Small Business, Big Loophole

Connor Colvin 

Every major federal political party supports small business. They’ll confidently tell you that they are the ones with the best plan to help small businesses. The “low-tax “ Conservatives are proposing cutting the small business tax rate from 11 per cent to 9 per cent. On the other hand, the “pro-middle class” Liberals are proposing cutting the small business tax rate from 11 per cent to 9 per cent. Finally, in a refreshing change of pace, the champion of ”hard working small business people” NDP are proposing cutting the small business tax rate from 11 per cent to 9 per cent. What’s a voter who supports small business to do?

Somewhat lost in this “robust” public debate is a policy discussion over whether lowering the small business tax rate is actually a good idea, and whether this is really the best way to help small businesses grow.

At the federal level in Canada, small businesses that qualify as a Canadian Controlled Private Corporation (CPCC) are eligible for a lower tax rate. The general corporate tax rate in Canada is 15 per cent, and CCPC’s are able to pay a lower 11 per cent tax rate for the first $500,000 of business income. The policy rationale behind the proposal to lower this preferential tax rate for small businesses to 9 per cent is that small businesses face higher proportional compliance costs than large enterprises. Also considering that larger companies benefit from economies of scale, the lower tax rate for small businesses is a way of leveling the playing field and helping small businesses compete with larger ones. Some politicians (and few economists) have claimed that cutting taxes for small business will be a way to spur growth and create jobs. However, there are many problems with the current preferential tax rate that lowering tax rates even further may exacerbate.

One problem is that the small business tax rate is poorly targeted, and ends up being a commonly used vehicle for tax avoidance. It is not just the neighbourhood mom and pop store or some flashy tech start-up that can and do qualify as CCPCs for the lower tax rate. Many top earners set up CCPCs as a way of shifting income from personal tax to a CCPC, which allows them to shield some of their income from taxation. In fact, research has shown that of the top 0.1 per cent (i.e. those making more than $2.6 million per year) of income earners, upwards of 70 per cent of them own a CCPC. Others have claimed that 60 per cent of the small business deduction goes to those making more than $150,000 per year. In many ways, CCPCs have become a form of tax planning for the rich in Canada. (here’s a link showing dentists how to do it!) I don’t think – or at least I hope – that giving the rich a tax cut is what our political parties had in mind when promising to lower the small business tax rate, which could make this tax planning problem even worse. But, at the same time, there is some economic rationale for helping small businesses and startups compete with larger businesses. Finding a way to help support actual small businesses instead of helping the rich lower their tax burden requires a more creative approach than just lowering the small business tax rate.

Another line of criticism regarding the small business tax deduction is that it could be creating a tax wall, which might be providing incentives for small businesses to stay small, instead of growing into larger, more productive firms. Policies that provide disincentives to economic growth are generally not ideal. As the gap between the tax rate small and large businesses pay increases, there is increasingly an incentive to stay small to avoid a greater tax burden. Recent work by the C.D. Howe Institute finds that small-business tax breaks do not create significant barriers to growth, but there is still an economic cost, as investment is shifted from large corporations to less-productive small firms. Increasing the small business deduction could make this problem even worse.

Finally, and at a more fundamental level, prioritizing the performance of small businesses over large businesses is questionable. We have all heard our political leaders claim that small businesses are the backbone of the Canadian economy, as they are “the creators of 80 per cent of all new jobs in this country” and employ 70 per cent of Canada’s non-government labour force. What is often missed it that small businesses generally pay lower wages, offer worse benefits, offer weaker employment security, and are less productive than large corporations. Due to their higher level of productivity, it is mostly large companies that create the stable, well-paying jobs that people can actually live off of. It is a nice thought that small local businesses are driving economic growth, but in reality, it is productive and innovative firms that drive growth, regardless of size. This is not to say that small businesses aren’t an important part of the Canadian economy, but any government support towards them should be geared towards helping them grow into large companies, something the evidence suggests is not happening, as small businesses make up 98% of all employer businesses – firms with at least one person on the payroll – in Canada. In a globally competitive economy, Canada needs its small businesses to grow larger.

Canada’s small business deduction is flawed and costs the federal government more than $3 billion in foregone revenue annually. Our federal politicians are doubling down by proposing to lower the rate even further and risk making these problems even worse, at an estimated cost of $5 billion annually. Instead of trying to solve the real problems surrounding small business head on, our politicians are taking the politically convenient route of satisfying the publics love of and bias towards small business and caving to the demands of interest groups like the Canadian Federation for Independent Business. I suppose that this should not really be surprising, but it is certainly nothing to be admired.

 

Connor Colvin is a 2016 Master of Public Policy candidate at the School of Public Policy and Governance, University of Toronto. He previously completed an Honours Bachelor of Arts in Economics at McMaster University. Connor is interested in a broad range of policy issues, but his main areas of interest include economic and social policy.

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