Capital and labour still too often tied up in less productive companies

Higher productivity gains needed to ensure future prosperity

As the population ages, labour supply growth is slowing, meaning that economic growth will increasingly have to be derived from productivity gains. However, such gains in the Netherlands have also shown a downward trend in recent decades, as in many other Western countries. It is essential to reverse this trend to ensure future prosperity.

Low business dynamism is holding back productivity gains

The number of business start-ups and closures in the Netherlands is falling and remains low compared with other EU Member States (see Figure 1). As few new companies enter or exit the market, capital and labour are less likely to shift towards the most productive businesses. The process known as creative destruction then slows down this shift: less efficient companies survive, while better-performing competitors or new entrants fail to win sufficient market share to displace them. As a result, scarce factors of production remain tied up in activities where they perform below their potential.

Many small businesses do not grow

The Dutch business landscape is heavily dominated by very small, long-established companies that show little sign of growth. Few companies in this group cease trading or go out of business. As a result, the Netherlands has a persistently large number of small, low-productivity businesses. This pattern is linked to various factors, including a strong focus on services, tax incentives for small businesses and specific features of the labour market such as protection from dismissal.

At the same time, larger companies tend to show strong growth in their initial years.  Although relatively few companies with employees are established, those that do emerge tend to grow comparatively quickly. Figure 2 shows that the Netherlands is among the frontrunners when it comes to the growth of start-ups with employees. This suggests that the Dutch business climate does not stand in the way of growth, but that the problem lies primarily in the high proportion of start-ups with no employees and limited growth ambitions.

No increase in market dominance despite lower dynamism

When market dynamics are weak, there is a risk that established companies will come to dominate the market. Ultimately, this could be detrimental to productivity and economic growth, as it hampers market entry by new players and reduces incentives to innovate. The weaker business dynamism in the Netherlands has not led to a significant increase in market dominance, as shown by two indicators: market concentration and mark-ups (the ratio between the selling price and the cost of producing an additional product or service). Market concentration has risen only slightly over the past fifteen years and, by international standards, is not at a high level. Nor do mark-ups show any clear upward trend.

It should be noted, however, that greater market concentration can have positive as well as negative effects. In the Netherlands, small businesses have a higher mark-up and lower productivity than larger businesses. Competition may cause the market share of these less productive companies to shift towards larger companies that benefit from economies of scale. At present, we are seeing this process play out primarily in sectors that compete internationally. It is important to prevent this trend from going too far and leading to the emergence of overly dominant market positions, which could, in the long run, undermine competition and innovation.

The right conditions are important…

The government can promote productivity gains by creating better conditions, and Europe can play a key role in this process. For the Netherlands, this is particularly relevant in the services sector, which accounts for a large share of the economy and where business dynamism is lagging behind the most. The greatest benefits of further European market integration are likely to accrue to companies that can leverage economies of scale and are able to operate internationally. Companies still frequently encounter differences in national regulations, which means that doing business across borders within the EU remains challenging. Further integration of the European single market and the development of a European capital markets union could offer companies greater opportunities for economies of scale and growth, and promote competition. It is also worth investigating whether Dutch insolvency law contributes to the low number of companies that cease trading.

…but be cautious with untargeted support

At the same time, caution is of the essence when it comes to far-reaching government intervention. Existing innovation and entrepreneurship schemes can promote business dynamism, provided they are designed to address clear market failures, such as knowledge spillovers from research activities or information asymmetry in lending. However, many government measures actually result in a less efficient allocation of factors of production, thus curtailing productivity gains. These include tax benefits for self-employed people and for small businesses that distort the labour market and discourage further growth.

Untargeted financial support measures may be warranted in specific cases, but they also tend to have a negative impact on economic dynamism. In the case of long-term support in particular, there is a risk that businesses with low productivity will be kept afloat. The COVID-19 support measures illustrate this dilemma: although such support was justified given the magnitude of the crisis, the misallocation of labour and capital increased significantly, still not having returned to pre-pandemic levels (see Figure 3).