ÍƼöÐÓ°ÉÔ­´´

Authors:

Frank M. Fossen
Professor of Economics and
Charles N. Mathewson Professor in Entrepreneurship
Department of Economics
ÍƼöÐÓ°ÉÔ­´´

Ege Can
Clinical Assistant Professor of Economics
Department of Economics, Accounting, and Finance
University of Alabama in Huntsville

In April 2024, the Federal Trade Commission (FTC) issued a final rule banning noncompete clauses with workers nationwide. Using noncompete clauses, employers prevent employees from working for a competitor or starting their own business in the same industry for a certain amount of time after leaving the company. The that noncompete clauses cover about 30 million workers in the United States. An exception to the new ban is that existing noncompete agreements with senior executives can remain in force.

Noncompetes have long been criticized for hindering the mobility of workers. Switching employers or threatening to do so is one of the most effective ways of negotiating higher wages, so banning noncompetes is expected to lead to rising wages. The move is also likely to lead to higher work satisfaction, as it will be easier for workers to choose their preferred job.

More recently, research has emphasized another important downside of noncompete clauses: As they prevent employees from spinning off and starting their own business in their industry of expertise, noncompetes can be a barrier to new firm formation. This hurts the economy because entrepreneurial activity is crucial for innovation and job creation. The cites a number of studies providing evidence that noncompetes hinder entrepreneurship, including a . We investigated policy reforms in Utah in 2016 and Massachusetts in 2018, limiting noncompetes' enforceability in these states. Both states restricted the duration of noncompetes to one year after an employee leaves a company, and Massachusetts went further and banned noncompetes altogether for all low-wage workers. Using data provided by the Census Bureau, we find that limiting the enforceability of noncompetes increased entrepreneurial activity in both states. In Massachusetts, the number of entrepreneurs starting unincorporated businesses grew, but not the number of entrepreneurs starting incorporated businesses. This is plausible because low-wage workers, who were freed entirely from noncompete clauses in Massachusetts, more often start unincorporated businesses. Our study is unique in looking at the low-wage sector separately and distinguishes between different types of entrepreneurs.

Utah and Massachusetts are not the only states that had leaped ahead and limited the enforceability of noncompetes before the FTC acted. For example, California had long banned noncompetes, which may have contributed to the development of California as a leading hub for startups and high-tech innovation. The new rule prohibiting noncompetes across the nation may contribute to leveling the playing field for entrepreneurship and innovation.

Proponents of noncompete clauses argue that they encourage employers to invest in their employees, as employers do not need to fear that employees will use the knowledge gained to compete against them. However, entrepreneurship research has found that incumbent firms are often reluctant to engage in radical innovation as they do not want to threaten their existing products and services. So, radical innovation is often pushed through by employees spinning off from their employers and starting their own businesses. Therefore, noncompete clauses seem predominantly harmful to the economy's overall dynamism, competitiveness, and innovativeness. The U.S. Chamber of Commerce has announced it will sue the FTC to block the noncompetes ban, so it is unclear whether the ban will eventually take effect. If it does, collecting and analyzing further data will be essential to evaluate whether the expected positive impact on entrepreneurship will materialize.

Frank Fossen thanks the Ewing Marion Kauffman Foundation for funding the study mentioned above. The contents of this publication are solely the responsibility of the authors.