Impact of Noncompetes on U.S. Entrepreneurship and Competitiveness

In January 2023, the Federal Trade Commission (FTC) proposed a rule that would “ban employers from imposing noncompetes on their workers.” Business groups raised immediate concerns and the U.S. Chamber of Commerce threatened to sue the FTC. Objections ranged from abrogation of state law to the proposed rule’s broad scope, with critics also arguing that noncompete agreements are needed to protect research and development, workforce training, and trade secrets.

From another perspective, however, strict enforcement of noncompetes can sideline entrepreneurs and gum up the free flow of ideas and talent that spawn the development of robust regional economies and innovation ecosystems. That could undermine U.S. competitiveness at a time when the federal government is allocating billions of dollars to enhance competitiveness at the regional level.

Mechanics and Politics of Noncompetes

Noncompetes, or noncompete agreements (formally, covenants not to compete), are contractual employment terms that restrict an employee from leaving a job to work for a competitor or start a competing business. The terms typically apply within a certain geographic area and are time limited.

Historically, noncompete agreements have been a state law issue, and states have long varied in how strictly they will enforce a noncompete agreement. Most famously, noncompetes have been unenforceable in California since the 19^th century. Other states have strict enforcement regimes: In the 1980s and 1990s, academics pointed to California’s approach as a key reason why the state (especially Silicon Valley) had pulled ahead of others such as Massachusetts and New Jersey in the creation of new high-technology firms, products, and services.

Despite objections from some business groups, the idea of federally mandated restrictions on noncompete agreements has had bipartisan support for several years. In 2019, Senators Todd Young (R-IN) and Chris Murphy (D-CT) introduced the Workforce Mobility Act (WMA) to limit the use of noncompete agreements. (The House introduced a complementary version as well.) The bipartisan WMA was reintroduced in both chambers in 2021 and again this February in the 118^th Congress. In the last few years, several states (including Massachusetts) have reformed their regulatory regimes to relax enforcement or only permit noncompete agreements above certain income levels.

Effects on Entrepreneurship

In announcing its rule, the FTC placed primary emphasis on worker wages. It’s well-established that “job switchers,” people who move to a new job at a different company, tend to enjoy higher wage growth than “job stayers,” those who move to a new job at the same company. Restrictions on that mobility thus presumably suppress wage growth.

A more interesting dimension of noncompete agreements and their enforcement pertains to entrepreneurship. In the published notice of proposed rulemaking, the FTC cites research findings that noncompete enforcement reduces new business formation, venture capital investment, and patenting: “New business formation increases competition first by bringing new ideas to market, and second, by forcing incumbent firms to respond to new firms’ ideas instead of stagnating. New businesses disproportionately create new jobs and are, as a group, more resilient to economic downturns.”

Each of these claims has been established by research, which the FTC cites. Is the logical conclusion that entrepreneurship, in the aggregate, would rise if noncompete agreements were banned? Perhaps, but not necessarily.

A 2023 GAO report that canvased the research literature found that the suppressive effect of noncompetes on entrepreneurship is only seen in the same industry in which the employee signed the agreement, not other industries. That is, when a potential entrepreneur leaves a company to start a new one does so in the same industry as the company they left, that’s where noncompetes have an effect.

We know that the average age of U.S. entrepreneurs is around age 40—workers gain experience in an industry and then go start a business in that industry. If noncompetes “only” reduce firm creation in the same industry, then noncompetes definitely do reduce entrepreneurship because the most likely pathway for new entrepreneurs is to launch a business in the same industry they spent years working in.

On the other hand, record-setting levels of new business formation over the past three years, including across states with various noncompete enforcement regimes, seem to be at odds with an argument that noncompete enforcement suppresses entrepreneurship. It’s possible, though hard to prove, that new business formation during this time period would have been even higher if noncompetes had been banned.

One caveat to that general rise of new businesses is that formation of certain types of businesses has not risen as much as the aggregate. The number of business applications from corporations—which are more likely to have employees and more likely to raise outside investment—is not much different today from what it was a decade ago. That could be an entrepreneurship-based argument for limiting use of noncompetes. If we’re concerned about not only the number of new businesses created but also the type and their potential economic impact, the FTC’s causal justification relating to entrepreneurship and noncompetes makes more sense.

Ecosystems Need Oxygen

There’s one line in FTC’s proposed rule, with no citation, that hints at the most important dimension when discussing noncompetes and entrepreneurship: “firms are more willing to enter markets in which they know there are potential sources of skilled and experienced labor, unhampered by noncompete clauses.” Noncompetes are, from a public policy perspective, an ecosystem issue.

Strict enforcement of noncompetes can create a chokepoint that prevents the rapid reallocation of people and ideas between companies— especially new companies. That reallocation, and how quickly and efficiently it can happen, is the essence of vibrant local economies and their entrepreneurial ecosystems. That’s the basis of what economists call agglomeration economies: they exist because people have options and ideas are, as Alfred Marshall put it in 1890, “in the air.” Strict enforcement of noncompete agreements takes those ideas out of the air or prevents their absorption.

That, of course, is also one of the reasons that so many businesses use noncompetes and prefer strict enforcement: they don’t want their ideas in the air. The concern is reasonable and it’s possible that other forms of legal protection—nondisclosure agreements, trade secrets law—are inadequate or too costly for many businesses compared to noncompetes.

Still, entrepreneurial ecosystems, like their ecological counterparts, need oxygen. In this case, that oxygen is the entrepreneurial know-how and experience embodied in people. The federal government is pouring tens of billions of dollars into the creation and growth of regional innovation hubs around the country. But it doesn’t matter how much taxpayer money is spent on place-based policy—if entrepreneurs can’t start a company or draw on regional know-how, you won’t get innovation clusters.

Conclusion

Regarding the FTC’s proposed ban, there are obviously significant concerns from legal and regulatory perspectives. As noted, noncompetes have traditionally been within the purview of state law. The Bipartisan Policy Center, as a rule, prefers complex issues such as noncompetes to be hashed out in Congress where different perspectives can be weighed and policy considerations balanced. We encourage Congress to take the ecosystem perspective into account and explore how the noncompete issue relates to its authorized spending in, for example, the CHIPS and Science Act of 2022.