Policy Interventions Favouring Small Business: Rationales, Results and Recommendations

Abstract

Small business has a well-deserved reputation as the driver of job growth and as a key contributor to innovation. In the 12 years ending in 2013, small and medium-sized enterprises (SMEs) accounted for about 90% of private sector job growth in Canada. What is less well-recognized, however, is that a small fraction of SMEs account for most of the job growth and innovation. As a result, governments have offered broad-based support for small businesses, rather than focusing on high-impact entrepreneurs. This approach is wasteful: firms that do not grow or innovate receive most of the benefits. Further, this approach can harm economic performance by promoting the expansion of smaller, lessefficient firms at the expense of larger ones. The federal government elected in 2015 is focussing new initiatives on innovative and growth-oriented businesses. Legislated reductions in the small business tax rate were reversed and targeted support for innovative SMEs was increased. While the change in direction is welcome, almost 85% of the $7 billion yearly funding for small business continues to provide broad-based support. The largest program is the special low rate of tax for small businesses, implemented to improve access to financing for capacity-expanding investment. This measure is harming economic performance because the cost of shifting capital and labour from large to smaller, less-efficient businesses outweighs the benefit from improving access to capital. Large subsidies for small business financing are also provided by the Business Development Bank of Canada (BDC). With access to cheap government funding, the BDC is profitable, but evaluated using a more realistic cost of financing, the bank operates at a substantial loss. This loss exceeds the benefit from improving access to capital, particularly for the bank’s direct-lending program. While there is a solid argument for supporting R&D, subsidies provided to small firms are so generous that they are harming economic performance. The federal government provides a 35% tax credit for R&D performed by small firms. Provincial tax credits raise the subsidy rate to about 42%. And those firms receiving support from the federal Industrial Research Assistance Program can have almost 60% of their project costs paid by the government. By way of contrast, large firms performing R&D receive subsidies from federal and provincial tax credits amounting to under a quarter of their costs, an intervention which improves economic performance. Canada has had what could be described as a small business policy – broad-based support for all small businesses. The newish federal government is moving to an entrepreneurship policy: new initiatives emphasize support for the high-impact firms and individuals that make an outsized contribution to Canada’s innovation and prosperity. Making the transition to the new framework will require overhauling legacy small business policies to free up resources for new initiatives and to secure fiscal savings. Three changes would pay big dividends: • Eliminate the small-business corporate income tax deduction. • Reduce the enhanced R&D tax credit rate to the same level as the regular credit. • Replace the BDC’s direct loan program with a loan guarantee program.