Government Should
Get Out of the
Small Business Business

Bill C-53, an Act to “increase the availability of financing for the establishment, expansion, modernization and improvement of small business” is presently being contemplated by the federal government.¹ The goal of this legislation, which is primarily an extension of the existing Small Business Loans Act, is to encourage debt financing to small and medium-sized businesses (hereafter referred to as SMEs). Under this legislation, the government (taxpayers) will guarantee loans granted to SMEs by financial institutions. Granting loans with government guarantees, however, is not the most effective or efficient way to help SMEs obtain financing.

Business lending

Allocating credit (in the form of investors’ savings) to individuals and businesses who require it, is one of the most important functions that financial institutions perform in an economy. The process directs financial resources and, in part, determines the future productive capacity of the economy. In other words, it helps increase economic growth.

The risk/return relationship

The risk/return relationship is the foundation of prudent banking; it establishes and safeguards the financial system. A project’s risk is determined by a host of factors including its composition, collateral, credit worthiness, and managerial experience, among other things. The riskiness of the project is directly related to the terms and conditions of the loan (the interest rate, duration, and so on). Projects are financed according to an expectation of repayment based on an interest cost that adequately compensates the lender or investor for the project’s riskiness. If the government intervenes in capital markets, specifically within the banking sector, the alteration of the risk/return relationship can have adverse impacts.²

A simple example illustrates the deleterious effects of government intervention. Consider 4 projects, A through D. Each project has a particular risk profile, as determined by the previously discussed factors. The lending institutions have a limited amount of credit and thus can only finance two projects. Assume that under the current environment, projects A and B receive credit. That is, given the level of permissible risk, it is profitable for the institutions to finance projects A and B.

Now assume that the government introduces debt guarantees, and that projects B and C are eligible. The riskiness of the projects has not changed, but the risk exposure to the bank has been altered by the presence of debt guarantees. Under the post-inter- vention environment, the bank now issues credit to projects B and C.

By intervening in the capital markets, the government has caused financial resources to be reallocated from project A to project C. The government guarantee has also transposed a portion of the risk from the lender to the government. Thus, projects that exceed the permissible risk are now financed because taxpayers are assuming part of the risk. In determining the impact of the reallocation of financial resources, one must take into account the success of project C compared to the negative effect on project A, as well as project A’s potential success had it received credit.

Current Bank³ Lending

The notion that there is a lack of commercial credit is not supported by the facts. Table 1 includes credit statistics for commercial lending as of March 1998.

The amount of loans provided under the Small Business Loans Act is relatively small. In fact, the amount of loans issued under the Act represents only 18 percent of the total comparable loans issued by the major banks.

This is an overestimation since approximately 30 to 40 percent of the loans issued under the Act would have been approved without government guarantees.⁴ Thus, the total amount of outstanding loans issued under the Act represents between 7.3 percent and 10.9 percent of the total amount of loans authorized by the major banks.

It is also important to recognize that the major banks form only a segment of a larger financial services market that provides financing to SMEs.

Thompson, Lightstone and Company Survey

A Thompson, Lightstone and Company Survey,⁵ commissioned by the Canadian Bankers Association, concluded that half of all SME debt financing was provided by banks. More importantly, the survey showed that specialized suppliers had dramatically increased the debt financing they provide.

The survey indicated that 38 percent of SMEs, up from 30 percent the prior year, maintained multiple sources of financing. Similarly, the survey indicated a decline in the number of SMEs with single-source financing. In terms of debt financing, supplier credit (48%) was followed by credit cards (46%), and leasing (28%).

A significantly higher percentage of respondents indicated an increased use of retained earnings (51 percent versus 45 percent) as a source of equity financing. The survey identified personal savings as the other major source of equity financing. Equity financing provides a less onerous source of capital to SMEs and should be encouraged to a greater extent since it is, by its very nature, more flexible than debt. It is important to recognize that there are a host of tax-based policies that actually impede capitalization and thus the use of equity.⁶

Perhaps the most important insight garnered from the Thompson, Lightstone and Company survey relates to the approval rates for debt financing for SMEs. Table 2 summarizes the loan approval rates between 1996 and 1998.

Further evidence of the responsiveness of the major banks to SMEs is the survey’s conclusion that 92 percent of loan applications were approved on their initial submission. A major factor contributing to the improvement in loan approval rates is the state of the economy. As the economy has continued to improve, the approval rates for credit have similarly increased.

The commercial credit function of banks

Working capital financing

In the commercial credit market, banks have traditionally provided working capital financing. The working capital cycle is composed of the credit required to finance accounts receivable (sales on credit) and inventory, and the credit provided by suppliers. Banks have traditionally filled any void that exists between what a firm has in working capital finance, and what the firm requires for working capital. Working capital credit is relatively low risk, since it is always backed by liquidable assets, namely, accounts receivable and inventory.

The importance of working capital management cannot be underestimated in terms of its influence on the success of a business. A 1996 Statistics Canada study concluded that lack of adequate financial management was among the chief causes of business failures in Canada.⁷ The study specifically noted unbalanced capital structure, an inability to manage working capital, and undercapitalization as the principle financial difficulties facing firms. The study also noted that a lack of financing was principally caused by internal shortcomings, i.e., lack of knowledge of financing alternatives rather than any institutional difficulties.

Capital investment financing

In the area of credit, banks also provide commercial entities with financing for capital investment. Banks have provided partial financing for the purchase of new equipment, the acquisition of a building, etc. These types of credit projects are also relatively low risk since they are secured by tangible assets, such as equipment and land, which act as collateral. Within this area of financing a number of large financiers have entered the market to compete directly with the banks. Specialized financiers and supplier creditors have established a firm presence financing both equipment and capital development.

Small Business Financing Act

Given the large scale of lending by both traditional banks and a host of new competitors, one must ask whether the banks should even be involved in financing new ventures or expanding existing firms. Even if the risk/return relationship and the perils of altering that relationship were excluded, we suggest that it is not the banks’ function to provide such types of credit.

The banks, due to their capitalization and their need for prudent lending must focus on low-risk projects. It is not the government’s role to subsidize or otherwise socialize the risk-taking behaviour of financial intermediaries. Credit decisions must be based on such knowledge as the terms of collateral and the ability to repay credit with future earnings.

The real issue is high taxes

Canadian SMEs should be encouraged and allowed to use a greater percentage of equity financing. The major sources of equity financing for SMEs are direct investment (share capital and owners equity) and retained earnings (profits that are not disbursed). The current tax system, specifically the level of taxation, is a direct hindrance to SME capitalization. It is interesting to note that a January 1998 survey by the Canadian Federation of Independent Business found that its members considered taxation the top priority for action (80.5 percent).⁸

High taxation of capital gains and dividends reduces both the savings rate and aggregate investment. What matters most to investors is their rate of return after taxes. High taxes on capital gains reduce the net rate of return and consequently depress investment levels overall. The impact of such taxes in the long run is to slow down the rate of capital accumulation and economic growth. High taxes diminish the dynamic efficiency of the economy.

More burdensome to SMEs is the level of corporate and individual taxation in Canada. The relative and absolute high rates of taxation in Canada reduce income and thus impede businesses from using their own income to finance expansion and new ventures.

Corporate taxation

Canada’s high taxation levels prevent firms from re-investing in themselves. High levels of corporate taxes not only dissipate the amount of funds available for re-investment but also reduce the levels available for disbursement to investors and owners. Both the 1997 Report on Business Taxation⁹ and the Business Council on National Issues’ report¹⁰ called for a reduction in the level of business taxes in order to encourage competitiveness and capitalization.

Individual taxation

In cases where the business operates as a sole proprietor or partnership, the pertinent income tax rates are personal rather than corporate since the income of these businesses is claimed, for tax purposes, as individual income. Tables 3 and 4 provide information on the level of taxation assessed on individuals in Canada. Table 3 shows the marginal rates of taxation and the level of income at which they begin. Table 4 presents data on the total amount deducted for taxes by income level.

The high marginal tax rates coupled with the relatively low threshold on which they are assessed, and the high average tax rates combine to create an enormous disincentive and indeed an inability for smaller firms to accumulate and use retained earnings.

It is important to recognize that businesses can allocate profits in one of two ways: either retain them for investment, or disburse them to the owners. Encumbering SMEs with punitive taxation rates on both corporate and personal income does nothing to facilitate the capitalization of Canadian firms. Capitalization is integral for producing growth and consequently a higher standard of living for Canadians.¹¹

Conclusion

The major banks are clearly fulfilling the role they have traditionally occupied in the economy: financier of low-risk projects. The government must not enact legislation or regulation that alters the risk/return relationship if it is to preserve efficiency in the allocation of financial resources and credit. The need to safeguard prudent lending practices by financial institutions outweighs any possible marginal benefit gained from government intervention. Moreover, the government should not use overburdened Canadian taxpayer money to subsidize private business. The need of the hour is a rational reduction in tax rates—specifically capital gains rates, along with both corporate and individual income tax rates—which would do much more to facilitate investment in SMEs than any debt guarantee program, while at the same time preserving allocative efficiency.¹²

Notes

1Based on a submission made to the House of Commons Industry Committee on October 20, 1998.

²For information on the effects of government intervention see E. Brewer, et al., “Performance and Access to Government Guarantees: The Case of Small Business Investment Companies,” Economic Perspectives, Federal Reserve Bank of Chicago, 1996.

³Refers exclusively to the large Schedule I Banks (Royal Bank, CIBC, Bank of Montreal, Scotiabank, TD Bank, and the National Bank) and the largest Schedule II Bank, the Hongkong Bank of Canada.

⁴Industry Canada, “Assessing the Changing Needs,” March 1998.

⁵Thompson, Lightstone and Company Limited, “Small- & Medium-Sized Business in Canada: An Ongoing Perspective of Their Needs, Expectations and Satisfaction with Financial Institutions,” July 1998.

⁶For more information on the effect of alternative systems of taxation on business see: J.E. Golob (1996), “How Would a Flat Tax Affect Small Businesses?” Economic Review, Federal Reserve Bank of Kansas City; R.E. Hall and Alvin Rabushka (1985), The Flat Tax, Stanford: Hoover Institution Press; and Dennis Mills (1990), “The Single Tax: An Alternative to the GST?” Fraser Forum, March, pp. 4-14.

⁷Statistics Canada, Business Bankruptcy in Canada, 1996, 1996.

⁸In the same survey, respondents indicated availability of financing as a relatively low priority area; it received only a 28.6 percent response.

⁹Technical Committee on Business Taxation, Report on Business Taxation, December 1997. Submitted to the Minister of Finance.

¹⁰Business Council on National Issues, Creating Opportunity, Building Prosperity: A Tax Reduction Strategy for Canadians, October 1998.

¹¹For a more detailed discussion of capitalization and growth, see J. Frankel (1998), “Why Economies Grow the Way They Do,” Canadian Business Economics, vol. 6, no. 3, pp. 3-13.

¹²For information on the effect of technology on SME financing see: J. Yellen (1996), “Statement to Congress,” Federal Reserve Bulletin, July.

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Last Modified: Wednesday, October 20, 1999.