The Small Business Loans Act Economic Impacts. Prepared for: Industry Canada Corporate and Industrial Analysis Branch Contract Number: 67SFC HCA

Transcription

1 The Small Business Loans Act Economic Impacts Prepared for: Industry Canada Corporate and Industrial Analysis Branch Contract Number: 67SFC HCA Analysis and Author C.A. Sonnen Review G. Bromfield October 4, 1994 Informetrica

2 Executive Summary Study Focus and Method of Analysis This study estimates the general economic effects of loan insurance provided to lenders pursuant to the Small Business Loans Act (SBLA). These are measured as impacts on output, employment, and incomes, with each detailed for sectors that are appropriate. For incomes, effects on government balances are given special attention. Impacts are based on an assumption that the SBLA leads directly to additional business investment. For analytical purposes, an annual representative portfolio of incremental investment in the amount of approximately $1.0 billion (at 1994 prices) has been assumed to occur in each year of An econometric model representing the Canadian economy (The Informetrica Model - TIM) has been used for this analysis. The attributes of this model are such that a full set of multiplier effects are generated. More specifically, output (and employment) effects that follow directly from investment spending, are reinforced by impacts on producers that are indirectly affected incomes. Further, as events in one year have effect in succeeding periods, such dynamic properties of behaviour in the economy are also represented in these results. Impacts on the economy are traceable to two distinct characteristics of the SBLA. Business investment spending is a demand on the production of the construction industry, manufacturers that produce durable goods, and the goods and services suppliers of these directly affected industries. Such investment spending is an allocation of the country s income to additional, potentially productive, real capital stock. Associated with the use of that additional capital stock, there will be positive and negative effects on employment, and the output of industries supplying the new capital. Measuring the effects of investment spending is relatively straight forward. Whether the new firms and capital stock add to production and incomes by supplying new products, introducing lower costs of production from use of new processes, or through the real income benefits of increased competition in industry markets is less certain.

3 Given this uncertainty, we have developed two impact cases: a Model-Informed Case, in which TIM s view of the interactions of capital, employment, and the behaviour that determines cost/price formation, best represent how the economy is effected, and a Say s Law Case, in which it is assumed that additions to the stock of productive capital automatically generate an increase in aggregate demand sufficient to ensure that all of the additional capital stock is employed. The body of the main report, and the text below, focuses on the results for the Model-Informed Case. Principal Findings Table 1 documents the principal, measured findings of the Model-Informed Impact, with this followed by a presentation of the highlights. Table 1 Major Economic Indicators, Model-Informed Impact (% Impact) Real Gross domestic product Business Capital Stock Employment Levels in 000s (a) Consumer price index Disp. Income/capita ($86) All gov t net lending ($Bn) (a) Federal (a) Current account balance (a) (a) Level Impact Although $1 billion of additional investment spending will be a significant increase in demand i.e., constitute a new market) for some elements of the construction industry, and manufacturers of durable equipment, the impact of this, and subsequent operation of the new capital stock and firms is unlikely to have a major proportional effect on overall output and employment. 2

4 Of the employment increases reported in Table 1, approximately 10,000 each year are traceable to the additional business investment. The growing balance is derived from our estimate of how the new firms and capital are impacting the economy over time. We estimate that the positive effect on the capital stock would exceed that of additions to output over time. This indicates that not all of the new capital stock would be employed, or equivalently, that production from the new capital would substitute for capital (and employment) otherwise available in the economy. Apart from the cyclically-related productivity gains in the near term, we do not anticipate a change in output per employee over the long term. This follows partly from the high concentration of SBLA financing in services sectors where personal service, rather than productivity benefits embodied in new machinery, appear to be the dominant sources of productivity improvement. Our estimate that aggregate price levels will be reduced, and that real incomes of households are improved, follows in from related to the functioning of the Unemployment Insurance (UI) system. SBLA-related increased competition in industry markets also contributes to a lower aggregate price level. Our estimate of effects on the federal balance includes an assumption that SBLA borrowers would pay an up-front fee of 2 per cent, and that SBLA experiences a 6.2 per cent loan-loss ratio spread over ten years. We also assume that UI contribution rates would be insensitive to changes in economic prospects in , but following that, would be sensitive to an improved UI Fund balance. Cumulated over , federal borrowing is reduced by $220 million under these circumstances. Borrowing of other governments and public-sector organizations is cumulatively reduced by $630 million over the same period. Additional business investment constitutes a direct positive effect on Canadian final demand. A significant proportion of this, and additions to domestic demand from the multiplier effects, will be satisfied by increased imports. We estimate that these effects would be stronger than impacts on (increased) exports and (reduced) imports that follow from operation of the new capital and generally lower price (and cost) levels. Accordingly, Canadian borrowing from foreigners is increased by $3.2 billion, cumulated over This should not necessarily be interpreted with alarm, since in a broad sense, such borrowing has financed $5 billion in additional capital formation. One may take the view that details of the SBLA-related investment or behaviour in the economy operates differently than we have estimated in the case above, and that these uncertainties are sufficient to cause increases in aggregate demand and output that match those of the enlarged capital stock. As Table 2 documents, the output and employment effects would be much larger over the medium term. Cumulated over , the reduction in federal borrowing increases to $1.7 3

5 billion, with borrowing of other levels reduced by $2 billion. We have excluded presentation of the effects on the Current Account because effects there would be conditional on the extent to which the new capital led directly to increased exports (or, reduced imports). Table 2 Major Economic Indicators, Say s Law Impact (% Impact) Real Gross domestic product Business Capital Stock Employment Levels in 000s (a) Consumer price index Disp. Income/capita ($86) All gov t net lending ($Bn) (a) Federal (a) (a) Level Impact Application of These Results to Current SBLA Lending Activity In the five months ended August 31, 1994, SBLA-insured loans were being written at an annual rate of $3.5 billion. A recent study completed by Carleton University Professors George Haines Jr. and Allan L. Riding, entitled: Recent Experience with the SBLA: Economic Impacts, Incrementality and Risk Profile Analysis, indicates that as much as 60 per cent of the loans would not otherwise have been made in the absence of the SBLA program. Using this proportion, the current annual rates of lending, and assuming there is no leverage on SBLA insured lending to produce larger investment flows through other lending or equity, an estimate of SBLA effects on the economy would start with the assumption that SBLA is incrementally generating $2.1 billion in business investment. 4

6 Scaling our results by 2.1 ($2.1 billion / $1 billion) suggests that employment in 1994 is being increased by 23,500 if the Model-Informed view of impacts in correct. If this scale of new lending continues through 1998, then the Model-Informed view suggests SBLA-related employment increases by 1998 of 39,700. A Say s Law view of the impacts would suggest employment increases in 1998 of almost 161,000. CONTENTS 1 BACKGROUND TO, AND OBJECTIVE OF, THIS STUDY METHOD OF ANALYSIS Statement of The Impact Question Overview of Approach Used In This Study Two Impact Cases Basis For Estimating Industry And Structures/Equipment Distribution SBLA As Model Inputs Investment And Its Distribution Other Model Assumptions and Modifications IMPACT ON NATIONAL ECONOMY Model-Informed Impacts Say s Law Impact CONCLUSIONS AND QUALIFICATIONS OF THIS STUDY.. 19 APPENDIX A APPENDIX B APPENDIX C APPENDIX D APPENDIX E TIM MODEL STRUCTURE TIM INDUSTRIES: INVESTMENT INVESTMENT ASSUMPTIONS, $ IMPACTS INVESTMENT ASSUMPTIONS, PER CENT IMPACTS MODEL-INFORMED IMPACT TABLES

7 1 BACKGROUND TO, AND OBJECTIVE OF, THIS STUDY By ensuring that the Government of Canada has been liable to pay an approved lender 85 per cent of the amount of any loss sustained by the lender, The Small Business Loans Act (SBLA) encourages financing by 1200 lending institutions to targeted groups. Those targeted are small businesses in a wide range of industries, with lending support for start ups and expansion. Changes to the Act, effective April 1, 1993, have expanded the list of industries eligible for support, increased the size of loans and businesses (measured by revenues) that are eligible, the extent of the government guarantee, and fees charged by government. Subsequent to April, lending under the SBLA has increased rapidly. Industry Canada is reviewing several aspects of this program. Of some import to the federal treasury is the question of whether increased fees charged for each loan made under the SBLA are sufficient to cover the pooled risk of loans that fail. Related to this, but also of separate interest, is the question of whether the lending supported is incremental to loans that the private financial institutions would provide in the absence of the government guarantee support. Questions of these kinds are addressed in a recent report of Professor Haines and Riding of Carleton University, who were commissioned to prepare a study by the Department. 1/ The report concludes that somewhat more than one-half the loans made would not otherwise have been made in the absence of the SBLA program. Also reported in that study were survey-based indications that the expanded real capital supported by the SBLA lending led to increased sales (two-thirds of respondents), new jobs (88 per cent), cost decreases (29 per cent), an increased ability to export (9 per cent), and that lending helped the firm to survive (two fifths). That is, the survey suggested that a priori (from economic reasoning) influences that generate a sustainably larger economy are at work. In support of

8 Page 2 innovation, the new capital facilitates the production of new products (possibly reflected in increased sales and in export increases), and new processes (seen in cost reductions). Whether the new, and otherwise supported, firms added to average productivity of the industries in which they are located, and how this affected prices, wages, and additions to income and employment is uncertain from this report, given its partial focus on SBLA recipients and, through surveys of the Canadian Federation of Independent Business, small business, more generally measured. Nor does it provide information that would suggest beyond the rough indicators inferred above, what mechanisms may be at work to increase industry and total-economy output, real incomes and employment. This study is targeted on those questions. This is accomplished by assuming that SBLA lending has the effect of generating approximately $1 billion (at 1994 prices) of new business investment in each of That is, we assume this investment effect is incremental (would not occurred in the absence of the SBLA) to the economy. 1/ George Haines, Jr. and Allan L. Riding, Recent Experiences with the SBLA: Economic Impacts, Incrementality and Risk Profile Analysis. August 17, The Haines and Riding study has assessed the extent to which SBLA lending is incremental. As well, if SBLA loans are leveraged by equity participation or other lending then an SBLA loan could well generate an increase in investment that is larger than the size of the SBLA loan. Again, other studies at Industry Canada will evaluate the extent to which this occurs. In any event, for those who apply these results to an SBLA flow of loans, the effects herein should be scaled to reflect incrementality and leverage ratios, and the difference between the flow of funds assessed and the $1 billion assumed in this study. An example may be useful. In the five months ended August 31, 1994, SBLA-insured loans were being written at an annual rate of $3.5 billion. Haines and Riding concluded that as much as 60 per cent of the loans would not otherwise have been made in the absence of the SBLA program. Using this proportion, the current annual rates of lending, and assuming there is no leverage on SBLA insured lending to produce larger investment flows through other lending or equity, an estimate of SBLA effects on the economy would start with the assumption that SBLA is incrementally generating $2.1 billion in business investment. Accordingly, one could scale (up) the results of this report for real economic activity (e.g., output, employment) by 2.1 times to develop an estimate of impacts derived from recent SBLA lending activity. 2 METHOD OF ANALYSIS

9 Page Statement Of The Impact Question The Impact of business investment that follows from SBLA lending can be decomposed into two main influences. 1. Investment spending of those who are the beneficiaries of the loans uses Canadian economic resources to supply the machinery, and goods and services that go into construction of structures housing the businesses, or in leasehold improvements and other modifications to existing business infrastructure. Net of the direct and indirect import content needed to supply the additional equipment and materials for structures, supply of these requirements adds to employment, and provides income for the labour and businesses supplying these materials. Re-spending of these incomes in the form of additional household consumption, and investment by the supplying businesses, can induce yet more expansion to the economy. 2. From the point-of-view of the borrowing small business, the purpose of investing in new fixed capital, obviously, is to provide goods and services demanded domestically, or by foreigners. Several mechanisms exist for achieving this objective. The firm may produce new products and services not otherwise available in their market. They may use new processes or otherwise be more productive than other firms supplying like goods and services, using this advantage to take market share away from existing firms by offering their outputs at lower prices than can otherwise be obtained by customers. The SBLA-benefited firm may produce standard products using standard processes, but still survive if other supply was not otherwise available. For this to be incremental to the economy, private financing would have been insufficiently informed of this opportunity. These firm-based views of the direct impact of financing new, productive fixed capital must be reflected in aggregate economic activity if there is to be a positive overall impact of the original lending. With additional capital, industry and economy-wide capital deepening is occurring that should be reflected in improved output per employee (labour productivity ) as successive years of new improved real compensation of labour may occur to provide the basis for inducing, through consumption, further expansion of the economy. Or, such productivity gains may be allocated to property (beyond those necessary to cover the capital consumption of the SBLA-related capital) inducing yet further investment spending by business. Or, the productivity benefits may be allocated in the form of lower industry prices leading to increased real demand for the industry s (and economy s) products and services. Notwithstanding productivity effects, impacts may occur in any event. Through

10 Page 4 SBLA-related increased supply, strengthened competition in industry markets may lead to reduced prices faced by consumers. Absent productivity effects, this would imply reduced industry returns to capital for incorporated and unincorporated businesses. Pressure on property incomes could lead to downward pressures on industry-wide wage rates, providing yet another mechanism for reduced prices. 2.2 Overview of Approach Used In This Study This study looks at both elements of the impact that can be traced to the SBLA program in that SBLA-related investment is introduced into the economy and the consequent increase in the economy s productive capital stock is assessed to determine its consequences. The procedure for estimating these effects follows standard macroeconomic impact protocols. A Base Case view of economic activity is prepared, assuming there is no SBLA program. A second, Impact Case view of the future is prepared, assuming the SBLA program is introduced into the economy. Comparison of the Impact to Base Case economies constitutes the measures of economic effect. In this study, the assessment is provided for each year of An econometric model is used to formalize the measurements, and to provide a discipline to thinking about the impacts. The Informetrica Model (TIM) is the model employed. Appendix A provides an overview of the model s structure. Here, we highlight some features that are notably relevant to the study of the SBLA. Although frequently characterized as a macroeconomic model focused on total measures of economic performance and relations between real measures of activity and government fiscal monetary and other instruments, TIM is highly detailed in industry terms. That is, the model may be otherwise characterized as a collection of industry models (approximately 120), linked together as descriptions of national aggregate economic performance through more traditional perceptions of a macroeconomic model. For each of the industries separately identified in TIM, elements of production are specified in that labour and capital, with requirements for operating goods and services, are specified. Payments to labour and property, with payments for purchased goods and services, serve as the basis for price determination for each industry, with indirect taxes and subsidies also influencing price formation of each. Final, and intermediate industry, demand is again separately identified for each of the approximately 120 industries. Demand prices, which are sensitive to industry prices, as well as incomes, population and other influences, determine demand in detail.

11 Page 5 This disaggregated, or highly detailed, structure of TIM is relevant to an analysis of the SBLA. Access to that program is qualified by industry (firms in some industries are ineligible for support) and by size of firm. As the proportion of small firms in some industries where access is otherwise eligible is large or small depending n the industry, the effect of the SBLA on industry productivity, unit labour and capital costs, and prices will vary because of varying industry characteristics. Put in other terms, the detail available in TIM permits a more precise introduction of the SBLA program into the economy than is customarily possible with most macroeconomic models. TIM, like most macroeconomic models, has dynamic characteristics, in that impacts in one year have an influence on economic performance in succeeding periods. SBLA-related investment in one year alters the size of the capital stock, and relationship between capital and labour in all succeeding years. In each of those succeeding years, changes to productivity, and decisions about how this affects incomes of labour and capital vary by industry. In aggregate, this alters overall price measures, dynamically affecting wage and price formation in succeeding years. Disaggregation in TIM is a key to understanding or results. As is detailed in a later section, SBLA-related investment is introduced into the model detailed by industry. Further, for each industry, investment is divided between investment in machinery and equipment and for structures. As a consequence, the leakage of this increase in demand to imports is sensitive to the nature of the investment spending that is undertaken by each of the industries that SBLA affects. Industries that invest in advanced, high technology equipment for which little production capacity exists in Canada will cause less Canadian production than investment spending by industries that can purchase their equipment from an established domestic supply capacity. Investment in new structures, or leasehold improvements, will require cement, bricks, structural steel, and other products normally produced in Canada, and where import content is inhibited by the sensitivity of the construction materials to transport costs. Evaluation of how the SBLA-related increase in productive capital has influence on the economy is also aided by the disaggregation of TIM. Prospects for productivity impacts, or for the allocation of productivity gains between labour, capital, and customers (price reductions) will vary significantly between, for example, the fisheries, trucking industry, and investments made in restaurants or recreational facilities. Model details enable us to review how each of these influences varies at the industry level. The aggregation of industries within the model ensures that the weighting of these varying influences is properly calculated to yield overall results. 2.3 Two Impact Cases

12 Page 6 In defining the impact of SBLA, we draw on administrative data to ensure that a representative view of direct impacts on the investment of industries is produced. These are drawn from a period when the economy was in a recovery, or operating strongly, a condition of that we presume will also prevail. Thus, in degree as cyclical influences have effect on investment opportunities by industry, some standardization of the impact for conditions that we believe will prevail has been incorporated into this impact study. Eligibility and other changes to the Act since March 1993, qualify this representativeness, but are likely second-order problems. Of greater doubt about effects are the consequences that follow from the operation of the new firms and capital that are supported by the SBLA. Do the new, or expanded, small businesses add new products (a fully incremental effect), or new processes with reduced unit costs of production and prices, or do they simply crowd into an already supplied industry, perhaps leading to losses for firms that are not, or were earlier supported by the SBLA? TIM, with our review, generates estimates of how these effects occur across industries and over time. Output (and employment) is increased, but by the fifth year of impact, the increase in output of the business sector is only 0.2 per cent while the increase in the size of the capital stock available to business has increased by 0.4 per cent. In short, some part of the SBLA-related capital stock is not being used, or equivalently, has substituted for the capital stock of other firms. We characterize this impact as the Model-Informed view of the effects, and it represents our best estimate of the likely effects, given the limited time and resources available to undertake this study. These results, however, do not meet the test of Say s Law, which argues that supply creates its own demand. Accordingly, we provide a second impact case in which it is presumed that foreign and domestic demand is exogenously increased sufficient to meet the test of Say s Law. This provides an upper boundary to effects that should occur. 2.4 Basis for Estimating Industry And Structures/Equipment Distribution As was noted above, among the input elements that should provide an impact that is specific to SBLA activity are views on which industries, at the margin, re beneficiaries of the loans. Further, whether the loans are used to finance equipment or structures purchases is also key to impacts related to investment, as well as to impacts that follow from an increase in the size of an industry s capital stock. Distributions of SBLA-related investment will vary from year-to-year based on the following: where the economy is in the business cycle, other external influences that may affect the risk perception of financial

13 Page 7 intermediaries, and structural changes to the SBLA itself, altering the enterprises/industries qualified for support, lending rates, and investment project coverage that is qualified (90/100 rule). Although changes to the Act since April 1993 will have effect on the distribution, and other survey data exist to indicate which industries are borrowing, the universe of SBLA borrowing is described only by SBLA administrative data. Accordingly, we draw on this for FY1989 and FY1990 (two strong-economy years) as indicative of SBLA lending distributions. We compare that picture to total business investment in approximately the same period. On review of this, it is clear that the distribution of loans made across industries, and for each industry, between investments made for structures and purchase of equipment did not change by major amounts between the two years. Accordingly, tabular information below uses the averages for those two years. Industry Distribution Table 1 provides a comparison of the industry distribution of SBLA loans with total business investment made in calendar years 1989 and / Table 1 Industry Distribution of Loans and Total Business Investment (per cent) ----System of National Accounts---- SBLA Loans(1) Equivalent Industry Total-Economy Fisheries Manufacturing Construction Communications Transportation Wholesale Trade (2) ---- Retail Trade Services Businesses Total (1) Excludes lending for loan and premises purchases (2) The Informetrica Model does not distinguish Trade Sector Investment Put on an equivalent footing (i.e., excluding the investment spending of the 45 per cent of the economy that was not industry-eligible), the SBLA lending is disproportionately concentrated in (1) services businesses, (2) domestic trade, (3) transportation, and (4) construction firms. There

14 Page 8 was also a disproportionately large amount of funding for the fisheries, but this is a small share of lending and investment activity. On the other hand, loans to manufacturing and communications firms were small compared to investment activity carried out in those industries. Distribution Affecting Impacts on Construction and Equipment Suppliers The impacts on the economy of investment activity (the investment shock ) are sensitive to the import content of the spending. Funds allocated to building or renovating structures have much lower direct and indirect import content than do funds allocated to the purchase of equipment. In Table 2, below, we have counted SBLA-defined funds allocated to Movable Equipment as purchases (in TIM and the System of National Accounts) of Machinery and Equipment. Other SBLA-defined spending ( Fixed Equipment, Improvement of Premises, and Construction of Premises ) have been allocated to TIM-defined investment in Structures. SBLA support of Purchase of Premises and Purchase of Land are regarded as spending for assets with no direct consequence on resource use in the economy. Accordingly, they both drop out of the impact. In 1989 and 1990, loans for these purposes accounted for per cent of loans to wholesale trade, retail trade, and services businesses, and 5 per cent of loans extended to manufacturing and construction. The proportions were smaller for fisheries, communications and transportation. Table 2 provides a view of the distribution of spending for equipment and structures, by industry, both for SBLA lending, and for spending of equivalent industries in the economy. Again, the table reports averages for As was true for the industry allocation, a detailed review indicated a high degree of stability in these distributions for the two years, and we report averages. 2/ Appendix B provides a tabulation displaying the industry investment categories available in TIM. This may be compared to the following seven categories denominated in the SBLA Annual Reports: fisheries, manufacturing, construction, communications, transportation, wholesale trade, retail trade, and services businesses. In mapping these to TIM categories, we have assumed the following detailed industries within our sectors are excluded: transportation, excludes air, rail, water, pipeline and storage to leave motor transportation as the sole SBLA-impacted industry within this sector, commercial services, excludes investments by education, religious and other membership organizations, and other institutional, to leave the investment that affects all other personal, community and business enterprises as the SBLA-impacted group. Fully excluded sectors include: agriculture, forestry, mining, utilities, and finance, insurance and real estate. Notice that the Haines and Riding distribution includes small amounts for mining and finance, insurance and real estate.

15 Page 9 Finally, while the SBLA data distinguish wholesale from retail trade, TIM does not disaggregate these, and we have had to aggregate SBLA spending for these two categories into one total trade investment. As this suggests, SBLA loans appear to be a little less equipment-intensive than does actual investment in the industries we are using as comparable to those of the SBLA-defined industries. The major exceptions appear to be in the fisheries and transportation where SBLA lending supports investment principally in equipment (boats and related equipment, and trucks?). Other things equal, the investment shock should be a little larger for an SBLA-defined view of the shock than would be the case if we used the distributions that occurred in the equivalent industries in Whether these distributions from are representative or not is an open question. That applies to both the SBLA distribution, and that of investment in the economy, among these industries. The economic accounts (and our tuned view of 1994 in our current forecast), indicates a strong increase in the proportion allocated to equipment since the end of Seen in aggregate, this is explained in part by the collapse of investment in commercial service structures investment, reflecting the over-building in commercial real estate in the late 1980s. That shift in distribution, however, is also apparent for manufacturing and communications. No notable changes occurred for fisheries, construction, or trade, and the structures element in transportation has increased notably. Table 2 Structures/Equipment Distribution of Loans and Total Business Investment, by Industry (per cent) Economic Accounts for SBLA Loans (1) Equivalent Industry Equipment Structures Equipment Structures Fisheries Manufacturing Construction Communications Transportation Wholesale Trade (2) Retail Trade Services Businesses Total (1) Excludes lending for loan and premises purchases (2) The Informetrica Model does not distinguish Trade Sector Investment

16 Page 10 In the early-1980s recession, and initial recovery from that, this distribution change does not appear to have occurred, either at the aggregate level, nor in the industry details. On that partial evidence, the recent change in distribution does not appear to be related to the business cycle. One can only speculate about what structural influences, and accidents of the past, may be at work; and even if they could be identified, one would have to determine how much longer the adjustments occasioned by the structural changes will last. Some speculations follow. The accident of over-building by the commercial real-estate industry is thought, by the consensus, as likely to have lasting (negative) effects on investment in structures for another 2-3 years. This implies that current (not reflected in the distribution) low levels of spending in the economy for structures, undertaken by the finance insurance and real estate industry, and services businesses would continue until late in the decade. This may also be having influence on currently low proportions of structures investment being undertaken by manufacturing and communications. Manufacturing may have an independent story, with the accident of so many establishments going bankrupt at the opening of the decade leaving a legacy of unused structures suitable for manufacturing. Other structural changes (e.g., GST,, FTA and NAFTA) may be accelerating the adoption of new technology with this embodied in new equipment that does not require major changes to the structures in which the equipment is housed. Any successful implementation of an information highway strategy provides mixed signals for equipment/structure distributions. On the one hand, carrier companies are likely to be looking at major new structures investments (optical cable replacement) accompanied by appropriate digital equipment. The space-savings features of new computing and communications equipment, on the other hand, suggests that information content suppliers will be focused on equipment investment, not structures. And whether any of this relates to SBLA lending to communications is problematical if most of this is supporting package and other courier services. Limitations of Cod and other fisheries in the Atlantic make the implications for the fisheries difficult to predict. There should be vast quantities of unemployed equipment around, but no fisheries in which to use it (even at fire-sale values for the assets). This does not suggest a switch towards structures, since structures for landing the catch (and fish processing facilities) will be in similar abundance. Aquaculture is a new chic replacement, and whether its mix of structures and equipment is different from the norm, and which would come first (structures or equipment) to influence the view of the next few years, is problematical.

17 Page 11 Based on a review of Tables 1 and 2, and considerations of the kind outlined immediately above, we, and Industry Canada officials, have assumed that the SBLA distributions represented in Tables 1 and 2 should be construed to be representative of likely patterns applicable to Our decision was influenced by the fact that distributions in the economy among industries, and with some exceptions, between machinery and structures did not change much over the past six years. Distributions of investment within manufacturing are not informed by SBLA administrative data. For that sector, TIM separately identifies spending for 31 industries. Based on discussions with Industry Canada, we have assumed that the following industries are excluded as candidates for SBLA lending: industrial chemicals, pulp and paper (but paper converters remain in), iron and steel, non-ferrous smelting, petroleum and coal refining, primary textiles, aircraft manufacture, shipbuilding and railroad equipment manufacturing. Unfortunately, TIM does not distinguish between assembly (SBLA size-excluded) and parts in the investment and capital stock for the automotive industry, but as we assume parts manufacturers are part of the SBLA beneficiaries, we have included investment in the motor vehicle industry as an element of the SBLA shock. Of the manufacturing industries that are left in, we have distributed our impact across these proportionate to Base Case distributions. Notice from Table 1 that manufacturing as a whole is only 8 per cent of total SBLA lending, so any departures these assumptions make from the real SBLA world within manufacturing are going to be weighted by this relatively small overall share for the sector. 2.5 SBLA As Models Inputs Investment and Its Distribution - TIM measures real demand on the economy, and real measures of production in terms of 1986 prices. To provide a standardized view of the impact, however, we have introduced the impacts at a level that would be consistent with five years of impacts at approximately $1 billion at 1994 prices. Table 3 provides a view of the ex ante shock in terms of nominal prices, 1994 dollars, and TIM-required 1986 dollars. Appendix C details each of these for all industries in TIM. Distributions were allocated as indicated in Table 1 and as per our assumptions for distributing investment within manufacturing. Table 3 Ex Ante Investment Total Economy (Millions of Dollars) at Nominal prices at 1994 Prices

18 Page 12 at 1986 Prices The following interesting features should be noted. Although our impact was designed to test the implications of a $1 billion (at 1994 prices) shock for each of , our procedures for allocating this amount to individual industries, with varying investment deflators, has yielded an amount that is slightly smaller. Thus, any use of these results for scaling effects to reflect independent estimates of incrementality and leverage should use the annual figures reported in Table 3. A steady increase in nominal investments over time, relative to 1986 or denominated investments indicates a moderate (1.4 per cent) increase in annual investment prices for the SBLA package we have assumed. Note, however, that the 1986-denominated investment in the year 1994 is larger than the nominally denominated investment, indicating that since 1986, the SBLA aggregate of investment prices has fallen slightly. This reflects the well-known decline in computer and communications equipment deflators, and sensitivity of the SBLA investment package to this phenomenon. Nothing in this view of price levels, or changes in the future, would have significant effect on the scale of the impacts we report. Among the industries apparently being affected by the SBLA, most lending (as was reported in Table 1) is concentrated in commercial services, trade, and transportation. Given independent estimates of where small business is most heavily concentrated, this should not be a surprising result. Appendix D portrays the investment impact as a per cent of likely (Base Case) investment, by industry. As this indicates, per approximately $1 billion of SBLAfinanced investment, the SBLA investment exceeds or approximates 10 per cent of investment in the fisheries and truck transportation. In wholesale and retail trade, combined, the proportion is in the range of 7 per cent. If true SBLA-related financing (net of incrementality and leverage considerations) is larger than the $1 billion that underpins these calculations, then it is clear that SBLA-related financing is a very significant portion of financing for enterprises in some industries. 2.6 Other Model Assumptions And Modifications Among the results we report are fiscal ( balance ) effects for Canadian governments, by level. Other things equal, a positive effect on economic activity will tend to generate positive effects for government balances through increased personal and corporate income tax, and other

19 Page 13 revenues, and reduced expenditures for unemployment insurance, welfare payments, etc. In this regard, we have assumed that the UI contribution rate would be unaffected over , reflecting federal government policy stipulated in the Spring 1994 Budget. Table 4 Federal Loan-Loss Payments ($ millions) at Nominal Prices (19.3) (14.4) Note: ( ) indicates net contribution to federal treasury To ensure that federal fiscal results in our analysis incorporate directly related expenses of SBLA (provisions for loan loss), we have assumed such federal payments occur. Following discussions with officials at Industry Canada, we have assumed these are equivalent to 4.2 per cent of the stock of SBLA loans that are simulated. This follows from a 6.2 per cent loan loss ratio, spread over ten years, less a 2 per cent, up front, fee assumed to be in place for The annual flows of such assumed federal spending are reported in Table 4. Other things equal, TIM presumes employment increases in the fisheries and truck transportation are tied through a production function to output in those industries. Demand effects on the output of these industries are muted in the model, leaving little effect on output, and therefore, employment. The administrative record, as reflected in Annual Reports, and the high concentration of lending in those industries to machinery suggests this is financing of entrepreneurial start ups (purchases of truck tractors, boats, etc.). That record indicates the number of loans, and we have accordingly increased our estimate of non-wage employment approximately in line with such administrative records. This modification of the model structure adds about 1,000 to employment in 1994, rising to almost 2,000 by Other things equal, this would result in a sharp increase in industry selling prices (unit labour and capital costs would rise). We have offset this effect from the employment assumptions with a view that returns to unincorporated income are reduced. Effectively, for these two industries, this presumes that much of the additional supply is reflected in reduced, per firm, returns to property across the industry; that is, the new supply crowds out incomes of existing suppliers. 3 IMPACT ON NATIONAL ECONOMY 3.1 Model-Informed Impacts

20 Page 14 Appendix E provides several tabulations reporting the impact of our $1 billion SBLA investment shock, assuming that TIM acts as the principal evaluator of how the impact is translated through the economy. Table 5 summarizes some of the key features of the result. Highlights of this include the following. Measured by total real output, the impact on the economy as a whole of $1 billion in incremental SBLA lending is small, considering both the impact following from the demand for resources to supply the investment goods, and operation of the firms that are direct beneficiaries of the SBLA lending. As this represents a direct shock to investment spending, the single largest proportional impact is on business investment, among expenditure categories. Induced effects on consumption are equivalent to about 20 per cent of the ex ante investment shock, but proportionate to Base Case consumption, this effect is only about 0.5 per cent. This reflects a positive, but small, effect on disposable incomes of households. Induced effects on business investment are positive, but very small (less than 5 per cent of the ex ante shock). Table 5 Major Economic Indicators SBLA Model Informed % Impact Gross domestic product at market prices (Bn$86): Consumption expenditure Government expenditure Business investment Residential Nonresidential construction Machinery & equipment Inventory change (a) Net Exports (a) Exports (+) Imports (-) Gross domestic product Business Capital Stock Employment

21 Page 15 % Impact Gross domestic product at market prices (Bn$86): Levels in 000s (a) Wages ($000) & prices (1986=1): Wages per employee ($C) (1) Output per employee ($86) Total Factor Productivity Total unit labour cost Real Return on Corporate (a) Operating Surplus (%) Implicit deflator of GDP Consumer price index Incomes (Bn$C): Disp. income/capita ($86) Corp. profits before taxes All gov t net lending (a) Federal (a) Prov. & local, hospitals (a) Canada & Quebec pensions (a) Current account balance (a) Merchandise trade balance (a) (a) Level Impact Notes: (1) Includes supplementary labour income Leakages to imports are significant reflecting the high proportion of SBLA lending that is allocated to purchases of machinery and equipment. This, and the assumption that government fiscal benefits are used for debt reduction, yields an expenditure multiplier that is about 0.8, both in the impact year, and cumulated over the five years of The magnitude of the impact on imports is eroded over time, reflecting the reduction in Canada unit labour and capital costs that results from operation of the new firms. Still, increased imports remain significant in the fifth year, and the erosion of effects is muted in the case of the current account balance since earlier foreign borrowing adds cumulatively to interest payments to foreigners. Our estimate is that per $1 billion of SBLA-related incremental investments, employment would be increased by about 11,000 in the first year of the spending, rising to 19,000 after five successive years of a program operated at that same scale. We have made no effort to decompose this effect between employment related to the investment spending and operation of the SBLA-financed firms. Using interim simulations as a guide, we judge that the investment spending generates

22 Page 16 approximately 10,000 of employment annually. The balance of the employment effect reported here is then traceable to operation of the firms that benefit directly from the SBLA financing. The balances of provincial and local governments, the hospital system, and public pensions are unambiguously improved in each of the five years. Despite the assumption that federal expenditures for loan losses are directly increased as reported in Table 4, the federal government balance is also positively affected in During this period, reduced payments for unemployment insurance are uncompensated by an adjustment in the UI contribution rate, given current policy. The cumulative improvement in the UI account over the three years amounts to almost $1 billion. The relatively low multiplier reported follows partly from this (presumably transitory) stance of fiscal policy that balance benefits are not re-cycled back to spending sectors in contribution rate reduction, or any other, form. In any event, in 1997, however, we assume that contribution rates would return to the longer-term policy of sensitivity to impacts on the UI Fund s balance, and contribution rates decline to reflect improvements in the account. This, with rising loan loss obligations, yields a negative impact on federal balances in 1997, and, at a smaller amount, again, in It should be noted that the reduction in the UI contribution rate in 1997 has other significant consequences. Reduction of this payroll tax in that year reinforces deflationary pressures otherwise generated by an enlarged capital stock and, implicitly, larger number of enterprises. Reduced prices are reflected in a significant improvement in real disposable incomes, and through this, increased personal consumption. Reduced unit costs of production also have positive effects for net exports. A key to understanding the effects of this impact over the last several years of the impact lies in the effects on costs and price formation. The assumed capital deepening across a broad range of industries yields improved labour productivity (in labour terms) for most industries, the notable exceptions being the fisheries and truck transportation. Aggregate productivity initially is improved, mainly through cyclical benefits, but in the longer term is little changed as resources are shifted through the details of SBLA financing from industries with high to lower productivity levels. Improved employment prospects in construction (from the increased demand for structures) and in commercial services (e.g., food and accommodation, personal services, and recreation services) from the increase in the number of firms financed by the SBLA suggest a positive impact on nominal wage rates, thereby distributing at least part of the productivity gain in those industries to labour. How much is the key issue. We have taken the view that an increased number of suppliers in those industries will dampen the positive effect on nominal wage rates in those industries,