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Revised tax policy for small businesses hinders growth, economists say

Ottawa's decision to resurrect its small-business tax cuts is a case of shrewd politics trumping sound policy. While the political urgency behind the move had become glaring, the economic logic is sorely lacking, even contradictory.

In the face of a torrent of vocal opposition to its proposed toughening of tax rules governing small corporations, the Liberal government announced on Monday that it would reduce the small-business corporate tax rate to 9 per cent by the start of 2019, from the current 10.5 per cent.

This put back on track a plan from the previous Conservative government to reduce the small-business rate – and, just maybe, quells the rising anger directed at the Liberals from the country's small-business community.

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The arguments trotted out for a further lowering of the small-business rate – which is already well below the general corporate rate of 15 per cent and has already been cut twice in the past decade – are very familiar to Canadians by now. Foundation of our economy. Biggest source of job creation. Critical growth engine. "Small businesses are the backbone of our economy," Prime Minister Justin Trudeau said in a statement.

"They make up 98 per cent of all business operations in Canada, employ over 70 per cent of the total labour force in the private sector and contribute more than 30 per cent to our gross domestic product.

"We know that when small businesses prosper, so does Canada," he said.

That's the standard motherhood-and-maple-syrup justification for giving small business a massively preferential tax rate, one that is about to become even more generous. It's an emotional argument, and a political one, designed to appeal to Main Street voters.

It doesn't much appeal to economists.

"I don't think there's a good case to lower [the small-business rate]," said Alexandre Laurin, director of research at the C.D. Howe Institute, a leading Canadian economic-policy think tank. "I don't even think there's a very good case to have a [preferential] small-business tax rate in the first place."

The problem, many economists say, is that a lower tax rate for small business is essentially an incentive to be small. Canada already has a problem with businesses failing to mature and grow into large operations; the share of large firms in the Canadian corporate sector has historically been well below that of the United States. And that, economists say, is a key reason why Canadian productivity rates routinely lag those of the United States: Small firms are only about 55 per cent as productive as large operations and Canada's tax policy is tilted toward being small.

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A recent paper from the University of Calgary's school of public policy noted that while small and medium-sized businesses were responsible for "about 90 per cent" of private-sector job growth from 2001 to 2013, that statistic masks that most of those jobs were created by "only a small fraction" of companies in that size category. The conclusion was that the government has been offering a huge and broadly based tax incentive to all small businesses that has failed to focus on the "high-impact entrepreneurs" – the small subset of innovative, rapidly expanding businesses that are behind most of the growth and job creation.

Lindsay Tedds, a professor at the University of Victoria who focuses on tax policy, calls the lower tax rate for small business "a blunt tool for a well-defined problem."

"We want to target the new growth firms – not all small firms," she said.

A recent study released by the International Monetary Fund suggested that governments would be better off targeting the bulk of their tax incentives to research and development at young, innovative firms with high growth potential, rather than spreading the benefit among all small businesses, many of which simply aren't built for substantial growth and job creation.

"Tax incentives that discriminate by firm size, without specifically targeting R&D investment, can create disincentives for firms to invest and grow, negatively affecting firm productivity and growth," the study said.

And perhaps the biggest irony in all this is that by pledging to further slash its small-business rate, the government is flying in the face of the very reason it said it wanted to reform small-business tax rules in the first place – to remove incentives for Canadians to use the corporate structure to shield income from taxes. At the root of the problem is the huge gap between the tax rate charged on personal income, which exceeds 50 per cent for high earners in most provinces, and the 14.4-per-cent average combined federal-provincial rate for small businesses. At the same time as the government is trying to remove the tax-planning advantage of a small corporation, it is increasing the biggest underlying incentive of all.

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"I absolutely question the logic, given the problem we are dealing with," Prof. Tedds said.

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About the Author
Economics Reporter

David Parkinson has been covering business and financial markets since 1990, and has been with The Globe and Mail since 2000. A Calgary native, he received a Southam Fellowship from the University of Toronto in 1999-2000, studying international political economics. More

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