John Lester is a former federal government economist who writes on public policy issues. John’s last public service assignment was Director of Research for the Expert Panel Review of Federal Support to Research and Development. Prior to that, he managed the Tax Evaluations and Research Group at Finance Canada. Since leaving the public service, John has published papers with The School of Public Policy at the University of Calgary, the Canadian Tax Journal, Canadian Public Policy and the C.D. Howe Institute.

Overall, you appear to argue that grants are generally not effective in creating real economic growth. Is this mainly because grant programs are costly to administer, or are they ineffective at incentivizing businesses to meet the government’s intended policy?

Governments in Canada spend almost $30 billion a year on business subsidies. These subsidies are delivered through the tax system, through direct spending programs (grants and contributions) and through goods and services supplied by government business enterprises. About 30% of these subsidies provide income support without the expectation of improved economic performance. Of the 70% of subsidies that are intended to make Canadians richer, only about a third achieves this objective.

Subsidies will always cause businesses to do more of the subsidized activity. This can raise real income if private markets are not allocating labour and capital to their best uses. Business subsidies typically fail to improve economic performance because they are provided when markets are functioning appropriately. Failure does not typically occur because of costly administration or compliance costs, although this does happen.

It is a fact that many SMEs have a very hard time obtaining financing from conventional institutions, especially when it comes to carrying out R&D. Does this give rise to a market deficiency in Canada? Would you say this is the main reason such deficiency needs to be corrected by business grants in Canada and/or government incentives?

I think you are right to highlight the financing problems of young innovative firms. They don’t have a track record and their activities are hard to understand for most lenders and investors. The case for government intervention is strongest at the seed capital or angel investor stage. Entrepreneurs tend to be risk-averse because they cannot diversify their portfolios. As a result, investment in risky start-ups is too low from society’s perspective.

The “side-car” investment approach now used in the venture capital segment could be used to subsidize the supply of seed capital. In this approach, the government passively invests in angel investors, capping its upside return but accepting the possibility of loss of all the capital invested. Angel investors would select projects to finance without input from the government participant. This investment model raises the expected return to the private investors, which will increase supply. Some of the increase in expected return will be passed on to entrepreneurs, prompting more of them to accept financing offers.

From the perspective of administering funds, which, in your opinion, is a more effective delivery platform; grants or refundable tax credits?

Refundable tax credits are similar to grants in that access does not depend on the tax status of firms: all firms meeting stated criteria obtain funding. As a result, refundable tax credits have been classified as program spending since 2012 in all jurisdictions in Canada. There are, however, two important differences between the two delivery mechanisms. First, business grants in Canada have a funding cap but refundable tax credits do not. Second, the time and money spent selecting recipients for grants can make them more expensive to deliver than refundable tax credits. Strictly defined, grants are unconditional subsidies: recipients are not required to report on the use of funds and are not audited. However, subsidy programs often take the form of “contributions”, which are subject to performance conditions, reporting requirements and audits. Recipients of refundable tax credits are subject to audit.

As a result, each delivery vehicle can play a role. Refundable tax credits are provided for R&D performed by smaller firms since there are spillovers from all of the R&D performed. In most other cases, the potential benefits are narrower in scope so grants or contributions are more appropriate. The higher administration and compliance costs of contributions are, nevertheless, a concern. Governments should consider adopting measures to reduce this burden while maintaining accountability for spending. One possibility is to follow the example of CRA and perform selective audits of recipients.

The government always seems to tout jobs as its number one priority. Certainly, any press release on awarding government funding to a company always seems to underline the number of new jobs that the fund will create. However, you seem to indicate that business grants in Canada, or non-repayable contributions to businesses to hire labor—especially highly skilled labour—are generally not successful. Can you expand on this?

It is virtually impossible for business subsidies to create additional permanent jobs. The reason is that subsidies have to be financed, either by higher taxes or by cutting other government spending. Both of these alternatives will reduce the demand for labour, more or less exactly offsetting the jobs created by the subsidies. That does not mean business subsidies are always ineffective. In some cases, such as the performance of R&D, the market supply is too low, so government support can improve outcomes.

You indicate that there could be better transparency and accountability for the public if they knew where and whom government subsidies were allocated to. Do you think it would be useful for specific subsidy/grant programs to publish the assistance received by each recipient company? What are your thoughts on the National Research Council’s new public disclosure prototype?

There is a substantial amount of detailed information on transfer payments – including business subsidies – in the public domain. For example, the federal government publishes the names of all recipients of government transfers worth at least $100,000 in the public accounts and digitally through its open data initiative. The ministry, department, the name and location of the recipient, together with the total amount paid is shown. Some provincial governments provide similar information in digital format. The use of blockchain technology to provide information on IRAP contributions is in the same category.

Publishing details of subsidies is helpful, but it has to be in a form that facilitates analysis. The federal and provincial data on transfer recipients is difficult to use to obtain a clear picture of what the government is spending money on. More useful would be an historical dataset showing transfers to business by type (grant or contribution, including amounts recovered), by the department and program.

Do business grants in Canada have achievable policies? Is there a way of achieving them more effectively?

Almost half of government spending on business subsidies harms rather than helps economic performance. The reason for this poor outcome is that governments often intervene when markets are doing a good job of allocating labour and capital to where it is the most efficient. If business subsidies were only deployed to address market failures, their success rate would be closer to 100%.

If you could make any changes to improve Canada’s current system of government grants and incentives for businesses, what would it be and what impact do you think it would have?

Governments should be required to set out the rationale for implementing business incentives, the expected overall benefits and costs of the program, and provide information on the distribution of benefits and costs. That is, governments should explain why markets are failing to allocate labour and capital to their best uses, explain how the intervention will improve overall economic performance and provide some assurances that financing of the incentive does not redistribute income from poorer to richer Canadians.

Governments should also be required to evaluate the outcome of subsidies (and collect the data required to perform these evaluations). The evaluations of program success should be conducted by a third party. There is plenty of evidence that internal evaluation of program success is not working. There is an inherent conflict between internal evaluators and the minister responsible for the program. Internal evaluators are not going to report that programs supported by the minister are harming rather than helping economic performance. As a result, most internal evaluations do not address program success, focusing on improving program delivery instead. The exceptions occur when the minister has already decided that the program is not meeting its objectives.

This interview was conducted by Brian Cookson, President and Managing Director at RDP Associates.