Needed: A Fix for the Previous Fix

Many of us, especially politicians and pundits, have a special fondness for small businesses. I’ll admit often feel a little smug when I go to a locally-owned coffee shop instead of Starbucks, even if they charge more and sell worse coffee.

Or, I might patronise a mom and pop hardware store instead of the Home Depot, even if they offer less variety at a higher price. In part, this is because we feel more of a personal connection with the local small business owner, who we might know. There’s also the mystique that small businesses are the unsung hero of the American economy.

This idea is fueled by the fact that small businesses account for most job growth. Of course, they also destroy many jobs because small businesses are more likely to fail. Also, the real job creators are high-growth firms and "gazelles", young firms that suddenly grow quickly. Because successful businesses usually start small and create jobs as they grow, it leads the data to suggest that small businesses create most of the jobs. But once you control for firm age, the small-firm effect weakens.

So the question is whether we believe small businesses are so important and create so many jobs that in addition to paying too much for bad coffee, we should have policies to promote them. The government already guarantees small business loans and favours small businesses when awarding government contracts. But should it do more in terms of subsidies and tax treatment? From an economic perspective, favouring one industry or type of business is usually a bad idea. It is better to let the market chose the winners and losers. But if there does exist some market imperfections, then there may be some scope for useful government intervention. For example, information asymmetries might mean smaller firms face higher costs of capital than larger firms. That might justify some of the small business loan programmes. Though there is not much evidence that small businesses owners, or at least the ones who should get capital, are constrained at the moment.

Another market imperfection is compensation through benefits. To hire talented employees small businesses must offer the same calibre health and pension benefits large companies do. Administering even a modest 401(k) plan is expensive for a small business. For example, someone has to be the fiduciary and do record-keeping and firms who provide these services often charge small firms more. There exist economies of scale when it comes to benefit administration. Health care costs are also much higher for small businesses. In addition to higher administrative costs, a smaller pool of workers mean the insurer will charge higher premiums. From a benefits perspective, small firms are at a distinct disadvantage. So maybe there should be more subsidises or preferred tax treatment.

Or better yet, we could remove the policy which caused some of the disparity—that employer-provided health care costs are tax-free. This would radically reform the way health care is priced and possibly level the playing field for small businesses. The tax treatment of employer-sponsored health care provides an enormous incentive for large firms to compensate their workers with health care instead of income. That results in higher health care costs (because high premiums and low deductibles result in over-consumption and consumers disconnected from the costs health care). The favoured tax treatment for employers purchasing health insurance, relative to the employee purchasing it or paying for services directly, means that buying an individual plan (if your employer does not provide one) is much more expensive. That leaves small businesses on the hook to provide health benefits, if they want to be a competitive employer.

It’s too soon to tell what the impact on premiums from health care reform will be for small businesses. In principle, the effect should be ambiguous because certain aspects of it will help small business while others will make premiums more expensive. But John Cogan, Glenn Hubbard, and Daniel Kessler found that reform in Massachusetts (which is similar to the new national plan) raised premiums, especially for small businesses. Part of the new legislation is a tax credit for small businesses that provide health care, but it remains to be seen if this will compensate for higher premiums.

The current tax treatment of helath care penalises small businesses, which may provide justification for some intervention. But this is often how it goes. One government policy creates a market distortion so we need another policy to remedy it.

This article appeared in the Economics/Free Exchange section of the