Worry about a decline in start-ups

A number of prominent Canadians, including Bank of Canada Governor Stephen Poloz, have raised concerns about the state of business start-ups and entrepreneurship in Canada. There is no question that entrepreneurship is critical to a well-functioning, prosperous economy. New firms are the lifeblood of innovation, creativity and economic progress.

And while the decline in business start-ups is a worrying sign for future economic dynamism and progress, the concern has not been met with practical solutions. Capital gains tax reform is one practical possibility.

Consider first the worrying trend in Canada that the rate of business start-ups, a key measure of entrepreneurship, is declining. Since peaking in 2004, the rate of business start-ups as a share of existing firms has declined by 16.2%.

Specifically, in 2004 there were 17.9 business start-ups (all sizes) per 100 existing firms. The rate has since declined to 15 business start-ups per 100 existing firms.

The rate of decline is more pronounced for larger firms (measured by employment). For instance, the rate of decline in business start-ups between 2004 and 2012 for firms with 50 to 100 employees was 68%.

Declines are also being observed in other industrialized countries. For instance, the US experienced an 8% decline from 2003 to 2012.

One likely and so far ignored explanation is the relationship between demographics and entrepreneurship. Younger people are less risk averse and more prone to question the status quo and experiment. Such characteristics are key to the entrepreneurial process. There are proportionately fewer young workers with these characteristics but they’re typically not in positions of influence within firms.

Canada’s population, like all industrialized countries, is aging with a growing share (increasing by 74.1% between 2008 and 2035 according to Statistics Canada) over the age of 65.

Given the importance of entrepreneurship to the economy and the absence of any serious policy options to deal with the demographics, it’s critical governments enact policies supportive of entrepreneurship.

Leverage capital gains

One such policy lever is capital gains tax reform. Capital gains taxes are applied to the sale of an asset when its sales price is nominally (not adjusted for inflation) above its original purchase price. The sale price is based on the present value expected by the purchaser from the future stream of income received by the asset. However, that stream of income is subject to annual taxes. Applying the tax after selling the asset is a type of double taxation that creates disincentives for entrepreneurs and firms that finance entrepreneurs.

Currently, Canada has the 14th highest capital gains tax rate among the OECD countries despite the two reductions in the tax rate implemented by the Chretien Liberals. A number of options for reform exist but one that holds great policy and practical promise is the replication of a Clinton-era US reform.

The Clinton Administration created a rollover provision whereby the proceeds of a sale of an asset are exempt from capital gains if they are re-invested within a specific time period, perhaps six months. Such a reform frees up capital today that could boost entrepreneurship while deferring the eventual capital gains taxes.

Improving the incentives would help mitigate the demographic issues, which have clear and serious implications for the economy. Capital gains tax relief offers an opportunity to super-charge entrepreneurship.

Jason Clemens and co-writer Niels Veldhuis are economists with the Fraser Institute and co-authors of Entrepreneurship, Demographics and Capital Gains Tax Relief, available at www.fraserinstitute.org. Distributed by Troy Media.