There is increasing recognition that entrepreneurs and the small-and medium-sized businesses they develop are vital to the overall health of our economy.

As such, governments across Canada have rushed to encourage small business development and entrepreneurship. Indeed every province, save for Quebec, as well as the federal government offer substantial support to small businesses in the form of reduced business income taxes as a way to encourage the growth and development of this sector. Quebec will introduce its own preferential rate next year.

Unfortunately, the reality is that this preferential rate has created an enormous tax barrier to growth for small businesses and entrepreneurs.

The current preferential income tax rates for small businesses at the provincial level range from a low of 2.0 percent in New Brunswick to 6.5 percent in Prince Edward Island. The preferential rates stand in stark contrast to those applied to general business: provincial general business income tax rates range from 8.9 percent in Quebec to 17.0 percent in Saskatchewan. The federal government also offers a substantial reduction in business income tax rates for small business: 12.0 percent versus 21.0 percent for general businesses.

The combination of federal and provincial preferential small business income tax rates, while well intentioned, results in steep increases in business income tax rates for businesses that grow and expand.

The smallest increase experienced by growing firms that move from the preferential small business income tax rate to the general business income tax rate occurs in British Columbia, Ontario, and Prince Edward Island, where the applicable statutory rates double.

For instance, the combined federal-provincial business income tax rate for successful small businesses in British Columbia increases from 16.5 percent to 33.0 percent. In Ontario, combined federal-provincial business income tax rates increase from 17.5 to 35.0 percent. The largest increase occurs in New Brunswick where the statutory rate increases from 14.0 to 34.0 percent; a 142.9 percent increase.

Published research indicates that such steep increases in business income tax rates create a powerful barrier, or disincentive, to growth and expansion. The large increases in business income tax rates as firms move from the small business income tax rate to the general income tax rate establishes strong incentives for firms to reorganize (split into multiple firms) and/or pay out additional monies in bonuses rather than growing and expanding.

Such tax planning may be a boon for accountants, lawyers, and financial planners but it means less effort and resources are put into business development, research, and expansion.

An important study by the federal government’s Technical Committee on Business Taxation investigated the barrier that preferential small business tax rates have on firm growth. Professors Kenneth Hendricks, Raphael Amit, and Diana Whistler, working in conjunction with Statistics Canada examined the behaviour and performance of approximately 900,000 businesses with employees in Canada between 1984 and 1993.

Hendricks and his colleagues concluded that businesses were indeed responding strongly to the tax incentives embedded in the preferential tax structure for small and medium-sized businesses. For example, they found that the majority of firms studied (98.0%) claimed taxable income below the threshold ($200,000) eligible for the small business tax rate, which is exactly what one would predict. In addition, the study concluded that the preferential tax rate largely benefited mature existing firms rather than start-ups and entrepreneurship.

The solution to this barrier is to eliminate the preferential business income tax rate for small businesses by reducing general business income tax rates at both the federal and provincial levels. In addition to reducing general business income tax rates, the small business income eligibility threshold, which is the amount of income firms can claim at the small business rate, should be aggressively increased.

The elimination of this rather significant tax barrier will help Canadian businesses grow and expand to reach their full potential.