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Published in the Globe and Mail on June 2, 2014

Benjamin Dachis and John Lester are co-authors of the recent C.D. Howe Institute commentary “Small Business Preferences as a Barrier to Growth: Not So Tall After All.”

Governments give small businesses special tax breaks and subsidies with a view to boosting job creation and innovation-led growth. Critics point out that because firms have to stay small to receive benefits, these programs could be causing firms to give up on growth. Both sides are missing the real point: the net impact on the economy. Our analysis shows that small-business tax breaks do not create significant barriers to growth, but they still have a high economic cost by shifting investment from large to less productive small firms.

With billions of taxpayers’ dollars at stake, it is important for governments to know the right approach. As it is, there is no agreement. The 2015 federal budget reduced the small-business tax rate, while Quebec’s budget tightened access to its small-business deduction.

In a recent C.D. Howe Institute report, we examined tax data for individual firms recently made available through Statistics Canada – under stringent conditions to preserve taxpayer confidentiality – to assess the importance of the “tax wall” created by two major programs. The Small Business Deduction (SBD) provides small business a special low income-tax rate – at a cost of about $3.25-billion to the federal treasury. The enhanced Scientific Research and Experimental Development (SR&ED) investment tax credit provides a higher subsidy for R&D undertaken by small firms – at a cost of about $1.5-billion.

For both programs, we observe clustering at the eligibility thresholds, signalling potential problems. However, the thresholds for the enhanced SR&ED investment tax credit are set high enough that there are few firms in the cluster, so the impact on investment decisions by small firms is negligible.

The SBD thresholds affect more firms, and the impact on investment incentives would be substantial if losing access to the tax break were causing firms to abandon an aggressive growth strategy. However, since larger size results in growing cost reductions from economies of scale, improved access to financing and a stronger presence in the market, there will be a point at which the benefits from growth exceed the cost of losing the SBD. As a result, firms wanting to grow only slightly larger than their size when the thresholds begin to bind have an incentive to curtail investment plans to keep the SBD, but firms geared to growth do not. With limited effects on investment, the cost of clustering is small relative to the fiscal cost of the program.

Although the two programs are not having a major impact on the size of small firms, they are still costly. The largest cost arises because the government must recoup forgone tax revenue by raising taxes elsewhere or cutting spending. Higher taxes harm economic performance by affecting incentives to work, save and invest; lower spending can also affect productivity and growth.

The most plausible financing source for the SBD is higher taxes on larger firms, since that option does not change the relative tax burden on businesses and individuals. By reducing costs, the SBD encourages more entrepreneurs to start a small business while a higher tax rate on large businesses causes larger firms to invest less. The net result is little change in the total amount of business investment, but more of it performed by small firms.

Why would that harm the economy? A Statistics Canada study reports that small firms are much less productive than larger firms. In 2008, the productivity gap was almost 50 per cent, so shifting output from large to small firms hurts overall productivity in Canada. In addition, faced with a higher tax rate, large businesses book less of their profits in Canada and the resulting tax revenue loss also makes us poorer.

The SBD is achieving its objective of allowing small business to finance more investment internally and it is encouraging more entrepreneurs to start a business, thus creating jobs and innovation in the small-business sector. But because revenue given up through the SBD has to be recovered and because small firms are so much less productive than large firms, the costs of the SBD exceed its benefits. Canadians would be better off if governments reduced or eliminated the small-business tax advantage and used the savings to lower the general corporate income-tax rate.