Why the little firms do not deserve all the tax breaks the Chancellor gives them

When it comes to promoting innovation, it's a company's age - not size - that matters

THE CHANCELLOR displayed a certain fiscal fondness for small firms in his Pre-Budget Report. Among the political goodies are tax breaks on share options for key players in small enterprises - "Enterprise Management Incentives"; 20 per cent corporation tax-relief for large firms investing in companies with under £15m assets - "corporate venturing"; Enterprise Grants for firms with under 250 people employed; generous capital allowances for plant and machinery investment; an R&D tax credit for small enterprises and many more lollipops for the little guys.

THE CHANCELLOR displayed a certain fiscal fondness for small firms in his Pre-Budget Report. Among the political goodies are tax breaks on share options for key players in small enterprises - "Enterprise Management Incentives"; 20 per cent corporation tax-relief for large firms investing in companies with under £15m assets - "corporate venturing"; Enterprise Grants for firms with under 250 people employed; generous capital allowances for plant and machinery investment; an R&D tax credit for small enterprises and many more lollipops for the little guys.

Support for small and medium-sized enterprises or SMEs is a strategy commanding support across the political spectrum, from the Opposition benches to the bureaux of Brussels. But what exactly is so great about small firms? Are they really the backbone of Britain?

The number of people working in smaller workplaces has certainly been growing but this, by itself, is certainly no argument for government intervention. Novelty is crucial to economic success, but innovation is more likely to come from companies because they are new rather than because they are small. This crucial distinction is often forgotten.

Government statistics show that workers in small workplaces are worse off than those in large workplaces. If you are employed in a small firm you will tend to have lower earnings, less training and a greater chance of losing your job because the firm is more likely to go belly up. Smaller firms create more jobs, but they also destroy more jobs.

Is this a peculiar problem of the UK economy? In fact, research on US firms has confirmed over and over again the same pattern as the UK - and more besides. One overview by Harvard academics also pointed to the worse fringe benefits and health and safety records of smaller firms.

The Tories were as keen on small firms, but less bothered about pay and conditions. So are small firms good because they are more productive and innovative? Again, the picture is not encouraging. Enterprises with under 200 employees account for about 13 per cent of R&D. Their productivity also tends to be lower. In manufacturing, for example, enterprises with under 200 employees produced less than £25,000 of value added per person. This compares with £30,000 per head in medium-sized firms (200-999 employees) and over £40,000 per head in large firms (1,000 or more employees). So if Mr Brown succeeded in simply switching the bulk of the economy into the small firm sector he would score a curious own goal in meeting the productivity challenge - aggregate productivity would fall, not rise.

These figures do not make the case for giving extra resources large companies; they are a warning light against exaggerating the benefits of small firms.

The Chancellor is nobody's fool. There is plenty of evidence that new firms are a force for innovation and growth through their bold experimentation with new ideas and their ability to knock some competitive life into sleepy incumbents. But not all small firms are new, and not all new entrants are small. For example, Wal-Mart's entry through the Asda takeover is shaking up the sleepy UK retailing sector, but it is the largest retailer in the world. Reducing barriers to entry, getting tough with anti-competitive practices and encouraging start-ups through better access to finance are laudable features of the Chancellor's Pre-Budget Report. Giving additional support to small firms, especially those who have failed to grow, is much harder to justify.

Perhaps the best argument for helping small firms is that they have "shallow pockets". Small enterprises have trouble raising the cash necessary to invest and raise productivity. This may be particularly true for hi-tech firms whose main collateral is primarily their ideas. On the other hand, lack of funding for smaller firms may be simply because there is a high-objective risk that they will not give a decent return on an investment.

After all, in a competitive market lenders have big incentives to find projects with good rates of return regardless of who performs the investment. Empirical evidence suggests that even larger British companies have trouble in getting into the R&D game and face financial constraints. In any case, if there is a market failure with the system of finance then the disease should be tackled at source, not indirectly by dealing with only the symptoms.

Can we - should we - drop the obsession with size? The Chancellor has been spot on in promoting macro-economic stability through independence for the Bank of England and adoption of the golden rule for public finances. But the unhealthy preoccupation with size has lead to a plethora of initiatives which individually cost little, but tangled together may bring confusion and red tape. Reducing microeconomic uncertainty is just as important as macroeconomic stability in promoting investment.

A quiet achievement of New Labour has been to redistribute income to families with small incomes. This has reversed years of redistribution to the rich from the poor under the Conservatives. There is, however, no obvious ethical justification for redistributing resources towards smaller firms. In my view, there is some economic justification for giving extra help to new firms, but no compelling reason to give extra help to firms who are small per se. It's time to take a long, hard look at whether being financially underweight is really a reason for government largesse.

John Van Reenen is a Professor of Economics, at University College London and a Research Follow at the Institute for Fiscal Studies.