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ROB Magazine

Small businesses have been getting special tax breaks for years
because they claimed to be job-creation machines. But it turns out they're no better at creating jobs than anyone else

Back in university, I started a roofing company and sweated through 70-hour workweeks, hiring staff, hauling shingles and doing everything else a small business owner does. I felt nothing but scorn as I watched the nine-to-five crowd head home after their puny, insignificant workdays. I was an entrepreneur. I was making my own way. I was special.

Several years later, my sister and brother-in-law launched a restaurant. After it succeeded, they started a few more. Once again, a sense of being special filled the air. "We're job creators," my brother-in-law told me as he fumed over the visit of a building inspector who had dared to question some rather dangerous-looking stairs to an upstairs bar. "Why can't government get off our backs?"

But are small businesses really that special? They've long enjoyed special tax breaks, certainly. Recently, feeling that those breaks were getting out of hand, Ottawa tried to crack down on the use of private corporations, a structure small business owners frequently use to reduce taxes.

The small-business lobby reacted to Ottawa's proposed new rules with fury. Small business is the backbone of the economy, it thundered. Small business creates jobs! Small business deserves every break it can get! Ottawa quickly caved, and the Liberals concluded the debate by vowing to cut the already low tax rate on small business even further.

This is a bad idea. It's founded on the notion—energetically advanced by the small-business lobby—that entrepreneurs deserve to pay less tax than others because of their economic importance. But their case for special treatment is riddled with errors. It deserves to be challenged.

Start with the claim that small business creates jobs. Or, to be more specific, start with that long-ago roofing company I once ran. I certainly had the impression I was creating jobs. But then an economics professor pointed out the horrible truth to me: There are only a certain number of roofs and, thus, a certain number of shingling contracts in any given year. For every job I produced, some other roofing company lost one. From the perspective of the economy as a whole, the net number of new jobs created as a result of all my labour was precisely zero.

To be sure, small businesses can be beneficial in other ways. Some upstart companies introduce new products. Others pioneer more efficient ways of doing things. By and large, though, many startups don't so much generate jobs as shuffle them around. The net economic benefit is much smaller than the small-business lobby would have you believe.

It's certainly far less than once thought. Back in 1979, David Birch, a professor at the Massachusetts Institute of Technology, claimed that firms with 20 or fewer employees had created two-thirds of all new jobs in the preceding years. His research helped fuel new tax policies around the globe that favoured small business.

But more up-to-date scholarship has knocked holes in that argument. Yes, it turns out, small business creates lots of new jobs. But small business also destroys lots of jobs, because so many tiny companies go bust. If you look at the net number of jobs generated, small firms' ability to create employment is nothing special. For instance, researchers at the Federal Reserve Bank of St. Louis found that businesses with fewer than 20 employees created a mere 16% of the net new jobs in the U.S. economy between 1992 and 2010. In contrast, it was the companies with 500 or more employees that emerged as the real heroes. They were responsible for nearly 40% of the net jobs created.

The debate about small businesses' role in job creation starts from the wrong premise, according to John Haltiwanger of the University of Maryland. In a 2013 paper, he and his co-authors concluded "there is no systematic relationship between firm size and growth." Instead, what matters is the age of the company. Young businesses of any size do churn out new jobs. But small old companies are not reliably better at creating employment than big old companies.

So why are we still lavishing tax breaks on small businesses as a group, rather than focusing on young companies that have a demonstrated ability to grow, no matter what their size? Maybe it's because entrepreneurs have been so good at arguing they're better than the rest of us—they work harder, take more risks and so on.

This, however, is a rather far-fetched notion. Nobody forces anyone to become an entrepreneur. People start businesses because they believe they can make more money working for themselves than for somebody else. That's perfectly understandable. But why should the rest of us subsidize their desire for wealth by giving them a tax break too? Does it really make sense for nurses and university researchers and computer engineers to pay higher rates so the owner of a dry-cleaning establishment can pay less? Fundamentally, it's not fair.

It's also not an economic panacea. Handing out special favours to small businesses rewards companies for staying tiny and relatively inefficient rather than pushing them to grow and achieve economies of scale. When pressed on such issues, small businesses' defenders fall back on the notion that it's entrepreneurs who will launch the RIMs and Amazons of the future. True enough. But here's something the entrepreneurial lobby doesn't rush to point out: The people who start ambitious, growth-oriented firms typically don't give a hoot about small-business tax breaks. They don't care because they don't plan on remaining small for long.

In Britain, a review of the tax system chaired by Nobel laureate James Mirrlees concluded in 2010 that it made sense to simplify taxation, but rejected the "case for blanket tax incentives for small businesses as such." Between 2010 and 2015, as part of a general move to lower all corporate tax rates, the country did away with its preferential rate for small companies. A couple of years later, the number of small businesses in the country has hit record levels. I'm confident Canada's upstart companies could also thrive—even in a world where they're treated just like everyone else.