Most governments in Canada, if not all, hold small and medium-sized enterprises (SMEs) in high esteem. SMEs are regularly touted as the source of job growth in the economy. Governments and their political opposition go out of their way to demonstrate their support for small business.
The problem is, the myth does not always conveniently align with the facts about the role that SMEs actually play in the economy. We have to consider the possibility that some public policy initiatives in support of SMEs may be squandering scarce public dollars, creating barriers to growth and success for many small businesses, and quite inadvertently, helping to ensure that they stay small. Rather than relying upon firm size, it's time to refocus public policy on firms with a high potential to grow and innovate – what we will call "growth-oriented enterprises" or GOEs.
Canada has relatively few regulatory barriers for creating new businesses and we thus have a high SME "birth rate" of more than 100,000 annually. SMEs in Canada are usually defined by the number of employees; a small enterprise has less than 100 employees and a medium-sized business less than 500. According to "Start-up Canada," there are more than 1.2 million businesses in Canada. The vast majority are SMEs, employing 5.1 million people and producing 30 per cent of gross domestic product.
However, up to half of SMEs go out of business within the first five years, often due to factors such as weak management capacity, insufficient access to private investment capital or limited ability to grow. So while SMEs have a large and continuing economic footprint in Canada, the churn rate is very high. By shifting the focus of policy intervention more toward GOEs, we can support stronger growth potential, higher levels of job creation and generate more value for money.
There is strong evidence that such a refocusing is warranted. Productivity growth is the surest way to create enduring wealth in an economy, and here Canadian SMEs are being outperformed by firms that are larger and more committed to growth and innovation. Various economic analysts – including the Bank of Canada – mhave demonstrated that firm-size differences between Canada and the United States play a significant role in explaining the productivity gap between the two countries. Similarly, firms that are larger and committed to growth invest much more of their revenue in research and development than SMEs, while providing better employee compensation and benefits.
There are a variety of reasons for SMEs having weaker productivity performance – ranging from access to financing, to market size, to management and work force skills – but the relationship between firm size and productivity performance is generally accepted among economists. Small may be beautiful, but it is not necessarily better.
Perhaps one of the largest policy obstacles to SME business growth and innovation is preferential tax treatment. Small businesses benefit from significantly lower corporate income taxes and from other tax advantages not available to large businesses, presumably because governments want to help SMEs get established by preserving cash for re-investment and growth. In some cases, SMEs also benefit from reduced regulatory compliance. However, preferential taxes and reduced regulatory regimes can distort market forces, create financial and psychological barriers to growth, and inadvertently encourage businesses to stay small. There is little evidence that coddling SMEs on taxes and regulations helps them to grow taller and stronger.
On the international trade and investment front, Canada is increasingly aiming to diversify away from a dominant relationship with the United States and toward other trading partners, notably high-growth emerging markets. For some analysts, this shift in focus means we should be creating new programs and initiatives to encourage SMEs to "go global."
Here too, there is growing evidence that pursuing business in high-growth markets is not for beginners. By virtue of their smaller size, SMEs often don't have the expertise to venture into exotic but riskier new markets. A recent Conference Board study demonstrated that all firms, but especially SMEs, need a critical mass of international trade expertise, experience and risk management capacity before venturing to emerging markets to do business. Firms that don't have this expertise in advance are at much greater risk of failure, up to and including putting themselves out of business.
In short, the public policy love affair with SMEs likely overstates their importance in creating wealth. It may even be encouraging many small businesses to stay small – or even, indirectly, to fail.
Rather than supporting SMEs because of their size, governments should refocus their energy and scarce resources on other more important business attributes, regardless the size of the business: high growth potential; the capacity to innovate; a demonstrated ability to launch new products and services; and the willingness and expertise to tackle new growth markets successfully. This refocusing would improve value for the money spent on government policy initiatives, and foster overall growth for businesses and the economy.
Glen Hodgson is senior vice-president and chief economist at the Conference Board of Canada.