Why we should stop giving small businesses big tax breaks

New IMF research finds there’s little benefit in providing lower taxes to small business, since it discourages them from growing

Man serving customers at a tiny food truck


Canada’s small-business lobby disliked the federal budget. The Canadian Federation of Independent Business (CFIB) grumbled about a “number of broken promises.” Top of the list was Finance Minister Bill Morneau’s decision to defer a plan to drop the rate smaller companies pay on their income to 9% from 10.5%. Such companies already enjoy a “supportive tax environment,” Morneau said in the budget. The CFIB retorted Morneau’s treachery would rob its members $900 million a year by 2019.

That would be lamentable if smaller companies were responsible for driving economic growth. But they aren’t. A new analysis by the International Monetary Fund shows Canada’s small-and-medium-sized enterprises are among the lowest-taxed in the world. Paired with some of the lowest interest rates on record, one might have thought these firms would have rewarded Ottawa’s kindness by leading an economic turnaround. Instead, they retreated. As Krishen Rangasamy, an economist at National Bank, observed this week, all the hiring in Canada over the past year has been by large businesses, not tiny ones.

Chart comparing small-business tax rates in jurisdictions worldwide

“Giving incentives to small firms do not guarantee there will be innovation, growth and employment creation,” Krishen said in a research note published April 6. The IMF agrees. It reviewed research on how fiscal policy affects innovation and entrepreneurship. Often, there is no standout policy. For example, in some places, including Canada, tax breaks are effective at encouraging more spending on research and development; in other countries, direct subsidies appear to be a better approach. But when it comes to coddling smaller companies just because they are small, the IMF is unequivocal in its conclusion. “Preferential tax treatment of small companies is too blunt an instrument to foster entrepreneurial activity efficiently,” the IMF says in its latest Fiscal Monitor.

That is a frontal attack on the small-business-as-job-creator myth that dominates the political discourse in countries such as the United States and Canada. This notion is supported more by contributions to political parties than it is to economic growth. Recent history shows not all entrepreneurs are created equal: Too many are content to remain small. The IMF’s literature review concludes that preferential tax rates reinforce this meekness, something economists call the “small business trap.” Too many owners of smaller companies avoid growing so they can continue enjoying their tax advantage. So special tax rates for smaller companies hurt economic growth rather than enhance it.

“Tax preferences should target new firms, not small ones,” the IMF says. A low tax rate is a minor consideration for a start-up, since few make any money for the first few years they are in business. If Morneau wants to use tax policy to encourage employment, he must find ways to help new entrepreneurs who dream of leaving existing companies in the dust; a tax rebate on losses of fast-growing firms over a set period, for example.

Small-business lobbies have little incentive to advertise this reality. They represent existing companies that enjoy a special status granted in recent decades when economic growth came easier. In its pre-budget submission to Morneau, the CFIB said its members “were not only key economic drivers,” but “also essential to the fabric of Canadian society.” That’s why companies that employ a few dozen people pay a considerably lower tax rate than those that employ a few hundred. Future favours should go to those companies that want to grow. Otherwise, the social fabric may start to fray.