Equity-based incentives are not the way to encourage innovation: Jack

Federal and provincial governments now spend almost $300 million on the small business venture capital and LSVCC tax credits. Other equity-based tax incentives include junior mining and oil/gas flow-through share tax credits, which have a budgetary cost of $212 million at the federal level. In recent years, bio or hi-tech flow-through shares proposals have also been proposed that would add on to taxpayer costs.

At least with flow-through shares companies renounce unused deductions and credits, thereby enabling companies to make better use of their unused corporate tax losses or exploration tax credits. However, it is an expensive way of providing tax relief compared with other alternatives. For example, the federal government pays a cheque to cover a portion of the value of the unused research tax credit in a year for small firms. This is a cheaper way to provide support than flow-through shares when the company is not paying taxes.

So what evidence is there that these equity-based incentives work outside giving some well-to-do investors a large tax break? Unfortunately for the proponents, many studies have generally shown they don’t pass the smell test. The LSVCC studies, especially by Doug Cummings and Jeff MacIntosh, were quite damning. Once excluding the tax breaks, most funds earned poor or negative financial rates of return and, even worse, crowded out funding of private venture capital. A Laval study showed poor returns for investments in Quebec’s Stock Saving Plans. A study on the B.C. investor tax credit also showed that these investments had poor financial returns even if they created jobs. Vijay Jog at Carleton University has shown that flow-through shares have generally funded projects with sub-optimal economic returns.

Obviously, encouraging uneconomic, low productivity investments to spur innovation will not grow the economy. So why have these equity-based incentives failed? Here are three reasons.

First, the incentive resulted in too many poor projects being funded, as investors were more interested in the tax benefits than financial returns. Without the incentive, these projects would not have been funded.

Second, the low returns in venture capital made it more difficult for high return projects to be funded by equity investors ineligible for the tax credits including pension funds. Indeed, in this past decade VC funds in Canada earned annual rates of return of roughly three per cent, about one-sixth of U.S. VC funds. In other words, good Canadian companies were being squeezed out of a capital market because pension plans and other investors were unwilling to invest in Canadian venture capital funds with inferior returns.

Third, stock investment houses collect substantial underwriting and trading fees, eating up some tax benefits. And for governments it is administratively a headache to determine eligibility.

Equity-based incentives are not a good mechanism to encourage innovation. Alberta and Ontario are right to avoid them. So should the federal government and other provinces that simply waste taxpayer money. Only the rent-seekers enjoy them.

Jack M. Mintz is the President’s Fellow at the University of Calgary’s School of Public Policy.