreneurs are the real jobs engines. That means the only sensible jobs plan is one that helps start-ups grow into Fortune 500 companies. Here is that plan.

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The best way to promote innovation is to clear the way for the main agents of innovation: the entrepreneurs who create new businesses. Existing firms innovate, but their contributions are usually incremental -- improvements in existing products or production processes, or the introduction of new products through pursuit of well-established R&D agendas. When it comes to so-called discontinuous or disruptive innovation -- the kinds of breakthroughs that topple the status quo and give rise to whole new industries -- the catalysts of change tend to be new firms. Think FedEx, WalMart, Microsoft, and Google, all of which were upstarts without any stake in the existing way of doing things.

How to make life easier for innovative entrepreneurs? The Kauffman Foundation unveiled this past July a wide-ranging series of legislative proposals aimed at reducing barriers to new, potentially high-growth businesses. The package is called the Startup Act of 2011.

Where great ideas really come from. A special report

First on the list is expanding the number of entrepreneurs by importing them from abroad. America's universities attract brilliant, creative young people from around the world, but after they get their degrees they are all too often shown the door. This terrible waste of talent needs to end. Foreigners who graduate from U.S schools with STEM (science, technology, engineering, and math) degrees should be welcomed here with a green card stapled to their diplomas. In addition, visas should be granted to foreign entrepreneurs who commit to establishing a business here and hiring U.S. workers.

Foreigners graduating from schools with sci/tech/math degrees should get a green card stapled to their diplomas.

New, innovative businesses with potential for high growth routinely struggle for financing to get them through their early years. Tax incentives could be a useful means of easing these growing pains. The Small Business Jobs Act of 2010 currently provides an exemption from capital gains taxes for long-term investments in startups, but it is slated to expire at the beginning of 2012. The exemption ought to be made permanent, or at least extended until fundamental tax reform zeroes out exemptions generally in exchange for lower rates. Another good idea along similar lines is to offer a 100% exclusion on taxable income earned by qualified small businesses in their first year of taxable profitability, followed by a 50% exclusion for the subsequent two years.

Offering publicly traded stock allows growing businesses to tap into vast pools of capital to fund their expansion. And in a startup's early years, the prospect of going public is a major inducement for angel investors and venture capitalists to get on board. Accordingly, regulatory restrictions that reduce the attractions of going public act as an unintended brake on entrepreneurial innovation. And that is precisely what the Sarbanes-Oxley Act, passed in the wake of the Enron and other accounting scandals, has ended up doing. Recognizing this problem, Congress in 2010 exempted public companies valued at under $75 million from the onerous "Sarbox" Section 404 (which requires management to provide annual assessments of internal controls on financial reporting). More, however, needs to be done. Since the purpose of Sarbox is to protect shareholders, why not leave it to the shareholders themselves to determine whether the law's strictures are worth it to them? Specifically, shareholders of smaller public companies (with market capitalizations under $1 billion) should be allowed to opt out of Sarbox requirements; such companies could then bear special designations in their exchange listings so all future potential shareholders are on notice.

America's great research universities are an enormous asset in the quest for innovation, but the process of commercializing academic research -- converting promising new ideas into saleable goods and services -- stands in need of significant improvement. Of particular concern is the bottleneck that currently hinders the licensing of new technology developed in university facilities. Faculty members interested in commercializing their academic research need to obtain licensing rights from the university - either for themselves if they are starting their own company or for some third party that wants to make use of the innovation. At present, however, they are usually bound by contract to use their own university's technology licensing office (TLO).

This arrangement gives each university's TLO a monopoly over deciding whether and how innovations developed at the school should be commercialized. But most TLOs lack the competence and resources to make these calls, and in any event the absence of competition is inevitably stultifying. The federal government could break up these local monopolies by requiring that, on all federal research grants, universities give their faculty the right to use licensing agents of their own choosing - whether attorneys or other agents or even other universities' TLOs. Licensing "free agency" would speed up commercialization and help rescue promising new ideas that are currently languishing in bureaucratic queues.

In addition to these more specific measures to help entrepreneurs, broad-based regulatory reform is also needed to create a more favorable policy environment for innovation. Regulatory compliance is often a fixed cost, which means that it weighs more heavily on small, new businesses than on larger incumbents. Consequently, excessive or outdated regulations can have an especially deleterious effect on entrepreneurs.

Since regulation is so variegated and complex, reforms in the general regulatory process are the best bet for improving matters. One promising idea is a blanket sunset requirement for all major rules (i.e., with estimated costs of at least $100 million). Rules would automatically expire after ten years unless reauthorized after a formal review process. A useful complement to this idea would be to require all major rules to pass a cost-benefit test. Admittedly, cost-benefit analysis inescapably involves complex and contested judgments, and any process can probably be gamed, but still some formal inquiry into regulations' cost-effectiveness would be a step in the right direction.

The reforms just discussed attack the problem of regulatory overkill at the federal level, but a great deal of regulation - and regulatory mischief - occurs at the state and local levels. Without horning in on state and local prerogatives, the federal government could help promote healthy competition among these jurisdictions by offering regular assessments of policies that affect the formation and growth of new businesses in all 50 states and major metropolitan areas - along the lines of what the World Bank's Doing Business reports do for different countries. The World Bank's rankings have helped to turn up the heat on countries that score poorly, and a similar dynamic could be expected here at home.

The proposals contained in the Startup Act represent a kind of "greatest hits" collection picked from a far broader set of promising reform ideas. It's important to recognize that there is no silver bullet solution: the challenge of creating a more entrepreneur-friendly policy environment must be worked at from multiple angles, and it must be worked at incessantly. Policy reform, like technological innovation, is a never-ending struggle against inertia and entrenched interest.

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Brink Lindsey is a senior fellow with the Cato Institute and the Ewing Marion Kauffman Foundation.

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