Is uncertainty causing small business owners to behave in ways that are hindering the recovery? That question is at the center of an intense public debate. Though reasonable arguments have been presented on both sides, there is not much empirical evidence to draw on. To contribute some to the discussion, we investigated the statistical association between data on small business plans to hire and make capital expenditures and a measure of policy uncertainty. Our analysis suggests that uncertainty is adversely affecting small business owners’ expansion plans.Small business ; Economic conditions - United States

Mark E. Schweitzer

Scott Shane

English

Research Papers in Economics

ECONOMIC COMMENTARY
Number 2011-24
November 29, 2011
Economic Policy Uncertainty and 
Small Business Expansion
 Mark E. Schweitzer and Scott Shane
Is uncertainty causing small business owners to behave in ways that are hindering the recovery? That question is at the 
center of an intense public debate. Though reasonable arguments have been presented on both sides, there is not much 
empirical evidence to draw on. To contribute some to the discussion, we investigated the statistical association between 
data on small business plans to hire and make capital expenditures and a measure of policy uncertainty. Our analysis 
suggests that uncertainty is adversely affecting small business owners’ expansion plans.
  ISSN 0428-1276
Small business owners have been saying for some time that 
uncertainty about the future direction of federal policies 
has caused them to hold back on hiring and capital invest-
ment. As the Federal Reserve Bank of Boston reported in 
July, businesses have expressed “concern about current and 
future negative effects of increased uncertainty, attributable 
in part to failure to resolve the U.S. debt ceiling dispute 
promptly and the associated unclear future course of federal 
expenditures and taxes.”1 
The media, pundits, and politicians have picked up this 
point. Some commentators now assert that currently high 
levels of “policy uncertainty” are choking off the recovery 
in the small business sector. Others counter that there is no 
evidence for this assertion. This debate is important to our 
elected ofﬁ  cials because policy uncertainty could be slowing 
the recovery. If small business owners do not hire or invest, 
economic expansion will be slower than if they do. 
In this Commentary, we empirically examine the hypothesis 
that “policy uncertainty” adversely impacts small busi-
ness owners’ expansion plans. To do this, we looked at 
the statistical association between data on small business 
plans to hire and make capital expenditures and a measure 
of “policy uncertainty.” The data on small business plans 
cover January 1986 through July 2011 and were col-
lected by the National Federation of Independent Business 
(NFIB).2 The uncertainty measures were created by Scott 
Baker, Nick Bloom, and Steve Davis and described in their 
paper “Measuring Economic Policy Uncertainty.”3 
The economic theory behind the hypothesis is straightfor-
ward. As Federal Reserve Board Chairman Ben Bernanke 
explained in a 1983 paper, business owners will delay costly 
capital investments and hiring decisions when the future 
is uncertain. They want to avoid making choices that turn 
out to be wrong when the future environment is revealed.4 
Therefore, if tax and regulatory policies are likely to change 
signiﬁ  cantly in the future, small business owners will reduce 
their planned hiring and investment. In simple terms, the 
theory predicts a negative correlation between policy uncer-
tainty and small business expansion plans.
Some observers have argued that existing data from the 
NFIB survey already negate the policy uncertainty argu-
ment.5 They say that policy uncertainty cannot account 
for small business owners’ reluctance to hire and invest 
because only a small fraction of them responds to a ques-
tion about the primary problem that they face by indicating 
“regulation” or “taxes.” Moreover, the share of respondents 
identifying taxes and regulations as their primary problem 
is not very different now from periods when small business 
owners were more willing to hire and invest.
However, the NFIB question to which these observers refer 
asks about regulation and taxes, not policy uncertainty. Un-
certainty about regulation and taxes may separately affect 
small business expansion even if regulation and taxes are 
not currently a problem. Our approach brings in additional 
information about the uncertainty itself.
Measures
To quantify small business expansion plans, we obtained 
two monthly measures collected by the NFIB in its survey 
of members (who are small business owners). The ﬁ  rst, 
which we call “hiring plans,” is the net percentage of small 
business owners who indicate that they plan to hire over the 
upcoming three months.6 The second, which we call “capital 
investment plans,” is the percentage of small business own-
ers who indicate that they plan to make a capital expendi-
ture over the upcoming three to six months. First, it looks reasonable. The measure increases in response 
to events that most observers believe have increased policy 
uncertainty and decreases in response to events that most 
observers think reduced that uncertainty. In addition, the 
authors show that other measures developed using the same 
approach accurately predict other types of uncertainty, 
such as ﬁ  nancial uncertainty. Finally, the measure predicts 
changes in several measures of economic activity, such as 
employment and GDP. 
A critical technical complication in the Baker, Bloom, and 
Davis paper and other econometric work on uncertainty is 
that bad economic conditions could cause economic uncer-
tainty to rise, rather than the other way around. Most of the 
existing work on the topic uses some statistical modeling 
assumptions to help solve this problem. 
We deal with the problem differently. First, we focus on 
the attitudes of small businesses rather than the general 
economic outcomes. Second, we estimate a statistical model 
that predicts most of the variation in business attitudes 
based on business cycle and ﬁ  nance variables and then 
we add policy uncertainty to see how it changes the initial 
model’s estimates.
What the Data Show
Figure 1 plots the measures of policy uncertainty and small 
business hiring plans over the past 25 years, identifying 
key events that occurred over this period. As the ﬁ  gure 
shows, the trends in both small business hiring plans and 
policy uncertainty look reasonable, with the Second Gulf 
War, the 2001 Bush tax cut debate, the stimulus debate, 
and the banking crisis all leading to spikes in policy uncer-
tainty. Several of these periods also saw sharp declines in 
small business hiring plans.
Figure 1.  Policy Uncertainty and Small 
Business Hiring Plans
Figure 2.  Effects of Uncertainty on Small 
Business Hiring Plans 
–20
0
20
40
60
0
100
200
300
400
1986 1989 1992 1995 1998 2001 2004 2007 2010
Index Percent of small business owners
1st Gulf War
Clinton 
election 9/11
2nd Gulf War
Lehman, 
TARP
Debt ceiling dispute
Bush 
election
Tax cuts
Stimulus 
debate
Obama election
Banking crisis
Planning 
to hire
Uncertainty index
–10
–5
0
5
10
15
20
1986 1989 1992 1995 1998 2001 2004 2007 2010
Activity level
Expected outcome
Without uncertainty
Average
We believe that the NFIB data are accurate measures of 
small business hiring plans. To verify this, we compared 
the NFIB hiring-plan measure with the ADP Employment 
Report measure of the percentage change in employment at 
establishments with 1 to 49 employees, a commonly used 
measure of changes in small business employment. We 
found that the NFIB measure is strongly correlated (0.67) 
with the ADP measure of the employment change three 
months later, for the period over which the two indexes 
overlap (December 2000 to July 2011). 
Moreover, economists working with the NFIB evaluated 
how informative the survey variables were in models cre-
ated to predict a number of macroeconomic variables in 
2003.7 The two variables we chose to investigate were both 
shown to be informative. The analysis showed that small 
business hiring plans are helpful in predicting the overall 
unemployment rate, while small business capital expansion 
plans are predictive for economy-wide capital expenditures.
The policy uncertainty measure is also a monthly measure. 
It contains three components. According to its creators: 
“One component quantiﬁ  es newspaper coverage of policy-
related economic uncertainty. A second component reﬂ  ects 
the number of federal tax code provisions set to expire in fu-
ture years. The third component uses disagreement among 
economic forecasters as a proxy for uncertainty.” 
The components are weighted as follows: 50 percent on the 
news component and 16.67 percent each on tax expirations, 
forecaster disagreement about the future CPI, and forecaster 
disagreement about future federal expenditures. 
We believe that the Baker, Bloom, and Davis measure 
accurately captures policy uncertainty for several reasons. 
Note: Shaded bars indicate recessions.
Source: Authors’ calculations.
Source: Created from data from National Federation of Independent Business 
and Baker, Bloom, and Davis (2011).While this casual empiricism shows the link between uncer-
tainty and slower business expansion, the rise in policy un-
certainty is also clearly correlated with recessions. Economic 
problems encourage policy changes, but they also dampen 
businesses’ enthusiasm for expansion. This is the reason 
that controlling for cyclical variables that are predictive of 
small business sentiments is important to the analysis. 
To ensure that we isolate the effect of uncertainty from 
general economic conditions, we ﬁ  rst construct a model that 
does well at predicting hiring and capital expansion plans 
without including policy uncertainty. We ﬁ  nd that the un-
employment rate and employment growth are very effective 
at picking up how recessions and expansions affect small 
businesses’ plans.8 
We are also concerned that the availability of ﬁ  nancing af-
fects small business expansion plans and is correlated with 
economic growth. To control for the ﬁ  nancing conditions 
facing small businesses, we include both the prime rate and 
the 6-month Libor. The ﬁ  rst of these captures the cost of 
line-of-credit ﬁ  nancing, while the second picks up the fund-
ing costs of banks and the effects of the ﬁ  nancial crisis on 
those costs. 
Including just the control variables and a simple time trend, 
our regression explains 79 percent of the monthly variation 
in reported plans to hire and 76 percent of the variation in 
reported capital investment plans. These results are strong 
enough to accurately pick up the decreases in expansion 
plans around three recessions since 1986, and the general 
pattern of expansion plans between recessions.
When we add policy uncertainty to the model, statistical 
tests suggest that this variable helps the model ﬁ  t the data 
better. Policy uncertainty has a statistically signiﬁ  cant nega-
tive effect on both small business hiring plans and small 
capital expenditure plans. 
In order to show the size of the effect of policy uncertainty, 
we compare what small business owners’ hiring plans would 
be in the face of average uncertainty and above-average 
uncertainty, according to our model (ﬁ  gure 2). 
Consistent with the assertions made by the critics of the 
policy uncertainty argument, our model shows that econom-
ic conditions dramatically lower predicted small business 
planned hiring, particularly from 2007 to 2009. A compari-
son for capital expansion shows similar results.
The effects of the recession and ﬁ  nancing conditions are still 
weighing on business hiring plans. In the summer of 2011, 
for instance, we estimate that measures of economic condi-
tions reduced NFIB planned hiring by over 4 percentage 
points from the average and by about 10 percentage points 
from early 2007 levels. 
While the downturn and weak recovery certainly had a 
large negative effect on small business hiring plans, policy 
uncertainty has exacerbated this effect. In the summer of 
2011, the net percentage of small business owners planning 
to hire would be 6 percentage points higher if it were not 
for policy uncertainty. That is, either 6 percent more small 
business owners would be planning to hire (or 6 percent 
more small business owners would not be planning to lay 
off workers), were policy uncertainty not currently an issue. 
The results for capital expenditures are very similar.
We also reanalyzed the data using two different versions 
of the uncertainty variable to make sure the results don’t 
depend on how uncertainty is measured. The results are 
maintained in these alternative speciﬁ  cations. 
An additional concern is whether the uncertainty index is 
picking up dips in consumer sentiment about the economy 
that are not connected with policy uncertainty. To address 
this concern, we examined how including a measure of con-
sumer conﬁ  dence inﬂ  uences the effect of policy uncertainty 
on small business expansion plans. We included the month-
ly score on the Michigan Consumer Sentiment Index as an 
additional control variable in the regression analysis. As 
one might expect from the tendency of policy uncertainty to 
be highly negatively correlated with consumer conﬁ  dence, 
including this variable reduces the size of the policy uncer-
tainty effect on small business expansion plans. However, 
in both regressions, the effect of policy uncertainty on small 
business expansion plans remains statistically signiﬁ  cant.
Implications
We ﬁ nd statistically signiﬁ  cant negative effects of policy 
uncertainty on small business owners’ plans to hire and 
make capital expenditures over the 1986 to 2011 period. We 
also ﬁ  nd a large effect of the economic downturn on small 
business plans, but the two effects do appear to be indepen-
dent. The negative effects of policy uncertainty show up 
even when we weight the components of policy uncertainty 
in several different ways. The results also stand up when 
consumer conﬁ  dence is controlled for, suggesting that the 
effects are distinct from consumer sentiment. 
While this statistical analysis is informative about the 
relationship between policy uncertainty and small business 
expansion plans, we cannot say that “policy uncertainty” 
causes small business hiring and capital expenditure plans 
to decline. That is because a purely statistical model cannot 
identify fundamental causes. But whatever the fundamental 
cause, our analysis indicates that adding information about 
policy uncertainty improves our ability to explain the survey 
responses provided by the NFIB’s survey respondents. 
In that sense, we can say that the correlations between the 
two are strong enough to reject the argument that policy 
uncertainty is irrelevant for currently weak small business 
expansion plans. In our view, policymakers should take 
seriously the widespread anecdotal reports that policy uncer-
tainty is adversely affecting small business owners’ expan-
sion plans.Mark E. Schweitzer is the research director at the Federal Reserve Bank of Cleveland, and Scott Shane is a visiting scholar at the Bank and 
the A. Malachi Mixon III Professor of Entrepreneurial Studies at Case Western Reserve University. The views they express here are theirs and 
not necessarily those of the Federal Reserve Bank of Cleveland, the Board of Governors of the Federal Reserve System, or Board staff.
Economic Commentary is published by the Research Department of the Federal Reserve Bank of Cleveland. To receive copies or be placed 
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Footnotes
1. “Report on Economic Conditions,” July 27, 2011. <http://www.
federalreserve.gov/fomc/beigebook/2011/20110727/FullReport.htm>.
2. “Small Business Economic Trends,” W. Dunkleberg and H. 
Wade, various years. National Federation of Independent Business.
3. “Measuring Economic Policy Uncertainty,” Scott R. Baker, 
Nicholas Bloom, and Steven J. Davis, 2011. Unpublished 
manuscript. <http://faculty.chicagobooth.edu/steven.davis/pdf/
PolicyUncertainty.pdf.>
4. “Irreversibility, Uncertainty, and Cyclical Investment,” Ben 
Bernanke, 1983. Quarterly Journal of Economics, vol. 98, pp. 85–106.
5. “Regulatory Uncertainty: A Phony Explanation for Our Jobs 
Problem,” L. Mishel, 2011.  Economic Policy Institute <http://www.
epi.org/publication/regulatory-uncertainty-phony-explanation/>.
6. The net percentage is the percentage planning to increase hir-
ing minus the percentage planning to decrease hiring.
7. “Small Business Indicators of Macroeconomic Activity,” 
W. Dunkleberg, A. Scott, and W. Dennis. 2003. Washington, 
DC: National Federation of Independent Business.
8. Employment growth is measured using a three-month 
moving average of nonfarm employment growth.

Economic policy uncertainty and small business expansion

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