Federal Support for Small Business Needs Focus

Small business has a well-deserved reputation as the engine of job growth and a key contributor to innovation. Over the 10 years ending in 2015, SMEs accounted for about 95% of private sector net job creation. What is less well recognized, however, is that most of the job creation comes from a small number of firms. Researchers at Statistics Canada have found that just under 20% of firms account for almost half of employment growth by existing firms. Similarly, U.S. researchers estimate that about 10-20% of small firms successfully develop and commercialize new ideas.

As a result of this disconnect, Canada, along with many other countries, has had what could be described as a small business policy – broad-based support for all small firms. 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. 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, about 85% of the $7 billion yearly funding for non-farm small business continues to provide broad-based support. This lack of focus means that taxpayers aren’t getting much of a return on their investment. Firms that do not grow or innovate receive most of the benefits and economic performance suffers from the promotion of smaller, less-efficient firms at the expense of larger ones.

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 deduction (SBD)

The largest federal program is the special low rate of tax for small businesses, implemented to improve access to financing for capacity-expanding investment. If the alternative is a lower general corporate income tax rate, this measure is harming economic performance by shifting capital and labour from large to smaller, less-efficient businesses. My research demonstrates that this loss in efficiency outweighs the benefit from improved access to capital by small firms.

The SBD cost about $3.5 billion in 2016. The long-run fiscal savings from eliminating the SBD would be somewhat less than this because part of the cost is recovered when firms begin paying dividends.

Reduce the enhanced SR&ED tax credit rate

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 per cent of their project costs paid by the government.

Reducing the enhanced SR&ED tax credit rate to 15% — the same as for larger firms – would lower the combined federal-provincial rate to about 25%, which is roughly 5% points higher than the combined rate for larger firms. Aligning the two federal tax credit rates would save about $700 million a year.

Replace the BDC’s direct loans with loan guarantees

The Business Development Bank’s largest business line is direct lending to SMEs, with almost $20 billion in outstanding loans in fiscal 2016. The average interest rate on these loans was 4.9%, ranging from 4.3% to 5.6% over five risk categories. The BDC made a $450 million accounting profit on its direct loan program in 2015-16. But this favourable outcome depends on access to cheap federal financing.

Based on the average cost of capital in the Canadian economy – likely about 8% — the BDC made a loss of about $1.1 billion on its direct lending. My research indicates that the benefits from improving access to finance for SMEs are too small to offset this cost, even if it is assumed that all of the BDC loans were incremental, as is implied by its mandate to provide services that are complementary to, rather than competitive with, commercial banks. With such low interest rates, concerns about BDC competing for loans are plausible.

The federal government also operates a loan guarantee program for SMEs. This program is a much less expensive way to improve access to financing by SMEs, in large measure because competition with private lenders is not an issue. I estimate that Canadians could save about $650 million a year by replacing the BDC direct lending program with a guaranteed loan program and merging it with the government’s existing guarantee program.

The federal government spends a large amount of money supporting small business. Focussing support on measures promoting the high-impact entrepreneurship that makes a fundamental difference to innovation and growth would improve economic performance while contributing to deficit reduction.