Economists believe that the government should not distort the private sector’s efficiency in allocating scarce resources. However, in reality, government often acts in an indirect manner by creating policy in order to encourage entrepreneurs to invest in certain sectors. SR&ED and flow-through shares are both examples of government incentives for entrepreneurs.
Canada is the global leader in mining and resource finance in the world because of the federal government’s flow-through share program. The flow-through share program is a Canadian innovation that is widely successful. Flow-through shares are an effective way of generating investment when immediate capital costs are high, and the profit is distant, by converting current and future losses into present operating capital. The flow through share is a common share on which the issuer renounces qualifying expenses to the share subscriber, who can then deduct the qualifying expenses for personal income tax purposes.
Flow-through shares provides up to a 45% rebate back to the investor, in the form of tax deductions at the highest marginal tax rate. They also allow the issuer to obtain a premium for its shares, in exchange for the investor’s tax deductions. This provides increased cashflow for the issuer in exchange for losses that are of no immediate use to the issuer.
The SR&ED program operates in a very similar manner. When the government provides tax credits for research and development expenses, it incentivizes the company to conduct research and development, while still allowing it to allocate its own capital. If the company opts to invest in research and development, then the (refundable) tax credits it receives can then be redeployed back into the company, and be used to create more jobs.
Both the SR&ED and flow-through share program are examples of how government can incentivize certain activities instead of “picking winners.” These programs showcase how the government can play productive roles in the private sector without creating inefficiences and distorting the private business environment.