Public policy, entrepreneurship, and economic freedom.

• Author: Kreft, Steven F.

The "entrepreneurial spirit" is something that has long been associated with the driving force behind economic progress and growth. Joseph Schumpeter (1942) stated that the key to the success of markets lies in the spirits of entrepreneurs who persist in developing new products and technologies, through a process he termed as "creative destruction." Kaiser (1990) modeled the entrepreneur on the basis of many historical characterizations, including the Schumpeterian innovator, and concluded that the major characteristics of the entrepreneur--innovator, risk taker, and resource allocator--are complementary and inseparable facets of entrepreneurship. Kirzner (1997) argues that the entrepreneurial discovery process is vital to the effectiveness of markets, where discovery entails entrepreneurs discovering profit opportunities by trial and error. In this same respect, Jenner (1998) models the Schumpeterian entrepreneurial process as a dynamic process in which entrepreneurs search for new combinations of products and production techniques that will lead to increased productivity and economic growth. Knight (1921) views the entrepreneur as the bearer of the uninsurable uncertainty present in the marketplace, with the profit earned being the compensation for bearing this uncertainty.

Recently, the conceptual link between entrepreneurship and economic growth has received renewed interest by economists. As argued by Minniti (1999), entrepreneurs are the catalysts for economic growth because they create a networking externally that promotes the creation of new ideas and new market formations. The finding that increased entrepreneurial activity leads to greater economic growth has been well-established at both the national and local levels. For example, Reynolds, Hay, and Camp (1999) show that one-third of the differences in national economic growth rates can be attributed to the level of entrepreneurship in each country. Supporting these findings, Zaeharakis, Bygrave, and Sheperd (2000) study 16 developed economies and find that entrepreneurial activity explains approximately one-half of the differences in GDP growth between countries. More recently, Henderson (2002) shows that entrepreneurs significantly impact economic activity at a more local level through fostering localized job creation, increasing wealth and local incomes, and connecting local economies to the larger global economy.

Based on the increasing awareness of the role of entrepreneurs in driving economic growth, state and local economic development efforts have been more heavily directed toward promoting entrepreneurship. These development efforts have mainly focused on reducing the financial constraints that entrepreneurs face--either through preferential loans to new businesses, as those supported by the Small Business Administration, or preferential tax treatment for new or small businesses. One such policy that has recently gained popularity aims to devote public resources toward attracting and building a larger amount of venture capital to encourage entrepreneurial activity. This development strategy is largely based on casual observation that areas with larger amounts of entrepreneurial activity generally tend to also have a larger amount of venture capital.

A recent controversial policy alternative has been popularized by Richard Florida (2002) in his book The Rise of the Creative Class. The author proposes that instead of focusing on developing capital inputs, development efforts should be focused toward making areas more attractive to bring in and nourish creative, entrepreneurial individuals. In addition, recent work by Gwartney and Lawson (2002), Farr, Lord, and Wolfenbarger (1998), Gwartney, Lawson, and Holeombe (1999), Cole (2003), and Powell (2003) highlight the role of economic freedom in promoting economic prosperity and growth. The results of this research suggest that policies consistent with expanding the economic freedom of individuals are the cornerstone of successful economic development policy.

In this article, we propose that the main difference between these competing development strategies is a question of the direction of causation between entrepreneurial activity and the quantity of venture capital. We then proceed to answer this question with an empirical test to determine whether it is more venture capital that causes more entrepreneurial activity in an area, or whether the presence of more entrepreneurial activity simply, and automatically, causes more venture capital to flow into an area. Not only is this an interesting academic question, it also has significant implications for how to best direct the limited resources available for state and local economic development efforts. The basic question is whether it is better to devote development efforts toward bringing in venture funds or to encourage more entrepreneurial activity among individuals in an area (or alternatively, to attract entrepreneurs to the area) by enacting policy reform that expands economic freedom. Even more interesting is the possibility that there is causation running simultaneously in both directions between venture capital and entrepreneurial activity. If these two phenomenon have this type of relationship, development efforts will only be successful if resources are devoted simultaneously to promoting both larger venture funds and encouraging entrepreneurial activity among individuals.

The next section of this article proceeds to uncover the direction of causality between venture capital and entrepreneurial activity. On the basis of these results, we then consider the issue of which government policies best stimulate the underlying causal factors that promote entrepreneurship. Finally, we present concluding remarks.

Direction of Causality between Venture Capital and Entrepreneurial Activity

One variable that has been widely supported in the literature as a major determinant of entrepreneurial activity is the amount of venture capital investment that is available to entrepreneurs. The Corporation for Enterprise Development (2001) lists eight core elements of an infrastructure necessary for supporting entrepreneurship. Six of those elements revolved around the financing that was available for potential entrepreneurs. Also, highlighting the importance of financing, Henderson (2002) states that the availability of financial resources in an area, especially venture capital investment, is vital to developing entrepreneurs. However, one important idea that has generally been overlooked by previous authors is the notion that venture capital investment may be endogenous to the model of entrepreneurial activity. More specifically, it is hard to determine if the venture capital investment is creating entrepreneurship, or if the investment is simply flowing to the states that already have significant levels of entrepreneurial activity.

We perform state-level panel causality tests on venture capital investment and two measures of entrepreneurial activity (sole proprietorships and patent activity). The measure of venture capital investment is from the 2002 Venture Capital Profiles published by PricewaterhouseCoopers/Thomson Venture Economics/NVCA Money tree, and includes cash-for-equity investments by professional venture capital firms in private emerging companies in the United States, where the venture capital firm can be based, or based abroad. (1) The first measure of entrepreneurial activity, sole proprietorships, has been widely supported in the literature as a good proxy for the level of entrepreneurship. (2) The second measure of entrepreneurship, patent activity, is new to this article, and is measured as the number of utility patents (those received for general inventions of innovations) granted annually in each state. The logic behind patent activity as a measure of entrepreneurship rests in the notion that the most direct and visible outcome of the entrepreneurial process is innovation, which should be reflected in the quantity of patents. (3)

The causality test procedure used here builds on the Granger (1969) and Sims (1972) causality framework by modifying the test to incorporate the pooled time-series properties of all the 50 states. One problem that may arise in using the pooled state data is that the differences across states may be significant enough to bias the true time-series information that is available in the data. Following the approach of Blomstrom, Lipsey, and Zejan (1996) and Farr, Lord, and Wolfenbarger (1998), state intercept dummies were included in each regression specification to avoid the possible bias by controlling for any state-specific influences. (4) Specifically, the effect of the state intercept dummies is to remove the cross-sectional differences of the states, while leaving only the time-series variations to be analyzed. (5)

The general Granger-Sims causality test of two variables X and Y, modified for state panel data, can be seen in the following equations, where equation (1) tests causality running from X to Y, and equation (2) tests causality running from Y to X.

(1) [Y.sub.t,i] = [[alpha].sub.i] [M.summation over (m=1)][[alpha].sub.m] [Y.sub.t-m,i]+[n.summation over (n=1) [[alpha].sub.n] [X.sub.t-n,i] + [epsilon].sub.t,i]

(2) [X.sub. t,i] = [[beta].sub.i] [V.summation over (v=1)][[beta].sub.v] [X.sub.t-v,i]+[w.summation over (w=1) [[beta].sub.w] [Y.sub.t-w,i] + [delta].sub.t,i]

Note that the subscript i refers to the corresponding state observation; the error terms [[epsilon].sub.t,i] and [[delta].sub. t,i] are assumed to be white noise; and, the number of lagged values (M and N or V and W) of the independent variables are chosen to adequately capture the relationship between X and Y.

To check for a one-way causal relationship, both directions of causality have to be investigated. In order to test if X Granger causes Y, equation (1) is estimated with and without the lagged X variables, and then an...