Why does entrepreneurship policy matter?

Entrepreneurship and the innovation it can deliver is a key driver of improvements in productivity. Entrepreneurial endeavours have taken humanity from subsistence to relative affluence and it is entrepreneurs who will raise long-term living standards of future generations. As we noted in our landmark essay collection Operation Innovation: How to make society richer, healthier and happier:

“The effect of accumulated innovations has transformed the world at a pace that would have been unimaginable to our not-so-distant ancestors. Even a rate of 2% growth per year – what is now considered slow – if sustained year after year, results in a doubling of measured living standards in just 35 years. The gap in living standards between 1423 and 1723 may have been noticeable to a typical fifteenth-century person, but the gap between 1723 and 2023 would have been beyond even an eighteenth-century person’s wildest imaginings. 

In 1723, the typical Brit would have spent a substantial portion of their wage on lighting and heating their home with sputtering candles and smoky coal. They would almost certainly have had no access to running water, been unable to afford to travel abroad, and only just about been able to fund some pastimes – some limited reading, if literate, and perhaps the occasional and expensive sip of a newly-imported luxury like coffee. Their work would have involved back-breakingly long hours, with little recourse for that broken back. They faced the constant threat of an early death from disease.

Thanks to the incremental and accumulated work of just a few thousand innovators in the intervening three centuries, we now enjoy the widespread availability of electricity, central heating, running water, toilets, cars, rail travel, literacy, television, restaurants, office jobs, and instantly effective treatments for many previously debilitating or life-threatening diseases – not to mention commonly available inventions that to the 1723 Brit would seem tantamount to magic, like human flight, impressively accurate weather forecasting, instantaneous communication with anyone in the world, and now machines that can reason and talk.”

Entrepreneurs are also working to solve society’s biggest problems from climate change to educational inequality, creating new jobs, expanding consumer choice, and supporting higher-quality public services.

Having an economy which enables and encourages entrepreneurship can also be a lifeline for individuals whose talents may be overlooked or undervalued in the ‘traditional’ economy.

What can policymakers do to support entrepreneurship?

While the guile and perseverance of individual founders will always be the most important factor in determining how entrepreneurial an economy is, there are a wider set of key conditions that policymakers can and should ensure are in place in order to best encourage and enable entrepreneurship to flourish.

We believe that to make Britain the best place to start and grow a business in the world policymakers need to focus on five key areas: innovation; skills; investment; competition; agglomeration.

Innovation

Whether they apply scientific knowledge, create disruptive business models, or simply spot opportunities for profit when incumbents lack competition, entrepreneurs play a vital role in the innovation process. The ability to take knowledge, labour, and capital, and put them to their most productive uses is how entrepreneurship drives long-term improvements in living standards. Economic progress is the result of a continual process of creative destruction – in which new businesses with new ideas capture market share from old businesses with old ideas.

New ideas are special. Unlike other inputs, the value of an idea doesn’t diminish with scale and is hard to exclude others from its value. Ideas can spillover. In fact, economist William Nordhaus estimates that innovators are only able to capture 2.2% of the total value to society of new inventions. As a result, there is a risk that the incentive to innovate can be too weak. At the same time, intellectual property protections, such as copyright, designed to incentivise innovation and creativity can stifle it too, when improperly applied.

The massive economic and social benefits of innovation should create a presumption in favour of allowing entrepreneurs to experiment with new business models and technologies unless there are compelling reasons to believe that the new invention will bring serious harm to society. In such cases, interventions should be targeted at the specific harm and designed to leave maximum flexibility for the innovator. Regulations should be under constant review as new technology can leave them unfit for purpose. Without constant vigilance, rules can be used by vested interests to keep out new more efficient entrants, which results in higher prices and reduced choice for consumers.

Emerging technologies such as artificial intelligence, autonomous vehicles or alternative proteins deserve special attention. Entrepreneurs working on developing these breakthrough technologies require a regulatory state which is responsive and proportionate. Britain should aim to be first port of call for emerging technology entrepreneurs to test their products at scale, and we should not be afraid of harnessing regulators of likeminded countries to speed up approvals of novel technologies here in the UK.

Innovative entrepreneurs are often not great engineers nor scientists. Rather, they have the unique ability to understand the true potential of scientific developments and a method for bringing the idea to market. Enabling new ideas to flow from the world of academia and research institutions to market should be a key concern for policymakers who want to support entrepreneurial innovation.

As well as removing regulatory barriers to innovation and providing adequate financing, it is important to raise the status of invention and entrepreneurship more widely.

Skills

You can’t build great businesses without great people. Entrepreneurs need access to high-skilled workers to turn their bright ideas into viable businesses. Founders tell us time and again that the difficulties they face when trying to hire the talent they is a key barrier to growth. To remove this obstacle, Britain needs to become more open to international talent as well as building an education system that equips young people with entrepreneurial skills as well as being more responsive to the needs of business.

But, the focus shouldn’t just be on a shortage of skilled workers – we also need to ensure that the supply of entrepreneurial talent doesn’t dry up. Thirty-nine percent of the UK’s fastest-growing startups have at least one foreign-born co-founder, we need to reform the visa system to retain the UK’s status as a top destination for entrepreneurial talent. There is a strong case for expanding initiatives such as the High Potential Individual visa, which allow the best and brightest to move to the UK without a job offer, using real-world labour market data. Although, we traditionally prioritise removing legal barriers to immigration, there is a strong case for going further and proactively seeking out international talent using scholarships.

We should also seek to draw entrepreneurial talent from a wider range of the population – we miss out on great ideas when we under-utilise half of the population. That’s why we set up the Female Founders Forum to encourage, support and promote female entrepreneurship. It is also means looking at the barriers which deter people in deprived communities from starting businesses.

Boosting the supply of entrepreneurial talent shouldn’t just be about maximising the number of people who start companies – quality, not quantity, should be key. Upgrading the skills of would-be entrepreneurs either through formal training programmes or through support and advice at incubators or accelerators is key to ensuring that good ideas can become great businesses. There is a strong case for starting young. Teaching young people to start businesses not only promotes venture creation down the line, but also improves employability more widely.

Investment

Although many of the costs associated with starting a businesses have fallen, entrepreneurs will always need access to capital in order to hire staff, rent office space, and purchase new equipment. The costs typically pile up before the business has made its first sale, and the most ambitious businesses can run losses for years as they reinvest in growth and experiment with different business models before eventually turning a profit.

Startups face significant barriers when raising finance as unlike more established competitors they are not able to provide trading histories or offer collateral. This forces lenders and investors to carry out costly due diligence reducing the viability of smaller investments, creating an SME equity funding gap.

Targeted tax reliefs such as the Enterprise Investment Scheme (EIS), Seed EIS, and Venture Capital Trusts (VCTs) have expanded access to capital for SMEs enabling businesses to grow. However, there is still room for improvement. Reducing the delays in the Advanced Assurance process would ease cashflow issues for startups and make it easier to attract investors to the schemes.

Innovations in finance such as crowdfunding and P2P lending, alongside established public markets for early stage firms such as the Alternative Investment Market (AIM) have helped to close the gap and allow more firms to scale. Regulators should work to ensure these alternatives are free to expand and support more investment in SMEs.

Taxes are important too. They can excessively penalise investment relative to consumption and distort the decisions of investors. Under the status quo, the treatment of new investments and trading losses biases the tax system in favour of established incumbents, hurting start-ups and dampening innovation.

Competition

Competitive markets empower consumers by forcing businesses to constantly improve – driving standards and choice up, and costs down. While the textbook economics model of perfect competition is unrealistic, businesses cannot make excessive profits for long, as high prices send a signal to entrepreneurs to enter the market.

The threat that competition from new entrants poses to a monopolist’s ‘quiet life’ can lead some incumbents to use regulation to raise barriers to entry. Regulation is essential to protect consumers, worker safety and the environment, but regulations can impose a disproportionate burden on smaller firms who lack the luxury of being able to spread the fixed costs of compliance over a large number of sales. Excessive licensing requirements or standards often fail to achieve their aims as competition is a key driver of improvements in quality.

At the same time, attempts to regulate businesses with market power can create unintended consequences. For instance, rules making mergers and acquisitions harder can have a negative impact on startup formation by removing a route of exit. A firm enjoying high market share does not equate to it being a monopolist – as long as competitive forces are present to keep it in check.

Regulators should have a mandate to promote competition and innovation. They should seek to simplify and rationalise regulations to ensure they achieve their important aims while imposing as minimal cost on new entrants as possible.

Agglomeration

Agglomeration refers to the concentration of economic activities in distinct geographic areas, and specifically the way by which this fosters greater rates of innovation and economic growth. Deeper labour markets mean people can be better and more quickly matched to jobs at which they are most well suited to. This in turn means they can more readily concentrate on producing what they are relatively best at producing, and trade the fruits of their labour with one another.

Spurring agglomeration requires us to enable more people to locate themselves in close proximity to one another. Policies that enable cities to build more homes and densify, or that improve transport links within and between urban areas will enable entrepreneurs, workers and investors to exchange ideas and expertise more readily. Even in an increasingly digitised economy, where working remotely has become commonplace, physical clusters retain an advantage of their own.

On a number of agglomeration metrics, Britain is falling short. We’ve failed to build more than 300,000 new homes a year since the 1970s, and a far smaller proportion of people can easily commute into city centres in the UK than is the case for many European nations. Facts like these prevent agglomeration from blossoming and hold back entrepreneurial ecosystems right across the country.