Small-business job engine sputters

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Small business is no longer the "engine" of U.S. job creation.

More than six years after the Great Recession unleashed a massive wave of layoffs, the economy market is finally replacing the last of the jobs lost since employment peaked in early 2008.

But that recovery—longer and deeper than any post-war recession—has been weakened by the fading fortunes of 5.7 million U.S. small businesses with a combined payroll of more than $2 trillion a year.

In fact, the role of small business as a job creator has fallen sharply, especially among younger businesses that once created the bulk of employment, according to an analysis of the government's jobs data.

"The U.S economy is becoming less dynamic and less entrepreneurial," said economist Ian Hathaway, co-author of a recent Brookings Institution paper on the decline small business creation. "There's a consolidation process going on, and a growing share of employment is going to the older and larger firms. These older larger firms are somehow advantaged, but we don't know the cause."

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For Robert Cioffi, CEO and co-founder of Yonkers, N.Y.- based Progressive Computing, rising costs have put a damper on his hiring plans, especially the cost of providing health care to his 15-person staff. Though his IT services firm, now in its 21st year, is doing well, he hasn't expanded his payroll since last year and expects to maintain a hiring freeze at least through next year. The reason, he said, is that costs are outpacing his company's growth.

"There is a lot of pressure to do more with less," said Cioffi. "If you look at line items like fuel, cellphones, taxes and rent, they're not much on their own, but add them up, it's a lot."

Health-care costs—rising double digits every year—hit the hardest. "That's two more bodies I could hire," he said.

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The problem is compounded by the lackluster pace of hiring among the small and medium-sized business Cioffi's company serves.

"Our revenue is a function of the size of our clients," said Cioffi. "If they're not hiring—or worse yet, shrinking—then our business stagnates."

That stagnation is starkly evident in the government data on small business hiring. Once the dominant source of new U.S. jobs, smaller companies have gradually lost ground to their larger competitors as he nation's top job creators.

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Over the past 20 years, companies with 500 or fewer employees created roughly two-thirds of net new employment, according to a CNBC analysis of BLS job data. By last year, that share had fallen to about a half of all new jobs.

"All of this belief that small businesses are net job creators isn't actually true," said Hathaway.

In fact, the U.S. job market is much bigger and more dynamic than the monthly government job data would indicate.

While the number of net jobs gained typically measured as a few hundred thousand, that number masks a much larger churn on jobs gains and losses. For example, in the third quarter of last year, the latest data available, there were nearly 7 million jobs created—or roughly 107,000 new jobs created every workday—from new businesses starting up or expansion of existing businesses. But those jobs were offset by roughly 100,000 jobs a day that were destroyed by businesses cutting back or shutting down.

Like the growth of the economy overall, the pace of job creation and destruction has ebbed and flowed over the last two decades. After a surge in entrepreneurship during the late '90's dot-com boom, the pace of job creation hit 8.8 new jobs in the first quarter of 2000—offset by the loss of roughly 8 million that were destroyed.

Even in the depths of the Great Recession, the economy continued to produce millions of jobs a month—though the pace of job destruction was much greater. Since then, the levels of both job gains and losses hasn't recovered. And the slowdown has hit small businesses hardest

The decline in small business job creation has multiple causes and has been underway for years, but economist are divided on the causes. Small business advocacy groups cite and expanding thicket of government regulation, from permitting paperwork to the mandate to provide health insurance for workers.

"If you look at all of these government policies, they're all pointed against growth and against entrepreneurship," said Raymond Keating, chief economist with the Small Business and Entrepreneurship Council.

But other economist argue that there are more important forces at work depressing new business formation to the lowest levels in the past decade. Self-employment—a bellwether for entrepreneurship —is also depressed from historical levels.

Hathaway, who is based in Silicon Valley, said government red tape doesn't seem to have slowed the pace of tech-based start-ups.

"Nobody here is thinking about regulations," he said. "So the regulation theory in my opinion is completely overblown."

But financing a new company has gotten a lot harder, he said, as venture capitalists have gotten a lot choosier about where they place their bets.

So have more traditional lenders that once provided the capital to get a new company off the ground. That is why alternative lenders have been rushing in to fill a void in the market over the last five years. Crowdfunding sites like Kickstarter and Indiegogo have been doling out money for start-ups and expansion capital for entrepreneurs. So have credit unions across the country. Increasingly they are getting in the business of offering small business loans to local businesses in their communities to help support Main Street.

But gone are the days when an aspiring entrepreneur could self-finance a garage-stage business overnight with a credit card or a home equity loan.

"Credit cards home equity lines are huge for small businesses getting off the ground," said Kelly. "And that's been a major change and an obstacle that start-ups now face."

Whatever the cause, the decline in the formation of new businesses is a troubling sign for the health of the U.S. job market and over economy. The churn of jobs—as they're destroyed by older companies and created by new ones—may be disruptive to the workers involved. But that churn—economist call it business dynamism—is essential to the long-term health of a growing economy.

"If I leave my job to get a better one and a younger less experienced person takes my old job, there's a cost to that disruption, said Hathaway. But overall that's a net positive. It's a more efficient allocation of labor."

The decline of that dynamism helps explain why—five years into one of the weakest recoveries on record—the pace of U.S. job creation is proceeding at a painfully slow pace

"When we're healthy—when our economy is doing well—you see that dynamism," said Keating." "People are experimenting and trying things; some businesses work, some businesses don't. But that's when Americans doing really well. "

—By CNBC's John Schoen. Follow him on Twitter @johnwschoen or email him.