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Ted Mallett is VP & Chief Economist of the Canadian Federation of Independent Business.

Governments have some very real challenges in crafting fair tax policies for the diverse set of businesses in the Canadian economy, a situation highlighted by Allan Lanthier’s July 23 op-ed in this paper that argued that Canada’s small-business tax rate should be repealed. Since the 1940s, the federal and provincial governments have applied a progressive approach to corporate taxation, with current combined rates of about 12 per cent for the first $500,000 or so of earnings and about 27 per cent above it.

Mr. Lanthier’s view, as with some other academics and commentators over the years, suggests that corporate income tax obligations need to be more proportional – i.e. the same tax rate – for all sizes of businesses. This view may sound reasonable on the surface, but it leaves out allowance for some legitimate real-world distortions that the lower small-business tax rate was explicitly designed to address.

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Most importantly, startups and small firms face disproportionately higher barriers to financing their growth and operations. Bank financing is more readily available at the higher end of the scale and investment is efficiently captured through pooled equity markets such as the TSX and others. To start or grow an SME, one must go all in – with their own money and pretty much by themselves. Given the vagaries of the business climate, the personal financial risk they take on is considerable. The lower small-business tax rate acts as a partial safety net to reduce that risk by increasing the potential for future business earnings to be retained.

Despite some of the government rhetoric of the past, small-business owners are not high-income earners for the most part – median market incomes of incorporated employers are a glaringly modest $56,000 according to the latest census, identical to that of full-time, full-year employees.

The other chief rationale for the small-business rate is that small firms deal with disproportionately higher costs of government regulations. Obviously limiting regulations to what is necessary and keeping them efficiently structured are the most important steps, but tax measures are a useful approach as well.

There have been many seemingly sensible arguments put forward on why a small-business tax rate is problematic, but evidence thins once one looks into the details. Although it has been blamed on causing Canada’s low productivity relative to the United States, the profile does not fit; Canada’s highest relative productivity performance had taken place in the 1970s and 80s when the gap between the small business and general tax rates had been at its highest. Indeed, measuring productivity is far from an exact science and harder still when dealing with a set of businesses that are often deeply embedded in the chain of production.

The policy has also been called a disincentive to growth. If so, we should be seeing a mountain of businesses clustered at the $500,000 taxable income margin; in fact there is only a molehill. The clustering is instead at the low end of the income scale, which suggests that there are plenty of growth disincentives that have nothing to do with tax rates.

With lower tax rates, SMEs do not appear to be cleaning the clocks of larger firms either. That said, citing the number of small businesses in the economy or the number of jobs contained in them does not exactly form an argument against the policy because it does not present a counterfactual – what those figures would have been had we not had a small-business tax rate in place. And international comparisons are problematic because every country has unique aspects to their business and policy climates that could affect relative SME performance.

Mr. Lanthier is absolutely right, though, in that the policy brings sizable complications to the corporate and personal tax systems. Those arise because of efforts to keep the tax advantage to small-business operations and not to personal earnings – not perfectly, but then again nothing is. Although tax complexity is a problem that needs to be minimized, it should not overshadow the greater need to encourage entrepreneurial activity.

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If there are better ways to encourage entrepreneurship broadly and fairly, they have yet to appear. SME owners are justifiably wary of other approaches. Governments could never be trusted with running an industrial-scale system of cash handouts, nor would a centralized lending entity work because it would encourage or force banks out of the small-business market. A menu of tax system changes needing joint federal, provincial and municipal co-ordination would also likely swiftly unravel.

Simply eliminating the small-business tax rate without a broader future framework is not the way to go. For all its warts, this measure is still an effective and impartial way of supporting and encouraging entrepreneurial activity, which benefits society and the economy in many ways, tangible and intangible. Countless numbers of Canadians have started their own businesses, created jobs and built communities by risking a lot – risks they may not have taken if their earnings were just going to be taxed like a GIC. Most never got rich with these endeavours, but Canada is richer for it.

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