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There are many topics I could deal with on this blog. I encourage you to comment on the existing posts and (in comments to this post) suggest future topics that you would find helpful. Feel free to ask questions. I will attempt to answer or tell you if I can't or will do so after more research.

Small business, big business, subsidies and bailouts

In my last post, I concluded that “Although small businesses no doubt are important for employment, it is questionable to say that they are better at generating new jobs than large companies.” From the perspective of job creation then, all companies should be treated equally. That post generated some comments which noted that large businesses get a lot more subsidies than small companies. Consequently, it is considered to be only fair that small businesses get more incentives. This can be seen as an example of the “balloon theory of economics”. If government pokes the economy in one place, it bulges out elsewhere and new interventions are necessary. 

Now, from a strict economic perspective all subsidies to business are questionable. In a competitive, free market, those companies that are efficient and effective are rewarded because they produce the goods and services people want at the lowest cost. Those who fail to do so will lose out to their competitors and will, eventually, go out of business. Government subsidies, then, distort the market and sustain companies that are less efficient. Consumers pay higher prices. If Christians should have a preference for the free market, as I believe Christians should, they ought, in principle, urge governments to reduce all subsidies and assistance. Unfortunately, we are probably well beyond the point that all support for businesses can be abolished. Just a few thoughts on the issue:

Too Big to fail:  The recent “great recession” gave rise to various government interventions to bail out larger companies including General Motors, Chrysler and various banks in the U.S. and Europe. Given the massive “multiplier” effect that the failure of such large companies would have on the economy, such intervention cannot be categorically rejected. As I noted in the last post, small businesses depend on large business—both directly because of the goods and services large businesses buy and indirectly as the employees of large businesses consume the goods produced by others. The loss of employment would significantly deepen the recession!

 It is true that when a company fails, not all jobs are necessarily lost. Companies can keep operating under court supervision during bankruptcy and restructuring. Eventually, a leaner, more efficient company is likely to emerge. Alternatively, the company may be sold to another company which will keep many employees on.  However, interim financing is often required to keep operating until the restructuring is completed. For these very large companies, government assistance may be the only resort. If this assistance is then provided in the way of loans or purchase of shares (which government can eventually sell), many jobs will be maintained at low, long-term, cost to the taxpayer.

It must be recognized that a significant factor in stopping a recession or coming out of one is expectations. If consumers expect a recession to get worse, they will cut back spending. If you think you may lose your job (or even fail to get a pay raise), you will try and save for that possible “rainy day”. Similarly, if businesses think the economic outlook remains somber, they are unlikely to make major new investments and hire more people. On the other hand, if consumers and businesses see a rosier outlook, they will increase their spending. Government bailouts of large businesses may well avoid further panic and, thus, prevent a recession becoming even worse.

That is particularly the case, when large banks fail. Although “runs” on weak banks like those of the Great Depression of the 1930’s will be less severe now since, in the developed world, depositors are partially protected by deposit insurance, they are still at risk. They still face the risk of not being able to get at their money for a period of time if a bank fails. Thus, many people will draw out their money if a bank appears to be at the brink of collapse. In the banking system, money will become “tight”. Even stable banks will reduce lending. Some bank loans will be “called in”—businesses required to repay loans immediately—and new loans significantly reduced. The effect of this will be further cuts in business spending and more layoffs of workers. Consequently, government bailouts of banks in order to maintain financial stability cannot be rejected out of hand. Certainly, small businesses will benefit from such confidence building efforts.

 

Supporting new investments: In addition to aiding financially troubled big companies, governments also frequently make significant contributions when companies build new factories, expand the existing ones. For example, the Ontario government recently announced that it will pump $85.7 million over five years into a Honda plant in Alliston in order, according to Premier Kathleen Wynne, to retain “thousands of auto sector jobs”[1].  That government assistance represents ten percent of the total planned investment of $857-million. In addition to the jobs saved or created in Honda, the government expects that thousands of jobs will saved in the auto supply chain.

In theory again, such subsidies should be rejected. In a free market, companies would build plants wherever its costs (of investing and operating) will be lowest. It will then be able to produce and sell its products at the lowest prices--to the benefit of consumers. Unfortunately, in real life, governments in other provinces and U.S. states (and cities) also provide such subsidies. As the president of Honda said “the Canadian operation must compete with facilities in other jurisdictions”. Governments compete with each other to attract job-creating investments—in North America as well as elsewhere. Given that others do it, can a government really refuse to make some attempt and see jobs move elsewhere?

It is, however, not totally certain that incentives are always necessary. While Honda’s president  publicly told premier Wynne, ”Without your support I’m not sure we could have done this,” The leader of the opposition Progressive Conservative party expressed the belief that Honda was prepared to make the investment without taxpayer money. In previous conversations with Honda officials, he had been told that they were more concerned with the high cost of hydro, payroll and other taxes in Ontario.  He called for a reduction in business costs, such as electricity, for all companies. While such a more general reduction in business taxes would allow all companies the opportunity to create more jobs (and is preferred), a reduction in electricity costs by the Ontario government owned utility companies would just be another form of subsidy.[2]

It is debatable, therefore, to what extent--if any—government should provide such subsidies. When they do subsidize, they must certainly keep in mind, the effect that helping one company has on its competitors. To help one company to create jobs may allow them to compete unfairly and cause competing companies to lose sales and be forced to lay off workers. For example[3], the province of Quebec recently approved the construction of the McInnis cement plant in Port-Daniel-Gascons on the Gaspé peninsula.  This plant, one of the largest industrial projects underway in Eastern Canada, was made possible by $350-million in loans and equity from the Quebec government. This incentive is being provided because it will bring much-needed jobs and investment to a distressed area. However, the decision is hotly debated because the industry is already in oversupply. Four competing cement companies and their employees will be negatively affected.

Overall, governments should seek to keep such support as low as possible.

 

Entrepreneurs: 

Not all small businesses are created equally, however. George Gilder, in his book, The Spirit of Enterprise, [4] made a strong argument that the key problems of the decades of the 70’s and 80’ were solved  by entrepreneurs, the pioneers in new industries using strategies and inventions that didn’t exist before. Steve Jobs of Apple and Bill Gates of Microsoft are recent  examples that come readily to mind. He argues (p.62) that “the expert-ridden companies already dominant in the field rarely produce the breakthroughs …From the failure of most carriage makers to produce a workable automobile to the failure of Kodak to make an instant camera, established firms have usually stood aside while new companies, or firms in other fields, have introduced the radical innovations”. The book is replete with other examples.  Contrary to my conclusion in the previous post, he also reports (p.47) that during this period in the U.S., large Fortune 500 companies lost some 3 million jobs while smaller companies created 7 Million—most of them in the innovative entrepreneurial sector.  He also concludes, however, that both large and small firms are necessary. “Large firms get usually got that way by being productive and their productivity is obviously vital to creation of employment (p.248).” That is, successful small business grow not larger businesses; many fail along the way.

Governments, however, have no ability to pick and motivate entrepreneurs. The best it can do is get out of the way. Starting small businesses should be easy and cheap—not slow and costly with multiple permits and loads of red tape.

 

Conclusion: 

Whether or not small businesses create more jobs than large ones is not clear. Favouring small businesses for that reason is questionable. The argument that small businesses should receive favour because large ones already get so many subsidies is also arguable. Rather, the subsidies to large ones should be reduced. However, because the failure of some very large companies would cause unacceptable havoc in the economy and because other government jurisdictions do provide incentives which distort proper market decisions, such incentives will necessarily have to be provided. Small companies get the benefit of maintaining employment in these large companies through providing products and services to them and their employees. Large companies keep small ones in business. No additional incentives are really necessary.

The only strong reason for special treatment for small businesses is, as mentioned last time, the uneven burden of tax and regulation compliance. A Dutch correspondent has pointed out that this issue is particularly significant in the Netherlands because of better employee protection.e.g.sick employees that must continue to be paid, terminated employees who must be paid supplements by the employer for many years. The degree to which small businesses need to compensated for this reason, however, remains uncertain. Overall, the least amount of government intervention in the market is, likely, to be best.  

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[1] http://www.brantfordexpositor.ca/2014/11/06/honda-ontario-government-investing-847m-in-alliston-plants

[2] This could be a direct cost to taxpayers or an increase of rates for individual consumers. He may also have had in mind a reduction in incentives for solar and wind energy which will continue to cause Ontario’s electricity prices to rise.

[3]  Nicolas Van Praet, “Lafarge joins legal challenge against $1-billion Quebec cement plant”

http://business.financialpost.com/2014/08/04

[4] George Gilder, The spirit of Enterprise, Simon & Schuster, New York, 1984

Should government discriminate in favour of small businesses?

Recently, the Canadian government introduced a new Small Business Job Credit which is “expected to save small businesses more than $550 million over the next two years.”  This saving is being provided as a cut in the Employment Insurance tax that small businesses pay based on the earnings of their employees.[1]
 

Now any cut in payroll taxes is welcome since these taxes are, in effect, a “tax on jobs”. Such taxes add to the wage cost that employers must pay. Since companies can afford to hire people only when the net revenue that can be generated  from the product or service these people produce is more than the cost of wages paid (including all taxes), any reduction in payroll taxes will make it possible for companies to create more jobs.

The question is, however, why provide this cut only for small businesses—why not for all? The new credit is not the first incentive provided for small businesses. In 2011, the government introduced a Hiring Credit for Small Business. Both federal and provincial corporate income taxes are also lower for small companies. In fact, both the federal and provincial governments have, for years zealously provided tax relief for small companies in an effort to shore up political support[2]. Can this bias in favour of small businesses be justified economically? Are they really better at creating new jobs than large companies?  If that were true, a stewardship perspective--which favours putting people to work--would certainly support our government’s bias.

On announcing, the new incentive, Joe Oliver, Canada’s Minister of Finance, stated:

 Small businesses drive Canadian prosperity, representing about 50% of jobs in the private sector and a third of Canada’s gross domestic product. That is why we are taking action to make small businesses stronger. Our new Small Business Job Credit will lower taxes for business owners and make it easier for them to create jobs for Canadians.

 In similar vein, Kevin Sorenson, Minister of State (Finance), is quoted:

Small businesses are crucial to Canada’s long-term prosperity. Canadian families depend on the jobs they create and the services they provide. That is why the Harper Government will continue to foster an environment for small businesses to grow and prosper.

However, if small businesses really provide 50% of the jobs, then, don't large companies provide the remaining 50%? And aren't they at least as important? What is the evidence that small companies are the engine of growth?

Small businesses depend on large businesses-William Watson, in a National Post editorial entitled “Small business good, big business bad”[3] ascribes this bias towards small businesses to the fact that there are just so many of them and, by implication, that they generate a lot of votes.Moreover, we all “know” from the media that big businesses are bad: they “mainly exist to pollute the environment, harass and exploit workers, and endanger everyone’s health by forcing us to eat, work with or live beside dangerous products”. Small businesses, in the public mind, apparently escape this condemnation and are generally considered “good”—the “political equivalent of cuddly puppies.”[4]. Economists, however, tend to push the concept of neutral taxes, ones that don’t discriminate between different business forms and sizes. Believing that good stewardship includes a preference for the market, I share that point of view.

Watson’s main theme, however, is that many small businesses are dependent on the large businesses. The small canteen truck that drops in at large construction sites depends on the large construction company.  The employees of large companies,” make use of all sorts of small businesses: coffee shops, restaurants, dry cleaners, print shops, bicycle delivery guys and girls, taxis, boutiques of all kinds. Most small businesses create jobs by hiring people both to provide services to large businesses directly and to meet the consumption needs of the employees of those businesses! If the small businesses’ ability to hire new workers depends on increasing needs of the larger businesses, why should tax policy not favour the large companies?

Good Stewardship-In an earlier post, I noted that good stewardship also means that we need to use our God-given resources as effectively and efficiently as possible. Unfair tax breaks for small business, as Jack Mintz has pointed out,  in fact, “produce an excess of inefficient firms” and “reward stagnation”.[5] Larger businesses tend to have a higher productivity[6]—they can produce at a lower cost due to economies of scale and specialization. That is, they can use more expensive automated equipment since they produce at a higher volume. Since Canada appears to be lagging behind some of its major trading partners in productivity, our ability to export (with related jobs) is already reduced. Favouring small business even more, further reduces our export competitiveness. 

 

 Moreover, larger companies also do more research and development than small ones[7]. They innovate more. They export more[8]. Moreover, although layoffs at large companies attract wide news coverage, small companies shed jobs at a faster rate in economic downturns and are more likely to go out of business altogether[9]. Furthermore, the contribution that large companies make to the economy is larger than their total (very significant) employment levels. They also tend to pay higher wages and better benefits—pensions, medical insurance etc.—and contribute a larger proportion of the total government tax revenues. Overall, good stewardship does not favour extra incentives for small businesses.

 

Regulatory/Tax Burden- One valid reason to help small businesses does, however, exist. The burden of complying with the myriad of government regulations and tax policies falls disproportionally heavily on smaller businesses. For example, the collection and remittance of sales taxes from customers and payroll taxes from employees requires the same basic efforts—learning and keeping up with the requirements, devising and maintaining processes (computer programs, etc)—for all companies. While these costs increase with the size of the company, they become relatively less significant in total as the size of the company increases. All companies need a basic system to deal with them; larger companies are better able to bear that basic cost. Governments, however, already make some adjustment for this. Sales tax (HST), for example does not have to be collected by businesses having sales of less than $30,000 annually. It is possible that compensation for complying with these programs may need to be increase. It is, however, unlikely, that these compliance costs justify the significant incentives currently in place for small businesses.

Conclusion—Although small businesses no doubt are important for employment, it is questionable to say that they are better at generating new jobs than large companies. We need them all- small, medium and large. Government incentives for business to create jobs should be offered to them all. Payroll taxes should be reduced for all—to the extent that we can afford it.

P.S. Focusing only on small businesses also creates a problem at the cut-off point between large and small. In the case of the current employment tax cut, when a company hits the $15,000 cut-off point, it loses the whole credit. Thus, at the cut-off point, there is an incentive of $2,234 for companies to fire a few people just to keep under the $15,000 cut off point.[10] It is unlikely, however, that a lot of companies would be just at that cut-off point. However, this problem and that of defining what is a small company is real for all such incentives.

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[1] From the current legislated rate of $1.88 to $1.60 per $100 of insurable earnings in 2015 and 2016.  The credit applies to any firm that pays employer EI premiums equal to or less than $15,000 in those years.

[2] Jack M. Mintz, “Rewarding Stagnation”, National Post, Feb. 8, 2008, FP13

[3] National Post, Sept. 23,2014

[4] William Watson, “Only in Canada, National Post, Apr. 28,2005, FP.23.

[5] Jack Mintz, “Rewarding stagnation”, National Post, Feb. 8, 2008, FP13

[6]  William Watson “Small beautiful but big works”, National Post ,Aug. 28,2013,  FP.9 with reference to  Statistics Canada study by John Baldwin, Danny Leung and Luke Rispoli.

[7] See also Jack M. Mintz, “Small-minded R&D”, National Post, Apr. 3, 2012, FP11

[8]  Watson, 2005.

[9] Jock Finalyson, “Where the jobs aren’t”, National Post, Nov. 8, 2003, FP11

[10]Mike Moffatt,September 15, 2014, http://www.macleans.ca/economy/economicanalysis/the-dangerous-misguided-flaw-in-the-small-business-tax-credit/